Updated: Jun 4, 2020
It’s important to manage risk. It’s something you’ve probably heard thousands of times before. But what does it really mean to manage risk?
If you wanted to learn how to manage risk, where would you go? Some might ask executives from an insurance company. After all, their whole business based on their ability to model risk and assign a price to that risk.
If your Allison Schrager, author of “An Economist Walks Into A Brothel”, you would go talk to sex workers, gamblers, and professional surfers to understand what risk management really means. If you are looking for an entertaining way to learn about managing risk, I highly recommend this book.
Let’s review some of the important topics discussed in the book.
We have a flawed view of risk
As Schrager points out, the human brain is not well equipped to comprehend risk. Many people view risk as “cause and effect.”
If I invest, I will lose my money.
If I speak my mind, I will alienate people.
If I ask her out, I’ll get rejected.
Many people have an “if this, then that” view of risk. However, risk is rarely that simple as to have a direct cause and effect.
Risk is simply an action that exposes you to a range of possible outcomes. Some of those outcomes are good, and some are bad. Each outcome has a different magnitude and a distinct probability.
The human brain is hard-wired to avoid risk. In an effort to protect itself from danger, the brain will overweight the probability and the magnitude of a bad outcome. This was a useful evolutionary feature when making a risky choice could have ended with being eaten by a bear.
This tendency to assume the worst outcome helped the human race survive long enough to get where we are today. However, looking at risk as cause and effect rather than a range of possible outcomes can hold us back.
Every risk should be taken with an end goal in mind
Before you make a risky decision, it’s essential to ask yourself what is the best possible outcome for the action I am about to take and how that can move be closer towards a clearly defined goal.
One of my clearly defined goals is to achieve financial independence. So, when I make the decision to invest my hard-earned money in a risky asset like stocks, I do so knowing two things.
The best possible outcome is that I achieve an exceptional return on investment.
That outcome will move me towards my goal of financial independence.
Every “risk-free” choice comes at a price
It is possible to achieve your goals without taking on risk, but the risk-free option always comes with a price.
In her book, Schrager uses the example of legal sex workers in the state of Nevada. Working in a legal brothel takes out much of the risk involved in illegal sex work. Primarily the health risk and risk of violence.
But, the risk-free option comes at a cost for sex workers. First, they have the relocation costs of moving to Nevada and then the fact that the legal sex workers give half of their earnings over to the brothel owner.
These costs are likely worth paying to avoid the possible negative outcomes of illegal sex work.
In a more relatable example, consider my goal of achieving financial independence.
I could achieve financial independence without investing in risky assets like stocks. But, to do so would require me to save a lot more money because the expected returns of non-risky assets are low.
The cost to me of avoiding risk is to save more of my money and thus lower my standard of living then if I embraced risk and invested in stocks.
We can avoid any risk if we are willing to pay. This transaction is best understood in the context of insurance. There are certain risks I am simply unwilling to take.
For example, the financial risk to my family if I died tomorrow is not a risk I am willing to take. So, I am willing to pay an insurance company a monthly premium in exchange for transferring that risk from my family to the insurance company.
A critical component of risk management is deciding whether or not you are willing to pay the price to take the risk-free option.
In the case of my achieving financial independence, I am not willing to pay the cost of avoiding risky assets like stocks.
In the case of my untimely death, I am willing to pay the insurance premium to remove the financial risk to my family.
Past performance is no guarantee of future results
When you invest in a mutual fund or an ETF, the fund provider sends you a legal document called a prospectus. This is a legal document that outlines the details of the investment fund. Buried in every one of these documents is a disclaimer that reads “past performance may not be indicative of future results.”
Translation: Just because a good or bad outcome has occurred from making a risky choice in the past does not mean the same result can be expected in the future.
Another reason the human brain is so bad at measuring risk is that it struggles with the concept of random outcomes.
Some of my friends enjoy gambling. So, I will, from time to time, find myself in a Casino. By far, the most interesting game to me is roulette.
There are 38 numbers on a roulette table.
18 black numbers.
18 Red numbers.
2 green numbers: “0” and “00”.
If you sit at a roulette table long enough, you will, without fail, see the same story play out.
The same color has come up multiple times in a row.
Let’s say it’s red. A red number has come up 5 times in a row.
Every time red comes up, the players around the table get excited and start aggressively putting more money down on black.
You’ll hear people say something like “a black number is due”.
In reality, black is not “due.” Each spin of the roulette wheel has a completely random outcome. Meaning that the next spin has zero correlation with the spins that came before it.
If the past 10,000 spins of the roulette wheel came up with a red number, the next spin has the same probability of coming up black as the 10,000 spins before it and the 10,000 spins after it.
The human brain can’t fully comprehend random outcomes, so it looks for patterns to cling on to.
This is why so many investors pour money into a stock that has had incredible recent returns.
Like the roulette player, they are making a bet based on what has just occurred, even though that has no impact on what will occur in the future.
Diversification helps manage unnecessary risk
There are two types of risk when investing in the stock market.
The risk of investing in the stock market through a low-cost index fund exposes you to systematic risk. Which is the risk that the entire stock market will crash. Something like an economic recession is a form of systematic risk, where nearly all stocks experience losses at the same time.
Investing in an individual stock also exposes you to both systematic risk and idiosyncratic risk, the risk facing an individual company.
If you are invested in an airline stock, the Coronavirus represents systematic risk as nearly all stocks are falling at once. However, since travel is restricted, and fewer people will be flying on planes, you are also exposed to idiosyncratic risk by investing in an airline stock.
The simple and powerful lesson for investors: idiosyncratic risk can be easily managed