Well, if we look at all the billions of people on this planet [AJC: is it 6 billion or 8 billion now … damn, I lost count] … the chances are minuscule.
If we take all the people who use the Internet daily … still microscopic.
If we take all the people who read Personal Finance blog … not much chance.
If we pick all people who read the self-prophesying headline to this post …. bloody great! You see, it WAS a trick question of sorts …
… all to lead me on to the subject of Probability … as in “it’s probable that your eyes will glaze over just about now, and you’ll click back to Pamela Anderson’s home page” … brought to my attention by a recent post from an excellent blog by All Financial Matters, appropriately titled Probability 101.
Even if you hated math [AJC: in other countries, known as: maths] and statistics, stick with me past this excerpt:
I’m in the process of reading Peter Bevelin’s awesome book, Seeking Wisdom – From Darwin to Munger (Not an Affiliate Link). I HIGHLY recommend this book for anyone interested in investing and behavioral finance. As boring as that sounds, this book is a page-turner. One of the sections of the book that I found most interesting was this illustration of probability on page 151:
A lottery has 100 tickets. Each ticket costs $10. The cash prize is $500. Is it worthwhile for Mary to buy a lottery ticket?
The expected value of this game is the probability of winning (1 in 100) multiplied with the prize ($500) less the probability of losing (99 our of 100) multiplied with the cost of playing ($10). For each outcome we take the probability and multiply the consequence (a reward or a cost) and then add the figures. This means that Mary’s expected value of buying a lottery ticket is a loss of about $5 (0.01 × $500 – 0.99 × $10).
The first comment that I would make is that whilst you need to understand the basics of a ‘good decision’ against a ‘bad decision’ in probability/statistical terms, simply running your eye over the key line “A lottery has 100 tickets. Each ticket costs $10. The cash prize is $500” should do the trick:
If you bought all 100 tickets, at $10 each, you would spend $1,000. But you would only win the cash prize of $500 … are YOU smarter than a 3rd Grader?
But, as one of the comments on that post pointed, out not all decision that SEEM to be mathematical ARE simply mathematical:
Unfortunately, probability doesn’t always translate directly into real-life situations.
Let’s take your example of the lottery, except we’ll change things up a little.
Mary is 50 years old and approaching retirement. She’s been financially savvy for her entire life and has accumulated $1M in cash.
Donald Trump decides to hold a lottery for only Mary. One ticket costs $1M, and she has a 50% chance of winning $10M.
If you looked at just probability, her EV is -(0.5 x $1M) + (0.5 X $10M), or +$4.5M. Does that mean she should buy the ticket? Obviously, no.
I think what this comment is saying is that EVEN THOUGH you have a 50/50 chance of winning 10 times your money, you shouldn’t invest your entire life savings into it … because you have an equal chance of ending up flat broke!
The concept is good, but I take issue with the “obviously no” bit …
The numbers in this example are ridiculously skewed for most people, so I tried to give some ‘closer to home’ examples in my post centred on that popular game show, Deal or No Deal.
It all boils down to this:
When a decision is potentially Life Changing … the numbers count less … the possible result counts more.
In practice:
1. You should understand basic probability because it is so important in life,
BUT
2. You should first make the Life Decision then look at the odds …
Deal or No Deal?!
