Contributed By : Jitendra Chawla, CFA
What is common between investing in early-stage start-ups, producing Hollywood movies and breeding horses on a stud farm? All have long tails (no pun intended) i.e. range of outcomes that have a skewed distribution – with a high probability of outcomes which lead to losses and a ‘long tail’ of successful but unlikely or low probability scenarios. You’ll learn this and lots of other interesting ways to understand risk in this very interesting new book – “An Economist walks into a Brothel”
Allison Schrager’s book takes a unique and fresh approach to explain concepts associated with risk, how people from all walks of life (not just investors) understand and deal with it, and what lessons one can take from these risk warriors.
Her writing is easy to read and devoid of all the jargon. Even those who have little or no background in economics will understand and immediately relate to their personal circumstances.
The most interesting thing about the book is the unusual settings Allison has picked. Allison interviewed sex workers and brothel owners to understand how they deal with risk in their business and price it. She studied the life and career of Kat Cole – who was once a waitress at Hooters and is now the COO of Focus Brands – parent of the American chain of baked goods stores and kiosks – Cinnabon. Allison says “Cole learned about managing risk by making unconventional choices early in life”. And then goes on to explain her life choices so far.
She explains how the movie-making business is inherently fraught with risk and returns that do not follow a normal distribution. In her words, “A movie is like an airport trip that will take anywhere between ten minutes and two hours.
Allison explains the difference between idiosyncratic risk and systematic risk by giving life story of a New York-based paparazzo – Santiago Baez. She likens his strategy to manage the risk he must confront to earn his livelihood to “low-tech version of what finance mavens employ”.
The real-life stories are riveting and make it easier for the reader to understand the message and apply the lessons easily in their own circumstances.
In the book, Allison walks the reader through “five rules for better assessing and employing risk in your life”. Each of these rules “describes a different risk concept “from financial economics, illustrated through people and places testing its limits, and then shows you how to apply this concept in your everyday life”.
These five rules are :
- No risk, no reward – explains how to assess what you want, how much risk you need to take to achieve it, and different types of risk
- I am irrational, and I know it – How it is difficult for us to think in probabilities because of our inherent biases and why we tend to underestimate the risks involved in our decisions.
- Get the biggest bang for your risk buck – Why and how we should assess the risk involved in comparison to expected rewards and how we should choose the option that leads to achieving our objective by taking minimal risk
- Be the master of your domain – How to improve our odds by eliminating unnecessary risk and even further reducing the risk by using tools of hedging and insurance
- Uncertainty happens – Difference between risk and uncertainty and how to protect oneself from uncertainty.
Allison Schrager pursued her Ph.D. in Economics as she had been drawn to the subject. But she struggled a lot early on, which made her even more determined to work hard. She chose economic of retirement as her research topic as she thought it was “the purest and most beautiful of all economic problems”.
She says the default “risk-free” option for her like most Ph.D. candidates was a job in academia. But when she started sitting for job interviews, she realized that – that was not what she wanted to do. She wanted to “avoid math, have fun and spend time with people”. So she chose journalism and started working for the Economist for no money. After that, she went on to work with Robert C. Merton – the Nobel prize-winning economist and together they worked on developing strategies to help people invest for retirement.
Taking her own career choices as an example, Allison explains how people make mistakes in calculating risk, in understanding what they want and then taking on less or more risk than they should have. “When we chase the wrong goal and take a risk, odds are it won’t go well”.
While they were working on the retirement problem together, Merton reframed the retirement problem for her – “by spelling out what risk-free means in retirement and from there how to manage risk.” “This strategy changed how I saw everything”, says Allison.
I think this book has been able to achieve its objective – that of making it easier for the reader to understand and analyze the risks – in choices they confront and decisions they make. That too while avoiding math, having fun and using real stories of real people. Personally, for me, the book provides an easier framework to understand risk, weigh my options and make an informed decision in a wide range of situations – career choices, saving for retirement, buying a house, moving cities, allocating investments and many more.
The book is not just suitable for novices – who don’t know much about the subject and may start looking the world through a different lens after reading it – but also experts, who understand the concept of risk very well, as they get to understand it from a new, easier and fresh perspective.