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May 31 - August 2, 2020
Hellmuth’s example teaches us to be confident enough to take a risk—become a professional poker player or work for a start-up—but once you make the decision, adopt a more risk-averse posture: be less reactive to losing and more consistent in your risk taking by using risk management strategies so you never have too much to lose and can stay focused on success.
Often the reason we take a big risk comes down to how we perceive probabilities. The most common ways we get probability wrong are: We overestimate certainty. When we do this, it doesn’t even occur to us that a decision has any risk associated with it. We assume if we’re buying a house, prices will only go up. Or people move to Hollywood because they believe they are better looking or more talented than most others.
We overestimate the risk of unlikely events. We assume a remote and terrible event is more likely than it is. This is why many people are more afraid of flying than driving, even if they know the odds of dying in a car accident are higher. A plane crash is especially horrific, which is why we put higher odds on its happening.
We assume correlations that don’t exist. After being dealt a few good hands in poker, you could think you’re on a roll and that the next hand is bound to be good too. In fact, each hand you are dealt has nothing to do with the last.
We put a big weight on very likely or unlikely events and put almost no weight on anything that happens in between. The difference between a 0 percent and 5 percent probability feels huge because it creates possibility. The difference between 100 percent and 95 percent also feels meaningful because it creates or eliminates risk. But the difference between 50 percent and 55 percent barely factors into our decisions. The closer we get to certainty, the more we weight a probability, but mathematically, a 5 percent increase should be given equal weight no matter what.
would-be criminals don’t think about risk in a linear way. If the odds of getting caught doubled from 10 percent to 20 percent, people were just as likely to commit a crime. But when the odds increased from 85 percent to 95 percent, that same 10 percent boost deterred many juveniles from reoffending.
how we perceive the odds something will happen depends on how risk is presented to us, and we have more control over that than we realize.
Our ability to make good probability inferences comes down to how risk is presented to us, but better awareness makes us less susceptible to the power of suggestion.
research shows that frequencies, the actual number of times something happens, resonate better than probabilities because they are more consistent with how humans think and provide the salience we need to make sense of risk.
when people are shown frequencies instead of probabilities they tend to make sensible, rational decisions and can make sense of probability. His findings also indicate that people are better able to remember frequencies than probabilities.
You can diversify to eliminate idiosyncratic risk, but you’re still exposed to systematic or market risk—the
when we focus only on returns, we often end up taking unnecessary risk because we try to pick only winners (which is impossible). If we picked stocks that balanced each other out instead, risk would be reduced and, on average, we’d get the same, or a better, return.
What takes skill is knowing exactly how to find the right balance between risk and reward, or knowing exactly how much risk to take.
In finance, hedging has a more precise meaning: de-risking, or taking less risk. It involves giving up your potential gains if things go well, in exchange for reducing the odds of things going wrong. Overall, de-risking increases the odds of your getting what you want, but you must give up the possibility of getting more.
Hedging is one of the oldest and simplest financial strategies, but it is often neglected or confused with diversification. Diversification eliminates unnecessary risk by owning shares in lots of different assets; it could be pooling risk with other celebrity photographers or owning an index fund that contains lots of stocks in your investment portfolio. Your expected return is the same, but risk is reduced, because no matter what happens, odds are something you own will pay off. Diversification can eliminate idiosyncratic risk, but it does not help you with systematic risk like the entire
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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
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Instead of buying a risk-free asset as a hedge, you could buy two different assets that move in opposite directions.
suppose you are captain of a cruise ship. When the cruise industry does well you get paid more: there are more trips and people pay more for cruises, which increases your pay. But if there’s another “poop cruise” incident, demand might fall, leading to fewer trips and lower fares, meaning lower pay or even the threat of losing your job. A cruise ship captain can hedge poop-cruise risk by investing in hotels or land-based resorts or other companies that profit when cruises are unpopular.
One hedging technique is to lend money to the government, a company, or a city by buying a bond that promises to pay you a certain amount for a prespecified time. Because the amount the bond pays is fixed, it is less risky than owning a stock, which means there’s less risk in your portfolio.* Shifting out of a risky investment like stocks and combining them with bonds can be a hedge.
The opposite strategy is borrowing money and using it to make a risky investment; this is called leverage, and it is a negative hedge.
For example, suppose you decide to become a commercial crab fisherman, one of the world’s most dangerous jobs. The odds of getting killed or disabled are much higher than they are for accountants. But all the risk can pay off. You can make up to $50,000 a month during crab season, more than most accountants get paid in a year. Hedging risk in this case would be avoiding the most dangerous fishing areas, like the Bering Sea, which has the roughest weather and also the biggest crabs. You take on less risk and also give up the potential for big earnings; maybe you make only $30,000 a month
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Often insurance is a good deal. Like magic, insurance can make some risk disappear. That’s because transferring risk to an insurance company is efficient. Suppose a model wants to insure against breaking her leg and losing months of income. If she self-insured, she’d need to put aside all that lost income, just in case something bad happens, because she bears all that risk on her own. But if she buys insurance, she only has to pay an insurance company a fraction of that lost income because it sells the same policy to hundreds of other models, and most of them won’t ever need their insurance
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Even if we don’t buy insurance, the price helps us gauge risk and understand which situations are riskier than others.
a financial instrument called a stock option, a contract stipulating you can buy or sell a stock for a certain price within a few months or years, depending on the terms. For example, if you buy a put option, you pay a premium and someone promises you can sell them stock at a particular price in the future. Suppose you buy Facebook stock for $200 a share. You are optimistic about the company’s future but a little worried that it shares stories from dubious news sources, which might pose a risk that the stock price will fall one day. You can buy a put option that gives you the right to sell
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Maybe you decide to take a chance on Twitter stock going from $19 to $40 in the next six months. Instead of buying one share of the stock, you could buy ten call options for $2 each, which gives you the right to buy Twitter stock for $30 anytime in the next six months. If the price does go to $40, you’ll make $80 ($80 = ($40 – $30)*10 – $20). That’s much more than the $21 you’d make if you just bought one share of Twitter, but there is also more risk. If the price falls to $17, your call options are worthless, and you lose the full $20 you spent on them. If you bought one share of the stock,
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The price of an option (a put or a call) depends on only four different parameters. How much each of these factors matters can tell us a lot about how much risk we face. In the Black-Scholes model these relationships are called the Greeks.
1. Vega: More Volatility, More Risk
We generally focus our risk concerns on the range of things that are most probable, called volatility. The bigger this range is, the more risk we face. And generally, the larger your volatility is, the more you have to give up to protect yourself from bad outcomes. The riskier any situation is, the more we must pay to insure ourselves.
2. Delta: Odds You’ll Be in the Money
Next you need to worry about the odds something will go wrong. Even if you compare two scenarios with the same amount of volatility, sometimes one is more likely to need insurance than the other. And the more likely you are to need insurance, the more expensive it is.
Hurricane insurance costs more for a house in Florida than it does in Arizona because Floridians are more likely...
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ticket, odds are you also sold an option and didn’t even realize it. As discussed in chapter 1, airlines reserve the option of kicking you off the plane if the flight is overbooked. The lower your fare class, or the cheaper your ticket, the higher you are on the list to be bumped off your flight. Your cheap ticket is so cheap, in part, because you sold an option to take a later flight if the plane is full. The more likely you are to be bumped, the more valuable the option is to the airline, so the bigger the discount on your plane ticket.
3. Theta: The Value of Time
Another consideration is how long the risk will last. Is there a risk of something going wrong for the next month or the next year? The longer you are at risk, the more risk you face. And the longer an insurance contract covers you for, the more expensive it is. There is a common misconception ...
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4. Rho: Risk-Free Rate
Often taking a risk is a choice. You can sit at home and watch Netflix on a rainy night, or you can go on a blind date. How appealing the safe option is matters. Before Netflix, TV choices were more limited. You might be more inclined to go out no matter what because staying in wasn’t so tempting. Now, thanks to streaming, the risk-free option is better, and the dating stakes are higher. How much we value risk—and, by extension, how much we are willing to pay to reduce it—often depends on what the safe alternative offers.
This value of the safe option also drives many aspects of risky decision making. For example, it explains why some economists now believe mass incarceration may have caused more crime than it prevented. You’d think putting more people in prison would reduce crime. After all, we are taking criminals off the street. But mass incarceration went too far and sent many nonviolent offenders to prison. Even if you are a lightweight criminal, going to prison can change you. You learn lawbreaking skills and gain connections in the criminal world. Once you get out of prison you have more opportunities in
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As a consumer, you must ask two questions when you buy insurance: What does the insurance cover exactly? What is your goal, and are you actually insuring against something that threatens it? Often it is tempting to buy insurance to cover a risk we aren’t worried about or one we are already insured against; for example, buying insurance for a car rental when we already have credit card insurance, or buying insurance in case our TV falls off the wall when we keep it on a stand.
How much does it cost? We can use the Greeks from the Black-Scholes model to figure out if the value of insurance is worth paying a premium: Are you facing a high-risk situation? What are the odds you’ll need insurance? How long does the policy last? How much would you save if you avoided risk instead?
Options pricing is merely an estimate of risk in an uncertain market. But the fact that risk price is never a precise truth misses the point of risk models and any price derived from them. Any map is inaccurate because it does not include every small road and tree, but that does not make the map worthless. Its purpose is to direct you by helping you to understand how certain features relate to each other. That is also what a financial model like Black-Scholes does: it offers a consistent, transparent, easy-to-use method to understand how different factors—current price, volatility, time—relate
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In 1975, the University of Chicago economist Sam Peltzman observed that improving car safety caused more accidents because people took more risks when driving. With power steering, antilock brakes, widespread use of seat belts, and driver-assist alerts if we are too close to another vehicle or pedestrian, cars are safer than ever, but we also drive faster. Taking a bigger risk because technology imparts a feeling of safety is known as the Peltzman effect.
With derivatives, more people invest, which means more wealth. Investment flows more readily to parts of the economy it did not before, which means more small businesses and developing countries get capital. But sometimes the risks don’t pay off and everyone suffers, even if we are better off overall.
Risk measurement is our best guess of what will happen, and risk management stacks the odds in your favor. But this all assumes our estimate of risk is a good one; we can anticipate most of the risky possibilities.
Risk models are valuable, but they can backfire if you assume the unpredictable has become completely predictable. Suppose you decide to take a risk and demand a raise from your boss. If you operate under the assumption you are invaluable, you might threaten to quit. You might be invaluable, but if you go in unaware of some top secret information, like the company is facing financial trouble and planning lay-offs, or if your boss is just having a bad day, you may find yourself out of a job because you didn’t anticipate this in your risk calculation.
“If you try to plan for everything and think you have too much certainty, you create vulnerabilities. If you try too hard to predict everything that can happen and shift from the realm of certainty to uncertainty, you are going to build vulnerabilities into your force.”
The first step in dealing with uncertainty is coming to terms with the fact that, no matter how much we plan, pore over data, and insure ourselves, we still face some uncertainty. We can reduce uncertainty but never eliminate it.
Risk measurement and risk management offer the most valuable ways to deal with risk and uncertainty. But like anything else, if they are used incorrectly, they create more risk than they prevent. The key is to use them well but still be prepared to change strategies and be ready for the unexpected.
Smart risk takers don’t back away from risky situations. Instead of debating whether or not to take a risk, go for what you want: measure the risk involved and then take only as much as you need to in order to get what you want. Knowing how to take just enough risk increases the odds our risks will work out and we can get more from life. It does not offer any guarantees but can embolden us to take risks more frequently and go for more.
