I’m standing on the 2ft wide girder of a bridge 300ft above a river. Nothing separates me from eternity but a strong gust of wind. No handrails, no ropes, no idea what I’m doing.
“I’m going to go a little farther out,” I think.
Risk. We all take it. Stepping out of the house each morning comes with all kinds of perils that we’re exposed to. Each day we implicitly and explicitly consider different options and compare the tradeoffs involved, hopefully making rational judgments in an attempt to make the right decision.
Stay at my job or take a new one?
Take the train or walk?
Keep hiking up the mountain or turn back?
There are some risks that are better than others. Walking out on the exposed girders of a bridge hundreds of feet above certain death is clearly a stupid thing to do. The risk is high and there are no spectacular benefits in doing so.
Without knowing it, we compare risk/reward tradeoffs every day. This is why most people wear seatbelts - the downside of being slightly less comfortable is easily outweighed by the safety benefits. When comparing the risk/reward tradeoff, we can use something called the Sharpe Ratio.
The Sharpe ratio is your expected returns in excess of some benchmark divided by the standard deviation of the returns. The standard deviation is another way to measure how much an outcome generally varies. Something that never varies has a standard deviation of 0. Something that varies wildly will have a much higher standard deviation.
We use the Sharpe Ratio as a way to compare opportunities. Ideally, we want to maximize our expected returns (more good stuff) and minimize the standard deviation (less risk). We want more upside with less risk. For example, I would much rather take an investment in which I was guaranteed $1M than one where I had a 50% chance of getting $3M and a 50% chance of losing $1M. Both of those have the same expected value ($1M) but the first option is clearly more attractive as the $1M is guaranteed. It has a higher Sharpe Ratio.
Insurance can help us by making our Sharpe Ratio better. With insurance, we decrease the fluctuation of our cash flows by exchanging potentially devastating large losses with monthly or annual payments that don’t vary much. Additionally, when we’re not worried about funding potential catastrophes we can spend our money on things that generate higher returns; things like education, businesses, stocks, and property. This is one reason insurance is seen as a social good; it helps individuals and businesses reallocate resources to opportunities with higher returns. This increases overall economic output.
Each day has its unique opportunities. Each day we have a chance to do something new. Each day we take risks.
Should I continue to build this relationship?
Should I start a new journey?
Should I keep pouring myself into this?
When evaluating, consider the Sharpe Ratio in your own life.
What has a lot of volatility and little return?
Do we understand the risks we’re taking?
Do we understand the upside?
There are some ways to make it better.
1) Know what the risk and return are. This involves thinking about things in new ways and challenging yourself to look at opportunities from unbiased perspectives. Evaluate using various mental models to understand what you’re getting into.
2) Reduce volatility. Find ways to remove the riskiness of the opportunity. Insurance is a great way to do this without greatly impacting returns. Many times people say that with more risk comes more reward. That’s not always the case. You can manage risk by finding ways to transfer, mitigate, avoid, and share it.
3) Increase return. When considering opportunities, look at ways to get the most out of them. If you’re only thinking of your own interests, you’ve already robbed yourself of some exceptional returns. We benefit the most when our opportunities impact others positively. Focus on objectives beyond yourself.
While that’s not always as simple as it sounds, it’s a good practice to take a step back and have a macro view of things. Thinking about opportunities in terms of the Sharpe Ratio is a useful paradigm when doing so.