Author: exor

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.

“The Butterfly Effect” is a fascinating theory. Even if you’re not very familiar with it, you likely believe one of its variations to be true at some level. You’ve likely seen two of my favorite movies with interpretations of this idea, “Back to the Future” and “The Butterfly Effect.” The version of the theory that interests me holds that changing small, seemingly inconsequential variations on the state of things has profound effects on the future.

This version is difficult to grasp for most of us, since our assumptions about the nature of the universe are often fatalistic. For example, say that your home football team lost by a touchdown, and you were not at the game. Would your presence have made any difference in the game at all? People generally think it would not have, unless you directly interacted with the team during the game.

But, consider: you’re interacting with the fans next to you, which sets off a small divergence in the way they act, which in turn affects others next to them. Effects compound over time; they are changes that continue to multiply with each other in increasing magnitude, similar to how a seemingly inconsequential change in a shot in the game of pool would have large effects if the table were sufficiently frictionless, giving the balls a chance to move around enough.

Our intuitions will normally disagree with this. They are fatalistic in that we tend to believe on some level that there’s an inherent dampening effect in the universe, where our small actions that effect small changes will be mitigated over time, such that any long-term future state of the world will be indistinguishable whether we do one action or another (so long as that action is sufficiently small). In other words, the confusion seems to come from an unrecognized assumption that the effects of our actions are buffered, leading to some tendency for small actions to lose consequence over time as the state of things settles toward some “normal” state, which supposes a universe with laws akin to fate or predestination.

It seems The Butterfly Effect will always stay an unprovable “theory” since we cannot test it. However, computers will be able to model the world with increasing accuracy, giving us a much more clear understanding of the butterfly effect through simulation.