Adjust raw expected value for risk aversion on large stakes
A 50% chance of losing everything is not equivalent to a certain 50% loss — adjust for your actual risk tolerance.
Key takeaways
- What it is: A 50% chance of losing everything is not equivalent to a certain 50% loss — adjust for your actual risk tolerance.
- Why it works: Raw expected monetary value ignores diminishing marginal utility: the pain of losing $10,000 is not just ten times the pain of losing $1,000; it can be much larger if the loss would meaningfully damage your situation. Utility theory formalizes this: for large stakes, convert monetary values to utility before computing EV. Practically, this means being willing to pay a premium to reduce variance when the downside would be catastrophic.
- Evidence: Backed by observational / correlational evidence.
- Avoid: Applying risk adjustment to small-stakes decisions (avoiding a coin-flip for $20) where expected value alone should dominate, while under-applying it to genuinely catastrophic scenarios.
Why it works
Raw expected monetary value ignores diminishing marginal utility: the pain of losing $10,000 is not just ten times the pain of losing $1,000; it can be much larger if the loss would meaningfully damage your situation. Utility theory formalizes this: for large stakes, convert monetary values to utility before computing EV. Practically, this means being willing to pay a premium to reduce variance when the downside would be catastrophic.
How to do it
- 1For each scenario, ask: "If this outcome happened, how would it actually affect my life relative to my current position?"
- 2Downscale the subjective value of outcomes that would be genuinely catastrophic beyond what the dollar amount suggests.
- 3Be willing to accept lower raw EV in exchange for a variance reduction that protects against ruin.
- 4Use the Kelly criterion or similar tools for decisions where ruin is a real scenario (gambling, highly concentrated investments).
What the evidence says
ObservationalExpected utility theory (von Neumann & Morgenstern) and its successors (prospect theory, Kahneman & Tversky) establish that people’s subjective response to outcomes is non-linear, justifying risk adjustment beyond raw EV in high-stakes decisions.
Honest caveat: Prospect theory describes how people do behave, not necessarily how they should; normative risk adjustment requires honest assessment of personal utility, which is hard.
- — Kahneman & Tversky (1979), prospect theory: an analysis of decision under risk, Econometrica
Common mistake
Applying risk adjustment to small-stakes decisions (avoiding a coin-flip for $20) where expected value alone should dominate, while under-applying it to genuinely catastrophic scenarios.
IX Coach flags when a decision’s downside scenarios would be genuinely life-altering and prompts a utility-adjusted analysis before recommending the highest raw-EV option.
Practice this with IX Coach →