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

by Allison Schrager

INVEST MORE IN A RISK-FREE ASSET The simplest way to hedge is to simply take less risk. Suppose your goal is to have $12,000 in five years to pay for your son’s first year of college, and you have $12,000 today. You’re hoping to make his first year of college extra special and spend another $3,000 so he can live in a nicer dorm. Your financial adviser tells you a well-diversified stock portfolio is expected to earn 8 percent a year. That means on average you can expect about $17,600 in five years, the money you need for tuition and a nice dorm room plus an extra bonus. But the stock market is risky. There is no promise it will actually return 8 percent a year and there’s a chance could lose money. Say the stock market drops 40 percent after the first year. Even if the market earns 8 percent each of the next four years, by year five you’ll only have about $9,800. To protect against this risk your adviser suggests a hedging strategy: invest $6,000 of your money in bonds. They only offer a 3 percent return, but you will definitely earn 3 percent each year. Your expected return will be 5.5 percent a year, lower than 8 percent, but odds are you will have about $15,000 in five years. If the stock market drops in the first year and then recovers, you’ll end up with about $12,000 in five years. Hedging by buying bonds relieves some of the risk of losing money, in exchange for giving up the possibility of that extra $2,600.