What are the three steps to better manage risk and get what you really want.
In this episode you’ll learn:
- Why goods and services that lessen risk tend to cost more.
- What is the three-step process for assessing and managing risk.
- Why defining the risk-free option or asset is critical to managing risk.
- Why immediate annuities are the retirement risk-free option rather than a conservative investment portfolio.
- What are the two types of risk and how do we mitigate them.
- What is the difference between hedging and insuring against risk.
Almost no decision is made without a certain level of risk attached, and it can be hard to know how to manage that risk, especially when it comes to our money. David unpacks how risk affects our everyday life, how we can accurately identify and assess different types of risk, and how to focus on what we really want. Be sure to listen to the entire episode for all the helpful tips and insights into healthy risk management!
Goods that lessen risk cost more…most of the time
Making decisions in the face of uncertainty is where knowing how to weigh risk comes into play. People are generally willing to pay more for goods and services where there is less risk attached. For example, David explains that once, he was waiting in line for a train that was supposed to come soon, but the line to get tickets was extremely long. He was running the risk of not catching the train. A man offered David a trip off of his 10-trip card for $5. The cost of a single ticket for the train was also $5. David decided to take the man up on his offer. The man knew that there was a demand for tickets, and he could have offered the trip on his card at a much higher cost. Because the man’s card was lessening the risk of missing the train, David would have been willing to spend more than $5 on it. The same idea applies to airfare costs. Some are willing to spend more on a ticket that reduces their risk of ending up in an uncomfortable, middle seat on the plane. This concept, however, doesn’t always work. Listen to the episode for an example of risk being taken at a possibly very-high cost.
How to manage risk in three steps
David shares strategies for how to manage risk from the book An Economist Walks Into a Brothel by Allison Schrager. In her insightful book, Schrager outlines three steps for assessing risk.
- Define the ultimate goal. What is it that you want?
- Identify how to achieve that goal without any risk or with as little risk as possible.
- Is the risk-free option what you want or need? If not, how much risk are you willing to take to achieve your goal?
Everyone’s goals are going to be different. David gives the example of selling his home at the same time as his sister was selling her home. While David wanted to sell his home because he didn’t want to face the cost of maintaining it through the winter, his sister wanted to sell her home at a specific price. Both received offers on their homes, and David took the lower offer given him because it mitigated the risk of having the home through the winter. His goal was achieved, and he did not counteroffer. His sister, however, did not take the lower offer given her because it did not achieve her goal of receiving a certain dollar amount. She took the risk of submitting a counteroffer to hopefully meet her goal. People’s “risk-free” options will look different depending on what it is they want.
Identifying risk and knowing how to de-risk
Knowing what type of risk you are facing can help you create a suitable strategy. Schrager explains two types of risk we often have to deal with.
- Idiosyncratic Risk: affects an individual asset and is specific to one situation.
- Systemic Risk: affects an entire system or a large number of assets/situations.
Idiosyncratic risk can be reduced by diversification in one’s portfolio. Warren Buffet recommended the 90/10 strategy for retirement funds—putting 90% into the U.S. stock market and 10% into T-Bills. Such a strategy would increase the systemic risk an investor would take because it would leave him open to any damage to the stock market as a whole. Diversifying asset classes and return drivers is one way to reduce systemic risk.
One way to “de-risk” is hedging. Schrager defines hedging as, “giving up your potential gains if things go well in exchange for reducing the odds of things going wrong.” Hedging provides protection from the danger of not meeting your goals, but it decreases the chance of exceeding your goals. It all goes back to what it is you want. Hedging is often thought of in financial terms, but its concepts apply to other areas of life. David uses the example of leaving his investment firm. His goal was the security of knowing that he would have a large enough nest egg to live on. With this as his goal, he let his partners buy him out over seven years. He gave up the opportunity to make a future career in investing for the security of consistent payments from the firm. The payments were his hedge. Though not entirely risk-free, they helped him achieve his goal.
Insurance is another type of de-risking. Listen to the episode to learn what makes a solid insurance operation and why insurance companies can afford to take on the risk of shouldering the cost of their clients’ disasters.
The freedom found in flexibility
An important part of effectively managing risk is knowing when to be flexible. The risk-free path is an option. It’s not the only path available. As new information comes to you, be willing to change your decisions. Having multiple options available can offset risk. David uses the example of going to a conference and having to decide whether or not to take a limited-time opportunity to buy cheap tickets for the same conference in the following year. While buying the cheap ticket reduces the risk of purchasing a more expensive ticket later on in the year, it increases the risk of being locked into attending the conference. If attending the conference turned out to be undesirable, then he could lose money. Choosing courses of action that provide room for flexibility can increase your freedom to make wise choices and help you avoid unnecessary risk. In the end, however, it all comes back to the question, “What is your goal? What do you want?”
- [0:17] Weighing the risk and knowing how to make a decision under uncertainty.
- [5:00] Three steps for assessing and managing risk.
- [9:11] Finding the risk-free asset in a retirement plan.
- [14:36] Idiosyncratic & systemic risk.
- [16:40] De-risking and using hedges to create a risk buffer.
- [20:22] Identifying a sound insurance operation.
- [23:36] Using flexibility as a risk management strategy.
Learn more about risk and uncertainty
Welcome to money for the rest of us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 268. It’s titled “How to Manage Risk.”
I’m in New York and New Jersey for a few days. I flew into JFK, rented a car to visit my sister, dropped the car back at JFK because Avis wanted $700 to drop the car off in Midtown Manhattan. After I dropped off the car, I took the AirTran to the Howard Beach Station. The price to take the AirTran and then connect to the subway into the city is $5. I got to the spot. There wasn’t anybody manning the booth. The machines to pay the $5 had a line eight people deep. There were three machines. There were 25 or 30 people waiting to pay to buy a ticket.
A man approached me and says, “I know you don’t want to wait in that line. Here’s an AirTran card that I’ll let you use.” I was a little wary. I said, “How much do you want?” “$5.” I jumped at the chance. He could have charged me 10 and I would have gladly paid because in my mind, I was saving $700 not dropping off the car in Manhattan, and he was right. I didn’t want to wait in that line. My concern was that by doing so, I would miss the train, that I wouldn’t know how long the line would be. The subway would come or the train would come and I would miss it. This was a good deal for him. He knew there was this bottleneck. He could buy a 10-trip AirTran card for only $26. That means he was making 2.50 each time someone used the card. The downside, after each fourth swipe, he has to wait 18 minutes before the card can be used again.
This is an example of weighing risk, making decisions under uncertainty. I recently finished a book that I very much enjoyed. It’s by the economist Allison Schrager, and it’s called An Economist Walks Into a Brothel. One of her points is “goods that lessen risk tend to cost more.” This gentleman could have charged me more because I wanted to reduce my risk of missing the train and having the inconvenience of waiting a long time in line. I would have been willing to pay more than $5 to reduce that risk. Schrager points out that basic economy plane tickets are cheaper than regular fare tickets because you’re more likely to get bumped with a basic economy ticket. You also don’t get to choose your seat. If you want to reduce the risk of having a middle seat or getting bumped, you’re willing to pay more to lessen those risks.
She points out though, that’s not always the case. She writes, “Some markets do not reward risk in a sensible way, usually because something interferes with its proper functioning. For example, information is scarce, risk is hard to measure or something limits competition among buyers or sellers of risk.”
Risk with DoorDash
We had an example of that last week when I was talking about the gig economy and DoorDash. I got a lot of emails on that episode, and I wasn’t proposing that those prices that DoorDash charges should be regulated. My biggest concern was the insurance risk. The observation that these gig economy workers don’t realize either through a lack of information or lack of research on their part that they’re taking a huge insurance risk, and that insurance risk isn’t factoring into either what they’re willing to take on these deliveries or what DoorDash is charging so that the workers can cover their insurance cost.
Because right now, many of these drivers are uninsured on their way to the restaurants to pick up the food. Once they pick up the food, then DoorDash’s insurance kicks in. So, this is really a risk being born by society that isn’t priced in to either what DoorDash charges or what workers accept, and the risk itself is being born by whoever happens to get hit by a DoorDash driver and then they find out that that particular driver is uninsured, that the driver’s insurance company will not pay because they consider it a commercial enterprise.
When it comes to risk then, there’s a lot of variables and what I loved about Schrager’s book is she does a great job identifying how to manage risk. She outlines a three-step process for assessing and managing risk.
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