Expected Value
Table of Contents
Core Formula
EV = Σ (Probability of outcome x Value of outcome)
EV = (p₁ × v₁) + (p₂ × v₂) + ... + (pₙ × vₙ)
where probabilities must sum to 1.0
Example: Launch feature with 60% chance of $100k revenue, 40% chance of -$20k sunk cost.
EV = (0.6 x $100k) + (0.4 x -$20k) = $60k - $8k = $52k (positive EV, rational to launch if risk tolerance allows)
Workflow
Copy this checklist and track your progress:
Expected Value Analysis Progress:
- [ ] Step 1: Define decision and alternatives
- [ ] Step 2: Identify possible outcomes
- [ ] Step 3: Estimate probabilities
- [ ] Step 4: Estimate payoffs (values)
- [ ] Step 5: Calculate expected values
- [ ] Step 6: Interpret and adjust for risk preferences
Step 1: Define decision and alternatives
What decision are you making? What are the mutually exclusive options? See resources/template.md.
Step 2: Identify possible outcomes
For each alternative, what could happen? List scenarios from best case to worst case. See resources/template.md.
Step 3: Estimate probabilities
What's the probability of each outcome? Use base rates, reference classes, expert judgment, data. See resources/methodology.md.
Step 4: Estimate payoffs (values)
What's the value (gain or loss) of each outcome? Quantify in dollars, time, utility. See resources/methodology.md.
Step 5: Calculate expected values
Multiply probabilities by payoffs, sum across outcomes for each alternative. See resources/template.md.
Step 6: Interpret and adjust for risk preferences
Choose option with highest EV? Or adjust for risk aversion, non-monetary factors, strategic value. See resources/methodology.md.
Validate using resources/evaluators/rubric_expected_value.json. Minimum standard: Average score ≥ 3.5.
Common Patterns
Pattern 1: Investment Decision (Discrete Outcomes)
- Structure: Go/no-go choice with 3-5 discrete scenarios (best, base, worst case)
- Use case: Product launch, hire vs. not hire, accept investment offer, buy vs. lease
- Pros: Simple, intuitive, easy to communicate (decision tree visualization)
- Cons: Oversimplifies continuous distributions, binary framing may miss nuance
- Example: Launch product feature (60% success $100k, 40% fail -$20k) → EV = $52k
Pattern 2: Portfolio Allocation (Multiple Options)
- Structure: Allocate budget across N projects, each with own EV and risk profile
- Use case: Venture portfolio, R&D budget, marketing spend allocation, team capacity
- Pros: Diversification reduces variance, can optimize for risk/return tradeoff
- Cons: Requires estimates for many variables, correlations matter (not independent)
- Example: Invest in 3 startups ($50k each), EVs = [$20k, $15k, -$10k]. Total EV = $25k. Diversified portfolio reduces risk vs. single $150k bet.
Pattern 3: Sequential Decision (Decision Tree)
- Structure: Series of decisions over time, outcomes of early decisions affect later options
- Use case: Clinical trials (Phase I → II → III), staged investment, explore then exploit
- Pros: Captures optionality (can stop if early results bad), fold-back induction finds optimal strategy
- Cons: Tree grows exponentially, need probabilities for all branches
- Example: Phase I drug trial (70% pass, $1M cost) → if pass, Phase II (50% pass, $5M) → if pass, Phase III (40% approve, $50M revenue). Calculate EV working backwards.
Pattern 4: Continuous Distribution (Monte Carlo)
- Structure: Outcomes are continuous (revenue could be $0-$1M), use probability distributions
- Use case: Financial modeling, project timelines, resource planning, sensitivity analysis
- Pros: Captures full uncertainty, avoids discrete scenario bias, provides confidence intervals
- Cons: Requires distributional assumptions, computationally intensive, harder to communicate
- Example: Revenue ~ Normal($500k, $100k std dev). Run 10,000 simulations → mean = $510k, 90% CI = [$350k, $670k].
Pattern 5: Competitive Game (Payoff Matrix)
- Structure: Your outcome depends on competitor's choice, create payoff matrix
- Use case: Pricing strategy, product launch timing, negotiation, auction bidding
- Pros: Incorporates strategic interaction, finds Nash equilibrium
- Cons: Requires estimating competitor's probabilities and payoffs, game-theoretic complexity
- Example: Price high vs. low, competitor prices high vs. low → 2×2 matrix. Calculate EV for each strategy given beliefs about competitor.
Guardrails
Probabilities should sum to 1.0: Listed outcomes need to be exhaustive (cover all possibilities) and mutually exclusive (no overlap). Verify: p1 + p2 + ... + pn = 1.0.
Adjust for risk on one-shot, high-stakes decisions: EV is a long-run average. For rare, irreversible decisions, factor in risk aversion. A 1% chance of $1B (EV = $10M) does not mean betting the house is rational.
Quantify uncertainty, don't hide it: Probabilities and payoffs are estimates. Use ranges, sensitivity analysis, or distributions rather than pretending false precision.
Consider non-monetary value: Some outcomes have utility not captured by money (reputation, learning, optionality, morale). Convert to a common scale or use multi-attribute utility.
Ground probabilities in data: Use base rates, reference classes, data, and expert forecasts rather than gut feel. Check calibration: are "70% confident" predictions right 70% of the time?
Account for correlated outcomes: If outcomes are not independent (e.g., economic downturn affects all portfolio companies), correlation reduces diversification benefit.
Time value of money: Discount future cash flows to present value. EV should use NPV, not nominal values.
Consider option value: In sequential decisions, fold-back induction finds optimal strategy. Factor in the option to stop early, pivot, or wait for more information.
Common pitfalls:
- ❌ Ignoring risk aversion: EV($100k, 50/50) = EV($50k, certain) but most prefer certain $50k. Use utility functions for risk-averse agents.
- ❌ Anchor on single scenario: "Best case is $1M!" → but probability is 5%. Focus on EV, not cherry-picked scenarios.
- ❌ False precision: "Probability = 67.3%" when you're guessing. Use ranges, express uncertainty.
- ❌ Sunk cost fallacy: Past costs are sunk, don't include in forward-looking EV. Only future costs/benefits matter.
- ❌ Ignoring tail risk: Low-probability, high-impact events (0.1% chance of -$10M) can dominate EV. Don't round to zero.
- ❌ Static analysis: Assume you can't update beliefs or change course. Real decisions allow learning and pivoting.
Quick Reference
Key formulas:
Expected Value: EV = Σ (pᵢ × vᵢ) where p = probability, v = value
Expected Utility (for risk aversion): EU = Σ (pᵢ × U(vᵢ)) where U = utility function
- Risk-neutral: U(x) = x (EV = EU)
- Risk-averse: U(x) = √x or U(x) = log(x) (concave)
- Risk-seeking: U(x) = x² (convex)
Net Present Value: NPV = Σ (CF_t / (1+r)^t) where CF = cash flow, r = discount rate, t = time period
Variance (risk measure): Var = Σ (pᵢ × (vᵢ - EV)²)
Standard Deviation: σ = √Var
Coefficient of Variation (risk/return ratio): CV = σ / EV (lower = better risk-adjusted return)
Breakeven probability: p* where EV = 0. Solve: p* × v_success + (1-p*) × v_failure = 0.
Decision rules:
- Maximize EV: Choose option with highest EV (risk-neutral, repeated decisions)
- Maximize EU: Choose option with highest expected utility (risk-averse, incorporates preferences)
- Minimax regret: Minimize maximum regret across scenarios (conservative, avoid worst mistake)
- Satisficing: Choose first option above threshold EV (bounded rationality)
Sensitivity analysis questions:
- How much do probabilities need to change to flip decision?
- What's EV in best case? Worst case? Which variables have most impact?
- At what probability does EV break even (EV = 0)?
Key resources:
- resources/template.md: Decision framing, outcome identification, EV calculation templates, sensitivity analysis
- resources/methodology.md: Probability estimation, payoff quantification, decision tree analysis, utility functions
- resources/evaluators/rubric_expected_value.json: Quality criteria (scenario completeness, probability calibration, payoff quantification, EV interpretation)
Inputs required:
- Decision: What are you choosing between? (2+ mutually exclusive alternatives)
- Outcomes: For each alternative, what could happen? (3-5 scenarios typical)
- Probabilities: How likely is each outcome? (sum to 1.0)
- Payoffs: What's the value (gain/loss) of each outcome? (dollars, time, utility)
Outputs produced:
expected-value-analysis.md: Decision framing, outcome scenarios with probabilities and payoffs, EV calculations, sensitivity analysis, recommendation with risk considerations
1---2name: expected-value3description: Calculates probability-weighted averages of all possible outcomes to enable rational decisions under uncertainty. Covers scenario identification, probability estimation, payoff quantification, and risk-adjusted interpretation. Use when comparing risky options (investments, product bets, strategic choices), prioritizing projects by expected return, assessing whether to take a gamble, or when user mentions expected value, EV calculation, risk-adjusted return, probability-weighted outcomes, or decision tree.4---5# Expected Value
6
7## Table of Contents
8- [Workflow](#workflow)
9- [Common Patterns](#common-patterns)
10- [Guardrails](#guardrails)
11- [Quick Reference](#quick-reference)
12
13## Core Formula
14
15**EV** = Σ (Probability of outcome x Value of outcome)
16
17```
18EV = (p₁ × v₁) + (p₂ × v₂) + ... + (pₙ × vₙ)
19where probabilities must sum to 1.0
20```
21
22**Example**: Launch feature with 60% chance of $100k revenue, 40% chance of -$20k sunk cost.
23EV = (0.6 x $100k) + (0.4 x -$20k) = $60k - $8k = **$52k** (positive EV, rational to launch if risk tolerance allows)
24
25## Workflow
26
27Copy this checklist and track your progress:
28
29```
30Expected Value Analysis Progress:
31- [ ] Step 1: Define decision and alternatives
32- [ ] Step 2: Identify possible outcomes
33- [ ] Step 3: Estimate probabilities
34- [ ] Step 4: Estimate payoffs (values)
35- [ ] Step 5: Calculate expected values
36- [ ] Step 6: Interpret and adjust for risk preferences
37```
38
39**Step 1: Define decision and alternatives**
40
41What decision are you making? What are the mutually exclusive options? See [resources/template.md](resources/template.md#decision-framing-template).
42
43**Step 2: Identify possible outcomes**
44
45For each alternative, what could happen? List scenarios from best case to worst case. See [resources/template.md](resources/template.md#outcome-identification-template).
46
47**Step 3: Estimate probabilities**
48
49What's the probability of each outcome? Use base rates, reference classes, expert judgment, data. See [resources/methodology.md](resources/methodology.md#1-probability-estimation-techniques).
50
51**Step 4: Estimate payoffs (values)**
52
53What's the value (gain or loss) of each outcome? Quantify in dollars, time, utility. See [resources/methodology.md](resources/methodology.md#2-payoff-quantification).
54
55**Step 5: Calculate expected values**
56
57Multiply probabilities by payoffs, sum across outcomes for each alternative. See [resources/template.md](resources/template.md#ev-calculation-template).
58
59**Step 6: Interpret and adjust for risk preferences**
60
61Choose option with highest EV? Or adjust for risk aversion, non-monetary factors, strategic value. See [resources/methodology.md](resources/methodology.md#4-risk-preferences-and-utility).
62
63Validate using [resources/evaluators/rubric_expected_value.json](resources/evaluators/rubric_expected_value.json). **Minimum standard**: Average score ≥ 3.5.
64
65## Common Patterns
66
67**Pattern 1: Investment Decision (Discrete Outcomes)**
68- **Structure**: Go/no-go choice with 3-5 discrete scenarios (best, base, worst case)
69- **Use case**: Product launch, hire vs. not hire, accept investment offer, buy vs. lease
70- **Pros**: Simple, intuitive, easy to communicate (decision tree visualization)
71- **Cons**: Oversimplifies continuous distributions, binary framing may miss nuance
72- **Example**: Launch product feature (60% success $100k, 40% fail -$20k) → EV = $52k
73
74**Pattern 2: Portfolio Allocation (Multiple Options)**
75- **Structure**: Allocate budget across N projects, each with own EV and risk profile
76- **Use case**: Venture portfolio, R&D budget, marketing spend allocation, team capacity
77- **Pros**: Diversification reduces variance, can optimize for risk/return tradeoff
78- **Cons**: Requires estimates for many variables, correlations matter (not independent)
79- **Example**: Invest in 3 startups ($50k each), EVs = [$20k, $15k, -$10k]. Total EV = $25k. Diversified portfolio reduces risk vs. single $150k bet.
80
81**Pattern 3: Sequential Decision (Decision Tree)**
82- **Structure**: Series of decisions over time, outcomes of early decisions affect later options
83- **Use case**: Clinical trials (Phase I → II → III), staged investment, explore then exploit
84- **Pros**: Captures optionality (can stop if early results bad), fold-back induction finds optimal strategy
85- **Cons**: Tree grows exponentially, need probabilities for all branches
86- **Example**: Phase I drug trial (70% pass, $1M cost) → if pass, Phase II (50% pass, $5M) → if pass, Phase III (40% approve, $50M revenue). Calculate EV working backwards.
87
88**Pattern 4: Continuous Distribution (Monte Carlo)**
89- **Structure**: Outcomes are continuous (revenue could be $0-$1M), use probability distributions
90- **Use case**: Financial modeling, project timelines, resource planning, sensitivity analysis
91- **Pros**: Captures full uncertainty, avoids discrete scenario bias, provides confidence intervals
92- **Cons**: Requires distributional assumptions, computationally intensive, harder to communicate
93- **Example**: Revenue ~ Normal($500k, $100k std dev). Run 10,000 simulations → mean = $510k, 90% CI = [$350k, $670k].
94
95**Pattern 5: Competitive Game (Payoff Matrix)**
96- **Structure**: Your outcome depends on competitor's choice, create payoff matrix
97- **Use case**: Pricing strategy, product launch timing, negotiation, auction bidding
98- **Pros**: Incorporates strategic interaction, finds Nash equilibrium
99- **Cons**: Requires estimating competitor's probabilities and payoffs, game-theoretic complexity
100- **Example**: Price high vs. low, competitor prices high vs. low → 2×2 matrix. Calculate EV for each strategy given beliefs about competitor.
101
102## Guardrails
103
1041. **Probabilities should sum to 1.0**: Listed outcomes need to be exhaustive (cover all possibilities) and mutually exclusive (no overlap). Verify: p1 + p2 + ... + pn = 1.0.
105
1062. **Adjust for risk on one-shot, high-stakes decisions**: EV is a long-run average. For rare, irreversible decisions, factor in risk aversion. A 1% chance of $1B (EV = $10M) does not mean betting the house is rational.
107
1083. **Quantify uncertainty, don't hide it**: Probabilities and payoffs are estimates. Use ranges, sensitivity analysis, or distributions rather than pretending false precision.
109
1104. **Consider non-monetary value**: Some outcomes have utility not captured by money (reputation, learning, optionality, morale). Convert to a common scale or use multi-attribute utility.
111
1125. **Ground probabilities in data**: Use base rates, reference classes, data, and expert forecasts rather than gut feel. Check calibration: are "70% confident" predictions right 70% of the time?
113
1146. **Account for correlated outcomes**: If outcomes are not independent (e.g., economic downturn affects all portfolio companies), correlation reduces diversification benefit.
115
1167. **Time value of money**: Discount future cash flows to present value. EV should use NPV, not nominal values.
117
1188. **Consider option value**: In sequential decisions, fold-back induction finds optimal strategy. Factor in the option to stop early, pivot, or wait for more information.
119
120**Common pitfalls:**
121
122- ❌ **Ignoring risk aversion**: EV($100k, 50/50) = EV($50k, certain) but most prefer certain $50k. Use utility functions for risk-averse agents.
123- ❌ **Anchor on single scenario**: "Best case is $1M!" → but probability is 5%. Focus on EV, not cherry-picked scenarios.
124- ❌ **False precision**: "Probability = 67.3%" when you're guessing. Use ranges, express uncertainty.
125- ❌ **Sunk cost fallacy**: Past costs are sunk, don't include in forward-looking EV. Only future costs/benefits matter.
126- ❌ **Ignoring tail risk**: Low-probability, high-impact events (0.1% chance of -$10M) can dominate EV. Don't round to zero.
127- ❌ **Static analysis**: Assume you can't update beliefs or change course. Real decisions allow learning and pivoting.
128
129## Quick Reference
130
131**Key formulas:**
132
133**Expected Value**: EV = Σ (pᵢ × vᵢ) where p = probability, v = value
134
135**Expected Utility** (for risk aversion): EU = Σ (pᵢ × U(vᵢ)) where U = utility function
136- Risk-neutral: U(x) = x (EV = EU)
137- Risk-averse: U(x) = √x or U(x) = log(x) (concave)
138- Risk-seeking: U(x) = x² (convex)
139
140**Net Present Value**: NPV = Σ (CF_t / (1+r)^t) where CF = cash flow, r = discount rate, t = time period
141
142**Variance** (risk measure): Var = Σ (pᵢ × (vᵢ - EV)²)
143
144**Standard Deviation**: σ = √Var
145
146**Coefficient of Variation** (risk/return ratio): CV = σ / EV (lower = better risk-adjusted return)
147
148**Breakeven probability**: p* where EV = 0. Solve: p* × v_success + (1-p*) × v_failure = 0.
149
150**Decision rules**:
151- **Maximize EV**: Choose option with highest EV (risk-neutral, repeated decisions)
152- **Maximize EU**: Choose option with highest expected utility (risk-averse, incorporates preferences)
153- **Minimax regret**: Minimize maximum regret across scenarios (conservative, avoid worst mistake)
154- **Satisficing**: Choose first option above threshold EV (bounded rationality)
155
156**Sensitivity analysis questions**:
157- How much do probabilities need to change to flip decision?
158- What's EV in best case? Worst case? Which variables have most impact?
159- At what probability does EV break even (EV = 0)?
160
161**Key resources:**
162- **[resources/template.md](resources/template.md)**: Decision framing, outcome identification, EV calculation templates, sensitivity analysis
163- **[resources/methodology.md](resources/methodology.md)**: Probability estimation, payoff quantification, decision tree analysis, utility functions
164- **[resources/evaluators/rubric_expected_value.json](resources/evaluators/rubric_expected_value.json)**: Quality criteria (scenario completeness, probability calibration, payoff quantification, EV interpretation)
165
166**Inputs required:**
167- **Decision**: What are you choosing between? (2+ mutually exclusive alternatives)
168- **Outcomes**: For each alternative, what could happen? (3-5 scenarios typical)
169- **Probabilities**: How likely is each outcome? (sum to 1.0)
170- **Payoffs**: What's the value (gain/loss) of each outcome? (dollars, time, utility)
171
172**Outputs produced:**
173- `expected-value-analysis.md`: Decision framing, outcome scenarios with probabilities and payoffs, EV calculations, sensitivity analysis, recommendation with risk considerations