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

by Allison Schrager

When people hear the word “risk,” they automatically think of something terrible, the worst-case scenario, like losing their job, their wealth, or their spouse. But we need to take risks to make our lives better. We must gamble to get what we want, even if it comes with the possibility of loss. If we want a great relationship, we risk heartbreak. If we want to get ahead at work, we have to volunteer for projects that we might fail at. If we avoid risk, our lives won’t move forward. Technically, risk describes everything that might happen—both good and bad—and how probable each of these outcomes is.

To put it 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.

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.

This book walks you through the following five rules for better assessing and employing risk in your life. Each one describes a different risk concept from financial economics, illustrated through people and places testing its limits, and then shows you how to apply this concept in your everyday life.

No risk, no reward. Risking loss is the price we pay for the chance of getting more.

the single most effective way to increase the odds that risk taking will pay off is fairly simple: define what risk and reward mean to you. 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 don’t always behave the way economic and financial models predict when faced with a risky decision. 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. We sometimes assume certainty when there is none, or that something unlikely is probable. I will help you change how you perceive risk no matter how it’s presented to you, to keep you in control.

Get the biggest bang for your risk buck. The bigger the potential reward, the more risk you must take. 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. You will learn how to diversify to reduce unnecessary risk and keep your potential for more reward intact.

Be the master of your domain. Next we’ll dive into risk management, or how to increase the odds of getting more and...

A risk is more likely to work out if you are seeking a reward you actually want. It sounds so obvious, but we often take risks just because we want change. And when we do that, we often lose, no matter what happens.

We all have days when we want to quit our jobs, ditch our relationships, and start fresh. Most of us know people who’ve done this, and more often than not, the gamble did not pay off. They still faced the same job and relationship issues they did before. In order to have a better job, we need to know what we want from our career. In order to have a better relationship, we need to be clear about what we are looking for in a partner.

Obviously, 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.

Risk for risk’s sake can even be a viable political strategy. When the inaction and infighting of traditional politicians frustrates us, candidates often emerge who promise “change” or that they will “shake things up.” This refreshing message appeals to us because the status quo is not that great. Change can be a winning message even if we don’t know what their policies are or what exactly will change. It is no wonder we often end up disappointed, because taking a risk on the ...

It sounds simple, but knowing what you want might be the hardest par...

This three-step process offers clarity and helps assess how much risk you might want to take to reach your goal. 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?

We often lionize risk takers, but the difference between who succeeds and who fails isn’t who takes the boldest risks—it is who take smart risks, or risks with a clear objective.

In her world, college was the surest path to success and stability, and she would be giving it up to be paid hourly at Hooters. It may sound like a risky decision, but Cole’s goal was to get a good job one day and achieve the security and stability she lacked as a child. At first, she thought that meant practicing corporate law, but then she realized that being a lawyer was not the ultimate goal—it was just one way to get there. And someone was offering her a path to what she ultimately wanted, even if it was not the way most people got it. She dropped out. Not everyone would have seen this so clearly; to many of us it would seem like a risky choice.

Her success comes down to being good at identifying her goal and the least risky way to get it.

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.

If your goal is $3,000 for a vacation next year, your risk-free option is the savings account that pays 1 percent interest. Figuring this out before you invest serves two important functions. First, it helps you gauge how much risk you need to take to achieve your goal. Suppose someone offers you an investment that is guaranteed to double your money in one year (actually, you should run far away and warn all your friends and family to avoid this person—but for the sake of argument let’s assume this offer is legitimate). If this investment really exists, there is no need to risk losing your money in the stock market, and you only need to save $1,500 for your family vacation. The risk-free rate puts a cost on getting what you want for certain. If you only have $1,500, you can’t afford risk-free, so you can either take more risk or take a less expensive vacation. Second, and more important, the process of defining risk-free helps to clarify your objectives. Defining what risk-free means to you forces you to think through what you want and what will happen when you get it. The 1 percent return is how much money you will have in one year. If you have $2,000 today, it will be $2,020 next year; if you have $2,970, you know you’ll have enough for your vacation.

We all have friends who desperately want to get married and figure that the risk-free way to achieve this is to marry the first person who loves them dearly, even if they don’t return the feeling. In fact, they feel safer because they assume this person will never leave them, so they’ll never get hurt. But often their marriage lacks a strong mutual connection and is not hardy enough to weather life’s challenges, and they divorce. If simply getting married is their goal, then it is a risk-free choice to wed the first person who loves them. But if their goal is being married, then settling is a high-risk choice.

Suppose you are thinking about taking a new job. You are comfortable in your current job; you have an understanding boss who lets you leave early when you need to be home; and you’ve mastered the skills your position requires. If your goal is advancing your career or earning a bigger salary, then staying in your present job won’t get you what you want and may even be riskier than making a switch. Changing jobs forces you to broaden your network and learn new skills, all of which can enhance your career, boost your earnings, and make you more employable in the future. But if your goal is work-life balance, leaving is a big risk since your new boss may not tolerate the other demands in your life. Mastering the new skills and company politics requires putting in more hours. The risky choice depends on your goal.

Anyone can take a risk. But doing so with a clear goal takes conviction and focus. It requires knowing exactly what you want, and few of us do.

One of Cole’s favorite catchphrases is to focus on things that are “small enough to change but big enough to matter.” In other words, take the lowest-risk path to achieve your goal.

Most twenty-three-year-olds would probably choose a sexier topic, but I was captivated by the concept of retirement. To me it was the purest and most beautiful of all economic problems: What is the best way to move resources into the future? How do you decide how much to save now versus later? This is the simplest and yet most complex question economists, or anyone, must answer.

People in the movie business explain that it is impossible to predict what will be a blockbuster or a flop. Each film is like a small business with hundreds of moving parts. The only way to manage risk is to make lots of movies; most won’t make money, but a few will hit it big and pay for the others. This is a risky way to run a business, and it also explains why there are so many bad movies, with terrible, derivative plots, that fail at the box office. Every year brings both a notorious clunker that cost hundreds of millions to make and an independent drama, with a great script, that cost only $10 million and earned $300 million.

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.

Financial economists separate risk into two broad categories: the first is idiosyncratic risk, or the risk unique to a particular asset. Suppose Facebook changes management; the future of the company is unclear, and the price of the stock might drop based on factors unique to Facebook that don’t impact any other stock.

The second kind of risk is systematic risk, or risk that affects the larger system instead of an individual asset. Systematic risk is when every stock rises or falls together because the entire market surges or crashes, as it did in 2008. Systematic risk events often happen because of a big economic disruption like a recession or an election result that people think will impact business. Systematic risks are harder to manage than idiosyncratic risks, and the downsides are potentially more dangerous. If the entire stock market tanks, you risk losing your job and stock portfolio at the same time.

Avoid Overconfidence to Maintain Focus

When we hedge, we give up some of our potential gains in exchange for reducing the chance of loss; in statistical terms, it cuts off the upper and lower tails of risk.

Hedging involves taking less risk by giving up big gains to avoid big losses. What takes skill is knowing exactly how to find the right balance between risk and reward, or knowing exactly how much risk to take. And when someone is born into poverty, hedging risk, rather than just shooting for the moon, is what it really takes to beat the odds.

He is willing to give up extra upside if it means he’s protected in the worst-case scenario.

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 Facebook for $150 any time during the next six months. A put option offers insurance against the chance that Facebook’s stock price will tank.

For example, you are often told it’s less risky to invest in stocks when you are young because if the stock market drops you have years to make it up. This is what financial economists call the “fallacy of time diversification” because that assumption is wrong. It is true there’s a good chance the market will recover in a decade or two; often time will wipe out a big loss. But that does not necessarily mean there’s less risk, because twenty years of investing means there’s also the possibility of twenty years of bad returns. If you are only investing for two years, that possibility doesn’t exist. Depending on how you look at it, a longer time in the market can mean more risk.

Women face pressure to marry young or get “left on the shelf.” But your odds of finding someone to marry remain high well into middle age (and even beyond), and your odds of getting divorced fall dramatically the older you are when you marry. That’s not only because you have fewer years of marriage when things can go wrong but also because people who marry older are more stable and fully formed. Marrying young is a risk. You’ll have more financial stress, and the person you marry may grow into a different person.

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.

Only those who will risk going too far can possibly find out how far one can go. —T. S. ELIOT

Plans are worthless, but planning is everything. —DWIGHT D. EISENHOWER