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

by Allison Schrager

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.

Everyone I interviewed has found clever ways to identify and manage risk in a rapidly changing economy. Their stories illustrate the most important principles of financial economics better than any story about the stock market ever could.

Unlike traditional pimps, Hof didn’t get rich by forcing young women into dangerous situations. Just the opposite: He made his money by enabling a safe transaction between a sex worker and her client. Each of them was willing to pay for that safety. That was where Hof took his cut.

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.

Financial economics assumes risk is also a critical component of value.

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.

Waze minimizes the risk of being stuck in traffic; Netflix increases the odds of watching a movie you’ll love; travel websites can predict whether the price of a flight will go up or down.

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

The hard part is knowing what constitutes a reasonable range. Is

what is difficult is knowing when you need to update your data. Often we don’t realize the world is changing until long after it has changed.

Being able to spot the difference is important because it determines what the best risk strategy is (we’ll cover this topic in later chapters). For example, when you are looking to buy a house, the price might be driven by idiosyncratic risk (a new trendy feature like concrete countertops in the kitchen) or systematic risk (the whole market is hot and driving up prices).

bond trader at the Chicago Board of Trade who had a morning loss is 15.5 percent more likely to take greater risk in the afternoon compared with a trader who had a morning gain.

The principle is the same: when you have less at stake to lose, you stay more rational.

Sinclair’s most critical skill isn’t her deep knowledge of magic or her ability to palm a card; rather, it is her ability to save any trick and still awe the audience even if things go wrong.

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, you would have lost only $2. Options can magnify gains and losses, similar to borrowing money to make a risky bet.

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.

The modern world offers you the chance to take bigger risks than you should, like surfing a 50-foot wave when you barely know how to swim or using a financial derivative to take on tons of leverage to bet on a stock. Each of these options offers the chance for huge rewards, but it is worth asking if that reward is really your goal, and if it is worth swimming in shark-filled waters to get it.