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.

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

1. For each scenario, ask: "If this outcome happened, how would it actually affect my life relative to my current position?"
2. Downscale the subjective value of outcomes that would be genuinely catastrophic beyond what the dollar amount suggests.
3. Be willing to accept lower raw EV in exchange for a variance reduction that protects against ruin.
4. Use the Kelly criterion or similar tools for decisions where ruin is a real scenario (gambling, highly concentrated investments).

Evidence

Expected 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. (observational)

Prospect theory describes how people do behave, not necessarily how they should; normative risk adjustment requires honest assessment of personal utility, which is hard.

Sources

• 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.