Here’s a neat concept that everyone can use, from professional poker players to Warren Buffett. In Alice Schroeder’s biography, The Snowball, she describes how in his youth, Warren was good at assigning odds to each horse in a race. This is called “handicapping.” Schroeder uses this as an analogy to explain how Buffett calculates investment probabilities.
It’s also the same concept underlying my previous post, How much is my startup worth?
Here it is in simple terms:
Your roof is leaking somewhere. The roofer offers a complete replacement of the roof for $10,000. He offers a 100% guarantee that your roof will be leak-free for three years, or else he’ll come back and completely replace it again for free. He gives you an alternative, as well: he can patch this one mossy spot for $2,000. He estimates that there’s a 25% chance this patch will fix the leak.
If you choose the patch, you have a 25% chance of saving yourself a $10,000 replacement. That’s kinda like saving 25% of $10,000, or $2,500. To get this chance, you have to spend $2,000 for the patch. In mathematical terms,
Value of Patch = -$2,000 + 0.25*$10,000 = $500
The $500 is what I’m calling Sklansky dollars, and it represents the increased economy of trying the repair first.
Crucially, these 500 Sklanksy dollars were still there even if you elect the repair and it doesn’t work. Now you’re in for the cost of the patch, $2,500, plus the cost of the replacement, $10,000, or $12,500 total. It hurts. But it was justifiably the right call to try the patch first because you had positive Sklansky dollars for that decision.
For further reading, read it in poker terms.