Risk

August 2019 · 1300 words · 6 minute read

Life is all about risk. Asking out the girl, going for the promotion, spending years of your life trying to start a company. These are risky endeavours. But, individually we don’t think about risk very well. Risk is scary for most people, they lack the mental model for them to be able to use risk.

I see risk as a tool, something you can change. Something you can use to advance your personal interests.

Aaron Brown, author of Red Blooded Risk, makes the distinction between:

Under this mental model life becomes fairly simple. Minimise the dangers as much as you can, take every opportunity that arises and then set your risk setting to the level you’re comfortable with.

Opportunities often have another name, luck. You’re lucky if something happens to fall into your lap but you cannot be said to have influenced the outcome. You’re lucky if you were born in the right place, if you went to the right schools, if you bought a house right before a real estate boom. These are all examples of luck in the world.

On the flip side, there are a number of dangers. Buying a family home right before the GFC is a danger. It was outside of your control, you just wanted a place to live and got caught in the cross fire. Working in an industry where automation is sweeping the manufacturing floors is another danger. You could be out of a job through no fault of your own, the world simply moved on.

Dangers are metaphorical steam rollers moving towards us. There’s not a lot we can do about them except to try and avoid them at all costs. Dangers are scary whereas risk is not.

Risk is where life starts to get fun. It’s the flow zone postulated by Mihaly Csikszentmihalyi. It’s the feeling you get when you seize an opportunity and win the game. It’s the feeling you get when you confess your feelings to the cute girl and she reciprocates. Risk is everywhere, lurking beneath the surface and we can use it to make ourselves happier and our lives more interesting.

What most do not understand is that risk is a setting. It’s something you can choose. Taking on a high risk setting opens you up to new upsides whilst also exposing yourself to new downsides.

Risk is not danger. You’re not increasing your risk if you drive 150km/h down a dark windy street at night. You’re not increasing your risk if you drive drunk. You’re just exposing yourself to new dangers as there’s no potential upside.

Risk is not necessarily symmetrical either. Risk can be either concave (curves inwards) or it can be convex (curves outwards). This is best shown graphically like below from Taylor Pearson:

Concavity versus Convexity

The top graph here is convex, the gain is potentially unlimited but the losses are capped. Buying an option grants you a convex payoff function and there are numerous other examples of convex payoff functions in life.

The bottom graph on the other hand is convex. There’s a window where the option pays off but there’s also a whole world of hurt awaiting you if it goes wrong. This is the risk you take when you sell an option.

Both of these are examples of risks and they can be managed and entered into unlike dangers or opportunities. This leads into a completely outrageous claim as follows:

Success in life comes from entering into as many convex risk trades as possible.

Why?

Because entering into convex risk maximises the potential for upside while minimising the downside. It’s a confident and positive approach to life, it requires doing something.

Most of us are too afraid to take on risk, we instead place ourselves in the concave region of life where there’s a minimal upside but a major potential downside. Staying in bad relationships is a concave risk, working as an employee is a concave risk, selling leveraged options is most definitely a concave risk.

The challenge we face is that we need to identify the convex risks and that this is non trivial. Furthermore, we want these risks to be small and plentiful not large and infrequent.

Entering into a single large convex risk is not a plan, if it pays off you get lucky. If it doesn’t you’re bankrupt and quite simply screwed. Single large risks are not good plans and to be honest they shift more towards the danger/opportunity side of the spectrum that in the nice risk zone.

The simplest way to introduce more convex risks into your life is to create a pipeline of options that you can take. These options are much more likely to exist in the human domain than they are in the natural domain. Examples of this include but are not limited too:

Broadly speaking, convex risks are those where you incur a small but known costs in order to obtain the potential for a large upside. In the examples above it’s mostly a small financial and time cost to try and obtain a major potential benefit.

Other options that are still convex but have a much larger cost are:

Each of these things may pay off, but they have a higher cost and a lower probability of working out. Furthermore, due to their size it’s unlikely that you’re going to do each of these more than once. As such, they don’t really fall into the convex risks that we want to take. We want to take many small risks and each of the above, by definition due to their scope limits the number of risks we can take.

Risk, both convex and concave is everywhere if we look for it. It takes time to build the judgement necessary to identify it but once you have it and you begin to systematically seize the opportunities that occur the overall quality of life improves dramatically. I systematically run thought experiments on most things in my life to identify what the downsides and what the upsides are. To do this I ask myself the following questions:

Applying a systematic approach to risk takes the emotion out of it. It’s a model that provides a guide to thinking and lets you systematically think through the potential outcomes. The trick is, you need to apply this to every part of your life. Nothing can be exempt. When you go through this process you’ll quickly identify that you should ignore or exclude the vast majority of the options that come up. Additionally, it’s important to know when something isn’t working so that you can stop. Remember, we’re looking for many small risks not a few large ones.

Don’t be afraid of risk. Find the good risks, minimise the bad. It makes life better.