CIMA P1 Syllabus D. Dealing With Risk And Uncertainty - Expected Values - Notes ^{2 / 5}

The ‘expected value’ rule calculates the average return that will be made if a decision is repeated again and again.

It does this by weighting each of the possible outcomes with their relative probability of occurring.

It is the weighted arithmetic mean of the possible outcomes.

The likelihood that an event will occur is known as its probability.

This is normally expressed in decimal form with a value between 0 and 1.

A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 signifies absolute certainty.

A probability of 0.4 means that the event is expected to occur four times out of ten.

The total of the probabilities for events that can possibly occur must sum up to 1.0.

An expected value is computed by multiplying the value of each possible outcome by the probability of that outcome, and summing the results.

EV = ∑px

Where:
p = probability of the outcome 
 x= the possible outcome

A risk neutral investor will generally make his decisions based on maximising EV.

Limitations of expected values

1. Ignores the range of possible outcomes

2. Heavily dependent on probability estimates

3. Long-run average and therefore inappropriate for one-off decisions

4. EV may not correspond to any of the actual possible outcomes