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

by Allison Schrager

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.