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Risk is part of our lives and cannot always be avoided. We have to cross streets or drive in cars.
When we are faced with a risky situation, we can make a better choice when we consider the odds as well as the payoff.
We all spend time making decisions with some risk involved. We look at each situation and consider the likelihood that something will happen as well as if it would be worth it.
For example, whether to sprint across the street when the sign says “don’t walk.”
Expected value is then the odds of something happening multiplied by the cost of the expected value of the situation.
Part of the expected value is estimating the chance or probability of the situation.
Many people have poor judgement calculating real probabilities. They overstate the chance of rare events and underestimate the possibility of common events.
For example, many people don't like to fly on planes because they are scared they might be in a crash, yet the actual chance is close to zero.
The cost or payoff is not always clear.
For example, people feel more pain from the loss of a dollar than pleasure from a dollar gained. It is called loss aversion.
The prospect theory combines the ideas of loss aversion and over- and under-weighing the odds. It helps to calculate the real expected value.
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