Risk is to be loved and managed. Here's how to think about it.


Risk is a bit of a nebulous concept, and most of us have trouble understanding how we think about it in our own lives. You'll often hear people describe themselves as "risk-averse". Others seem to be happy to jump into precarious situations repeatedly, and to hell with the consequences. When we ask ourselves, "how do I think about risk?", I doubt an answer jumps readily to our lips. When we consider it, what comes out is something garbled and uncertain. We understand certain risks; there is no overall "risk policy"; we take some actions just hoping for the best; we know we just have to take some risks, but there is no great framework for deciding which and how. Most of all, few of us like the word "risk". It brings connotations of bad things that can happen, and intuitively, it conjures up feelings of fear in the back of our mind.

It is useful first to define risk for ourselves. Risk is basically a situation with more than one outcome. That's it really. If you buy a pineapple flavour ice cream, which you've never tried before, you're taking risk. You may like it; you may not. Investing your life savings in a bed and breakfast hotel? risk. Changing job? risk. Picking a holiday? risk. Going to a movie? risk.

The point being, we think of risk when we do big things, take big decisions; but in fact, we take risk multiple times, every single day. We just don't think of it as risk, because for most of those decisions, the stakes are small to the point of insignificance.

When we take risk, every possible outcome has a probability attached to it. We rarely know the exact odds of each outcome; but we can normally estimate them fairly well. If I choose to catch my train at 7 am, I know with quite a high certainty I'll get a seat. 8 am, that becomes highly unlikely. Thus, for most decisions - if I take the trouble to think about it - I can estimate what the possible outcomes are, and how likely they are to happen.

Big Risk Is Good

Now don't worry - we are not going to build a mathematical construct of how to value and analyse your risk. For one thing, there is too much uncertainty around different variables for that to be very useful. What we'll discuss are some useful concepts to think about.

The first, and central point, is that BIG RISK IS GOOD. The old adage that states "no risk, no reward" is pretty much correct. That is to say, without risk, there cannot be big outcomes. Now, notice, I don't say big risk - I say some risk. How much risk is a point we'll come to. But the absolutely key point is that, without some risk in your life, you can never expect big outcomes. Want to top the NY Times bestseller list? Want to be a famous musician? A millionaire? Newsflash - none of that will happen without some risk. Another way to say it is that very few good things will happen to the risk-averse. There are degrees, and how risk-averse one is will affect the outcome; but as a generalisation, people that refuse to take risk are unlikely to reap many rewards. Again, semantics are important here - risk minimisation is ok, and indeed desirable; but not risk avoidance. If we want to do big things in life, we need to take risk.

Avoid Total Annihilation

Once we accept this as a guiding principle, we turn to the question of how? Once we've accepted the need to take risk, what are the principles which should guide us?

The next point is that in every situation which has risk, we can consider the worst-case scenario, and decide whether it's existential. For example, you might be considering changing your employer. You may land at a great place and love working there, or you may find you hate it and regret ever going there. Worse, they may hate you, and decide to fire you within 3 months of joining. This is pretty much the worst-case scenario. Notice that, so far, I haven't described your motivation for moving - the upside - nor the probability that the worst-case scenario is realised. I merely describe what the worst-case scenario is. In this case, we can say that the worst-case scenario, whilst unpleasant, isn't in any way existential. You'll get another job, life will go on. We don't know what decision you'll take - we haven't compared downside to upside, nor have we discussed likelihoods - but we have identified that, whatever happens, life will go on.

Compare a case where you're considering taking your family's entire life savings; including selling your house and using that cash - and buying Tesla stock with it. Not only that, but you intend to employ leverage, borrowing 3x that money against the cash and buying 4x the notional amount of stock. The worst-case scenario is that Tesla shares collapse, you get margin called and the entire nest egg is lost. Now, you and your family have nowhere to live, and your kids aren't going to college. Your marriage was precarious already (because you are a degenerate gambler) and your wife leaves you, taking the kids with her. In this case, your worst-case scenario is quite existential. Get this one wrong, and you're out of the game.

What we are referring to with these two examples is that there are certain bets you can't afford to lose. These, we don't take. Period. No matter the proposition; no matter the upside; no matter the fantasy land existence you will have if you get it right - don't take bets you can't afford to lose. There will always be another, less risky opportunity down the road.

Risk Chain

Other than these terminal risks, how do we think about everything else? There are two important concepts here.

One is that we should think about risk as a chain of events. We may think of each risk individually - it is a discrete event, with a spread of outcomes, of a certain probability. But it is also true to say that we can take a step back, and look at all of the events as a chain of risk events, that come one after the next. Consider a game, where we roll a regular six-sided die 100 times. Each time, if you roll a number from 1 to 5, then you win $100. If you roll a 6, then you lose $100. It is true to say that, at each individual roll you may win or lose $100. You may even lose 3 rolls in a row, going down $300. It is possible. However, it is clear that you would happily play this game, because over 100 rolls, your expected return is very highly positive. You will win on average five-sixths of the time, and lose one-sixth.

Your life is like this game. The odds may not be as consistent or as clear each time; but, if you can load your life into a series of risks, where the odds of success are greater than of failure; and the rewards of success are greater than