In your recent article "10 Laws of Building Wealth", you scoffed at the investor that would choose a guaranteed payment of $3000 instead of an 80% chance of $4000. Your rationale was that the expected payoff for the latter is $3200, which is more attractive than $3000. However, the justification for using the "expected value" to compare alternatives is based on the Law of Large Numbers, which does not apply if we're given the choice just once. In that case, there's no way to combine risk and reward into a single neat metric, and the choice of $3000 versus an 80% shot at $4000 depends, quite rationally, on the risk aversion of the individual.
A Canadian's random thoughts on personal finance
Sep 22, 2008
The fallacy of large numbers
Today's post from Michael James just reminded me of a letter I sent to the editor of Money Sense magazine last summer: