An Economist Walks Into A Brothel

Books · Management

(Read this in August 2019, adding to Notion in Feb 2021)

URL:

An Economist Walks Into a Brothel

What is risk?

Risk = high variance in probabilistic outcomes

Example

Legal sex workers make roughly the same or less as illegal ones after taxes and fees. But face far less risk. Also, they have a more guaranteed income stream. Legal sex might me more convenient that going to a brothel for customers, but it’s far more risky. Customers are willing to pay to reduce risk .

How to make better decisions in situations of risk?

Define goals, risk and reward for yourself. Be very explicit in this exercise.

  • start by defining what is risk-free
  • Measure risk

Don’t take risks for risk’s sake. Have your risk-reward ratio in line

  1. What’s your ultimate goal?
  2. How can goal be achieved with no risk at all, or with the least possible risk?
  3. Is the no risk option possible? If not, how much risk are you willing to take?

Defining risk

  • People feel more comfortable when you can put odds on success. But just because something is precisely defined doesn’t mean it’s accurate
  • Do your risks have fat tails? If so, protect the downside!
  • Your model might work for a while, but you have to continue updating and retraining it if you want longer term success
  • Differentiate between systematic risk (the entire market shifting) and idiosyncratic risk (a particular stock shifting). The latter is easier to manage than the former

Risk aversion can be both good and bad for you

  • Risk aversion (or downside protection) is common for most things in life
  • Prospect theory — your degree of risk aversion depends on how much money you already have
  • When we lose money, but have a chance to win it back soon — we take even bigger risks, and thereby subject ourselves to even bigger losses

Why do we take unnecessary risks?

  1. We overestimate certainty. When we do this, it doesn’t even occur to us that the decision has risk associated with it
  2. We overestimate the chances of unlikely events
  3. We assume correlations that don’t exist. Events are typically independent in each other

Diversification

Diversification helps eliminate unnecessary risk. If you diversify correctly, you get the closest thing to a free lunch. You can eliminate all idiosyncratic risk

When you’re new and untested, people are willing to take a bet on your potential. The fees you have when there’s more data about you and you’re objectively better (but not as good as predicted) are likely to be lower

Insurance vs hedging

Insurance and hedging are different risk strategies. In insurance, you pay a fixed fees to limit downside and keep 100% of upside. In hedging, you have a limited upside and downside

Hedging

Protect the downside! Hedge your risk, don’t just shoot for the moon. Specially if you’re born in poverty.

You can either buy a risk free asset as a hedge, or buy negatively correlated assets

Leverage is a negative hedge

Insurance

Reduces the cost of a risk gone wrong. With hedging, we reduce the upside if things go better than expected. But with insurance, we get to keep them while limiting the downside

Moral Hazards of insurance

The Peltsman effect. We take bigger risks when technology allows for more safety (driving faster, rising higher waves etc). But there’s no way to make an 80 foot wave safe. And there’s no way to make a 25:1 leverage ratio risk free

Uncertainty

Risk management does not eliminate uncertainty. We have to be prepared for unknown unknowns — or black swan — risks