We can use the simple example of a dice game. In this game, you bet $1 on the throw of a dice. Throwing a six wins a prize; throwing any other number means you lose your $1.
In version A of this game:
A bet costs $1, but you can win $10
Faced with this game, you have two alternatives - to play or not to play.
Once playing, there is nothing you can do to affect the outcome - so your decision on whether to play has to be made on the basis of the probabilities and impacts involved.
Because the situation is simple, the probabilities of the various possible outcomes can be objectively known. There is no subjectivity over the probabilities. The impacts, too, are fixed and clearly set out by the rules of the game (the prizes and the cost of playing).
If a choice is made to play, the probability of winning is 1 in 6 (0.166 or 16.66%) and the probability of losing 5 in 6 (0.834 or 83.4%).
If a choice is made not to play, risk is avoided (there is a single outcome that is certain) but there is also no potential benefit.
Decision tree for dice game version A:
Decision: Play dice game with chance of winning $10? Yes or No
NO
Decision ----> Risky Event ---> Possible outcomes ----> Probability -----> Impact
No -----> Nil ------> Avoid risk, keep money in pocket ----> 1.0 (certain) -----> Neurtral: spend ntohing, win nothing
YES
Decision ----> Risky Event ---> Possible outcomes ----> Probability -----> Impact
Yes -----> Stake $1 on throw of dice ----> Number 6 ----> 0.166 (1 in 6) ----> Gain Spend $1 Win $10
or
Yes -----> Stake $1 on throw of dice -----> Number 1, 2, 3, 4, or 5 -----> 0.834 (5 in 6) ----> Loss Spend $1 Win nothing
http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html
Keep INVESTING Simple and Safe (KISS) ****Investment Philosophy, Strategy and various Valuation Methods**** The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
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