Coin Flip Strategy
If a coin landed on heads 60% of the time and you are offered 1:1 odds would you play? Short answer, yes obviously we should play. The expected value is 20% per flip. EV = 0.6*x - 0.4*x = 0.2 But how much should you bet? This depends on your individual risk appetite. There is a whole area of economics dedicated to studying this known as utility theory . Economists use utility functions to quantify human preferences of different choices. Each individual aims to maximize their utility function. This can be applied to investment decisions with respect to the risk reward trade-off. For a given level of utility there is an indifference curve that represents the tradeoff between additional risk and additional expected return. An investor can be expected to get the same satisfaction from each point on this curve. This is all a fancy way of saying that traditional risk measurements do not account for the subjective aspect of risk. Everyone has a different attitude toward...