Understand Risk in 5 Minutes
If you can’t navigate chance, you’ll never make your best decisions
|Jun 16|| 14|
If you don’t understand risk correctly, you’ll always make subpar decisions.
Life consists entirely of tradeoffs. Every waking second, you’re trading choices against one another.
Many of these choices, especially on a day-to-day level, are meaningless in the sense that many options will do the job. The big picture of what you eat matters, but both a banana and an apple are healthy breakfast ingredients.
Some choices, however, have to be made relatively quickly yet come with profound implications. You have few days to accept the job offer, but doing so means you’ll need to move to a city you might not like. What do you do?
The difference between these two examples is their inherent level of risk.
We misunderstand risk for many reasons, starting with the definition of the word. In many dictionaries, you’ll find something along the lines of, “a situation involving exposure to danger.” Today, however, risk as in, “a situation where the outcome is uncertain,” feels more appropriate.
Risk is everywhere. The world of finance is full of it. Companies take risks all the time. Having kids is a risk, and so is taking that job in a city 500 miles away — yet none of these things indicate you might break a leg.
The first thing you can do to better understand risk is to detach it from the word “danger.” Reserve that word for threats to your health and survival, and you’ll already be more comfortable with the fact that most of life is uncertain. Risk is everywhere — and that’s okay.
The second reason we misestimate risk is that we’re really bad at basic math.
Let’s say I offer you a choice between two gambles:
We flip a coin, and if it lands heads, you’ll get $100,000. If it lands tails, however, you’ll get nothing.
We don’t flip a coin, and I just give you a guaranteed $10,000.
The twist here is that the second game isn’t a gamble at all. Getting $10,000 is a certain outcome, which is why any sane person — and the tiny voice in your head — would urge you to take the money.
An economist would call the $10,000 your “certainty equivalent.” According to Investopedia, it is “a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future.”
Your certainty equivalent is the answer to the question, “How much money do I have to give you right now for you to want to avoid taking the gamble?”
If the alternative to the $100,000 lottery is a $1,000 payment, you may be tempted to play the game. But if I keep upping the guaranteed sum, at some point, it becomes more attractive than the gamble. That’s when you’ve hit your certainty equivalent — and at $10,000, most people would have.
Certainty equivalents are all around us. Every insurance payment you make is a certainty equivalent: You pay $50 per month to avoid the gamble of damage to your car. A visit to your favorite restaurant is a certainty equivalent. You’d rather pay $20 for a tasty meal there than $15 for a new one you might not like. And when it comes to that job offer, if your current employer offers a 10% raise, chances are, you’d stay.
Most of the time, our certainty equivalents are pretty low. In case of the coin toss, economists sure think so. $10,000 is a lot of money, but if you dissect the problem with statistics, logic will dictate taking the gamble every time. It’s called the “expected value” of the gamble:
Your chance of winning $100,000 is 50% (or 0.5 mathematically).
Your chance of winning $0 is also 50%.
For the average result, add up the two:
$100,000 * 0.5 + $0 * 0.5 = $50,000.
The more often you repeat the bet, the closer to this average of $50,000 per round you’ll get. If I allowed you to choose between the coin flip and $10,000 infinitely, picking the coin flip each time would maximize your earnings.
The expected value of the coin toss never changes, but if you can only choose once, the pressure of getting it right will skew your perception. It’s easy to imagine the frustration of getting $0 and hard to grasp the difference between $10,000 and $50,000 in the moment. Of course, that $40,000 difference still exists, and it plays out very subtly in many other areas of life.
Economists call this difference “risk premium” — the larger reward you stand to gain from taking on more risk — and chances are, you don’t carry enough of it. You need to start weighing your options mathematically. You must make an effort to assess life with numbers. Not all the time and certainly not for every ice cream flavor you pick, but every time it matters.
Pick up your calculator for big life decisions. Try to estimate your certainty equivalent. How much risk premium is there to unlock? What are the odds? Make educated guesses. You don’t need to get every number right, but you must train your gut to make better decisions.
The third and final reason we’re bad at estimating risk is a result of the former two: We neglect opportunity costs.
We dismiss the fact that choosing one thing means not choosing another, and that whatever we stood to gain from option B will disappear along with its risk when we pick option A. As a result, we withdraw into certainty much more than we should, which comes with its own, steep price later in life: regret.
“What if I had taken that job? What’s the food at that new place like? What could I have done with that insurance money?” You’ll never know and that too can hurt — sometimes more than the $500 bill to fix a broken bumper.
The top 25 insurance companies are worth almost $15 trillion combined — taking the risk premium out of your hands pays good money. The reason this business is one of the most profitable is that we don’t demand higher certainty equivalents.
We agree to too little, and we let life — and other people — lowball us at every turn. Don’t. Do the math. Assess the important choices in your life. Ask for more, and don’t settle.
Could you save and later invest the money for theft insurance of a phone that might never be stolen? Could you laugh off a bad meal with your friends and still hope the next new restaurant will be awesome? Could you find a deep sense of satisfaction and joy in a career move that ends up not panning out?
You’ll never find the answers to these questions if you don’t give their corresponding risks a go.
It’s impossible to do the math of history, but it sure feels like, today, the world is more uncertain than it ever was. Much of this uncertainty hides opportunity rather than misfortune, but if we don’t make an effort to lift ambiguity’s veil, we’ll never make our best decisions — and we’ll never live our best life.
To be alive is to be a risk-taker. To study chance is to do the job well.
Life’s only guarantee is that you’re offered the gig just this once. I don’t need to crunch the numbers on that one to know you should take it.
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