The Fallacy of Entrepreneurship’s Expected Value

There are plenty of popular entrepreneurship motivational bloggers who preach along the lines of “just do it.” Some even attempt to mathematically show the rational move is to initiate your startup. At the core of one  popular analysis is a false premise that leads people into deciding that they should “go for it” despite their intuition.

The following is from the popular poker entrepreneur Billy Murphy:

“So, if I was trying to decide whether I should work a job or start a business, could I use EV to help me?”

Absolutely— it’s a perfect spot to use EV.

Here’s how his expected value analysis would apply to deciding whether to start a business:

1. You can choose to “work for the man” or build your own business
2. You can calculate your expected earnings (the sum of all potential earnings outcomes times probability of each outcome) as an entrepreneur, and compare this to your known earnings as an employee
3. If your expected earnings as an entrepreneur are significantly greater in entrepreneurship, then you should go for it

Let’s overlook the success bias that entrepreneurs in general will have in assigning a probability to their chances of success, and assume that the entrepreneur is conservative in his estimates. The problem I want to point out is that of the marginal utility of wealth.

Consider that the incremental value of any dollar amount you receive will decrease each time your account increases by that amount: e.g. your first $50,000 matters a lot more to your well-being and happiness than does the next $50,000. This is known as the diminishing marginal utility of wealth.

In the probability analysis, this is not accounted for. The reason your intuition tells you not to start a business is the same reason that people play it safe and “work for the man.” They have a correct gut feeling that the $50,000 / year guaranteed salary provides greater expected utility to them than entrepreneurship. Going broke in entrepreneurship means losing out on the first $50,000 (having $0 – or worse, $0 and debt). Such a great amount of the expected utility of wealth is front-loaded into that. Your quality of life would probably decline much more in this case ($50,000 to $0) than it would from the effects of going from a $100,000 salary to a $50,000 salary.

Mr. Murphy’s expected value calculations are great in situations like poker games because many games are played over the course of life and you, the exceptional poker player, always come out ahead by playing the greater expected value (assuming you are wise enough never to risk everything in one hand, where you can lose everything). In the game of life, we have to consider the expected utility, not the expected value. And the expected utility of entrepreneurship is very low for most people.