An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

Technically, risk describes everything that might happen—both good and bad—and how probable each of these outcomes is.

in terms of financial economics: if you need to decide between two portfolios with similar returns, choose the one that is less risky.

Legal brothels offer something women can’t get on their own: safety in exchange for earnings. Brothel work is what is known in finance as a hedge: giving up some of your potential earnings in exchange for reducing risk.

In any illicit market—exotic animals, guns, sex, stolen IDs—what determines if an illegal good costs more or less than the legal alternative is who has more market power, the buyer or the seller.

You would not assume the risks of an illegal transaction (being arrested or fined, for instance) unless you stood to save a lot of money. This isn’t the case for most illegal markets, however: the seller charges a markup because she is hawking something that’s either hard to find (exotic animals or obscure currencies) or restricted (guns, sex, or drugs) in the mainstream market.

I assumed legal sex work would follow the more obscure illegal-market scenario.

But illegal sex is a risky purchase and customers are willing to pay to reduce that risk.

The brothel tries to take risk out of the equation at every possible step. If a customer pays with his credit card, the charge appears on his statement under a harmless-sounding name. The buyer values the safety of legal sex work so much that he’s willing to travel and pay a large premium; this in turn gives legal brothels market power and the ability to impose big markups for their services.

Unusual markets often provide the clearest insight into how risk is assessed, bought, and sold. Because nothing is hidden in markets like sex work, the subtleties that exist in all markets are made obvious. This is why we can learn the most by studying how business is conducted at the edges of the economy and apply that knowledge to more typical economic transactions.

Financial science aims to separate out what portion of a price is driven by risk. Once that price is clear, it becomes much easier to identify the risks we face and figure out the best ways to take and reduce risk.

In most areas of economics, value is based on scarcity. It doesn’t work quite the same way in financial economics. Financial economics assumes risk is also a critical component of value. Goods that lessen risk tend to cost more. This critical piece of information can revolutionize the way you assess everyday decisions and help you make better, more informed choices.

A cheap ticket comes with the risk of being forced to miss your flight. Purchasing a more expensive ticket reduces that risk.

Making a good risky decision requires transparency and spotting what you are paying for risk.

This book walks you through the following five rules for better assessing and employing risk in your life.

No risk, no reward.

Risking loss is the price we pay for the chance of getting more.

The biggest mistake people make when they take a risk is not having a well-defined goal.

It may seem counterintuitive, but the best way to define a risky reward is to start by defining the opposite of risk, whatever is risk-free.

I am irrational and I know it.

We have an aversion to loss and sometimes this can lead us to take bigger risks than we should or even realize.

How we perceive risk is often not based on objective probabilities; rather, it depends on how risk is presented to us.

Get the biggest bang for your risk buck.

But a bigger risk doesn’t always mean more reward. Sometimes we face two options that offer the possibility for the same expected reward, but one is riskier than the other. Taking more risk than necessary is inefficient.

Be the master of your domain.

One strategy to minimize risk is hedging. Hedging protects you from losing by a counterbalancing action, trying to strike a balance between risk and safety, like the women in the brothel do. Or, hedging might be taking two bets at the same time where one pays off when the other does not. The result is you give up some potential gains to reduce the potential for loss.

insurance, where you pay someone else to bear downside risk for you.

Uncertainty happens.

Risk estimates everything we think might happen, but there are also all the things we never imagined could happen—the difference between risk (what can be estimated) and uncertainty (the things we never anticipate).

A risk is more likely to work out if you are seeking a reward you actually want.

if you have a destination in mind, you are much more likely to end up there. Yet we often take risks without a clear idea of what we are taking them for.

What is your ultimate goal? If you achieve it, what does that look like? How can you achieve your goal with no risk at all or as little risk as possible? In other words, what would guarantee you would accomplish your goal? Is that no-risk option possible or desirable? If not, how much risk do you need to take to get what you want?

The risk-free option is whatever delivers what you want with total certainty.

Risk-free looks different to each person, which is why figuring out what’s risk-free for you provides clarity and helps you value risk.

In financial economics, the first step is to identify your goal and price it in risk-free terms. There is an investment known as the risk-free asset that offers investors something no other asset can: predictability. In finance, risk-free promises a certain payoff no matter what happens. If markets crash, you know what you’ll get paid. If markets boom, you only get paid what you were initially promised. The price of that risk-free asset is the most critical piece of information in any investment problem, or any decision, you might face.

Articulating your goal and putting a risk-free price on it are the first steps of good risk taking.

Figuring out what we want and putting it in risk-free terms should be the first step in assessing any risk problem. But sometimes, perhaps most of the time, we identify the low-risk choice and it isn’t what we want or we can’t afford it.

We tend to think of taking a risk as a binary choice: either we take a risk or we don’t. But smart risk taking involves going for more, and taking just enough risk that we need to, or are comfortable with, to achieve our goal.

Calibrating the right amount of risk is the next step, but if we haven’t defined our goal and priced it in risk-free terms first, we set ourselves up for failure.

Average people and trust funders are not solving the same problem. Trust funders want to build a fortune that lasts for generations. For the rest of us, the goal is to save when we are young and spend when we are old. This problem requires a totally different solution than growing and maintaining wealth over generations—and to make matters worse, it is a much harder problem to solve. You don’t know how long your money needs to last, and if you spend too much you risk poverty in your most vulnerable years.

Conventional wisdom in the financial industry is to build up as much wealth as possible (the trust-fund strategy) and then to spend a certain percent, say 4 percent, each year once you retire. But the 4 percent per year isn’t a fixed amount—the actual amount you receive depends on what’s happening in the stock market. That’s where the strategy goes wrong. A predictable salary, like the one you earned when you were working, should be the goal of your retirement fund. Most workers wouldn’t accept a salary that varies with stock prices—why should retirees?

there is a good chance your retirement account is invested with a strategy called a target date fund. It mitigates the risk your portfolio will lose money as you age by taking your money out of stocks and investing it in short-term bonds; because short-term bond prices are fairly stable and predictable, your balance won’t fluctuate too much. This strategy offers some certainty about how much money you will have saved on the day you retire. But it does not offer any certainty about how much you can actually spend each year, because you can’t predict how long you will live or what the market will do to your savings during retirement. We can buy that certainty from an insurance company by purchasing a fixed, or simple life, annuity: you hand over your savings to an insurance company and it pays you a fixed amount* every year for as long as you and/or your partner live after you retire. This is as close to risk-free as retirement gets, delivering the goal of predictable income for every year you live, versus a lump amount saved up to day one of retirement that you still have to manage.

An important caveat to the risk-free option of owning an annuity is that buying one is not necessarily risk-free. Annuity prices are based on long-term interest rates. The lower the interest rates, the less income you get from an insurance company. Suppose you spend your working years with a single goal: $1 million in the bank on the day you retire. In 2000, when ten-year real interest rates were 4.4 percent, $1 million would buy you a twenty-year inflation-adjusted annuity that paid out $75,000 a year. In 2017, when real ten-year interest rates were 0.43 percent, that $1 million would buy you only $52,000 a year.

Investing for income in a low-risk way requires changing your portfolio strategy from short-term to long-term bonds so your wealth moves with annuity prices. Conventional wisdom tells you that short-term bonds are low risk because they ensure your asset balance won’t change very much, but they actually can be risky when your goal is retirement income because they don’t keep up with annuity prices.*

The annuity price helps you gauge how much risk you can bear or need to take in the market. Suppose of that $70,000, you estimate you need $50,000 a year for necessities, such as your car or your home, and $20,000 for more discretionary expenses, such as travel and eating out. It makes sense to invest about 30 percent of your retirement money in something risky, to finance the $20,000 in discretionary expenses and invest the rest in risk-free assets, such as long-term bonds or an annuity. This strategy ensures you can meet all your necessary expenses no matter what happens to the market and still offers some reward on what you can risk. The conversation you need to have with your financial planner concerning retirement is not how you feel about risk; instead, you should talk about how much income you can gamble. This type of discussion not only helps you plan for retirement but also changes the way you invest and approach risk.

Predicting winners is an especially hard risk problem. In most businesses, decision makers can rely on data from the past to help them figure out the more fruitful investments that will pay off in the future. A good risk estimate requires data that can do two things: (1) reveal lessons from the past that will be relevant in the future, and (2) predict that certain past outcomes are more likely than others. The nature of moviemaking means its business data lacks both of those things.

the simplest way to measure risk is to consider what happened in the past and assume something similar will happen in the future. This gives us a reliable estimate of the range of things that might occur.

Risk is our guess about what the future holds; more precisely, it is the range of things that might happen and how probable each event is.

A summer blockbuster has an excellent chance of earning between $1 million and $4 billion at the American box office. Four billion dollars is possible, but it’s a long shot, and a summer release will almost certainly earn more than $1 million, so making a good risk assessment requires narrowing the range of possibilities.

Estimating the range of what might happen using data is called risk measurement.

the law of large numbers, which says if you repeat an experiment enough times, you can estimate accurate probabilities of what might happen in the future.