Recently I saw a question posted in a Twitter account. Interesting question.
You have 2 options. 1. Get instant 1 million dollar in your hand now.
2. A 50% chance to win $50 million.
The second option is like, if we get heads from the toss of a coin, we can take $50 million home.
If tails, then we have to leave to home empty handed.
In short, 100% chance of $1 million.
or 50% chance of $50 million.
Let's Indianise this question.
Take 10 crore rupees home now. Or play a game to win 500 crores that has 50% chance of winning.
Which option would you choose? Have it chosen. We will analyse both the options in this episode.
Hi. My name is Vijay Mohan. You are watching - Investment Insights.
What did you choose?
"When we have a bird in hand, why bother about the birds in the bush? So just get the 10 crores and walk away" - Right?
Wise choice. But is it the right choice?
If it is the wise choice, wouldn't it be the right choice? Not necessarily.
What is the value of option 1? That is very clear - 10 Crore rupees.
Value of option 2? 500 Crores - but only 50% chance of winning it.
Then how can we calculate its value?
For that, we should use probability theory to calculate the expected value.
"Probability theory? This is not going to work out" - you might get nervous.
No problem. It is just a simple formula.
The chance of winning times the value of the prize.
So for our question, it is 50% times 500 crores = 250 crores.
So the value of second option is 250 crores.
Oh by the way, at school, we might learn complicated topics in Maths like Trigonometry, Calculus etc.
They might come handy in our career. But in our personal life, we rarely use them.
But the probability and statistics will be very helpful in our personal life especially with many investment decisions.
So it is important that we have our kids give special attention to Probability and Statistics while they grow up.
Now let's come back to our question.
Value of option 1 is 10 crores.
Value of option 2 is 250 crores.
So logically, we should have chosen option 2. But why did we choose option 1?
Now let's change this question little bit.
Option 1 is 10 rupees. Option 2 is, a 50% chance to win 500 rupees.
What would you choose now? 10 rupees? What can we do with that?
Second option looks much better. right?
Both the questions follow the same logic. A logic person would choose same option for both the questions.
Where is this difference coming from? It is not coming from logic.
It is coming from the value of the money which has potential to change our life.
10 Crores is something that has potential to totally change our life for many of us.
So we do not try to gamble with that.
Not just 500 crores, even for a 1000 crores we will not take that gamble, but will settle for this 10 crores.
This is called as "Marginal utility of money".
The first 10 crores in the 500 will make a huge impact in our life compared to the rest of the 490 crores.
That is why we are settling for 10 crores easily.
But the 10 rupees in second scenario is nothing.
That is why we are tempted to try out the chance of winning 500 rupees.
What is the purpose of this question now? There is a reason.
If we have given the same choice to Warren Buffet, what would he have chosen?
His networth Today is 10,000 crores. 10 crores is nothing for him.
This 10 crore is not going to bring any change to his life.
For his situation, he would look at the expected value to make the right choice.
That is 250 crores in second option, which is 25 times greater than 10 crores.
So given a choice, he would choose that second option. It will be the right choice and wise choice for him.
So what is right for Warren Buffet, does not have to be right for us.
His game is totally different from ours.
The marginal utility of money is totally different for different folks.
That is why we should not try to mimic folks like Warren Buffet or Ray Dalio.
This is personal finance. We have to make it personal to fit our needs.
There is no need to know about others portfolio.
It is good enough to invest in any asset that we understand well.
If we do not know about an asset, it is better to understand it better before investing in them.
We should never invest in an asset just because someone else is doing.
We will soon meet again in another episode. Thank You.