Scott H Young

Archive for November, 2012

Why the Risky Options Can Sometimes Be the Safest

Wednesday, November 28th, 2012

Last week I shared some of my concerns with what I called high-variance professions. A high-variance profession is one where a lot of people fail and a few succeed. Think actors, entrepreneurs, musicians and athletes.

I explained why high-variance is generally a bad thing, in terms of life outcomes, although it’s certainly not an open-and-shut case.

Interestingly, this logic doesn’t hold for high-variance activities. That is, having a high-variance profession (where, in the end, few succeed) doesn’t necessarily mean a short-term activity or project which has low success odds is a bad idea.

Often the opposite is the case. Taking lots of small risks, when added up, may actually be a safer strategy than pursuing just one or two “safe” options.

When More Risk Can Actually Be Safer

Let’s play a game. I flip a coin, if it’s heads I’ll pay you $150, if it’s tails you lose $100. Is this a game you want to play?

Well, if we only play once, the answer is probably not. For most people losing $100 will hurt more than winning $150. If you’re not sure, try imagining the numbers were instead changed to $10,000 and $15,000. Still want to play?

This tendency in human nature is called loss aversion. We turn down gambles skewed in our favor, because we don’t like the idea of losing. (For a great book on this effect, and the inspiration for the coin-flip game, see Thinking, Fast and Slow)

Now however imagine that I allowed you to play the game as much as you want. In this case, you’d be foolish to reject my offer. Every coin toss puts you, on average, $25 ahead, and the chance of losing any money decreases as you play more.

Taking many “risky” decisions ends up adding to a fairly safe bet.

When considering a high-variance profession, the decision is much like the coin-flip game you can only play once. You may win, but there’s also a good chance you’ll lose.

However, high-variance activities are like the multiple coin-flip game. The more you play, the safer it becomes.

We Pay Too Much For Safety

In most areas of life, humans are risk-averse. Given the choice between one round of my coin-flip game or $25, most people would pick the twenty-five dollars.

Because of this tendency in human nature, the economy rewards people who can reduce risk. Insurance and extended warranties only exist because people are willing to pay extra to eliminate uncertainty.

In finance, this is called a risk premium. Stocks, on average, return more than bonds. This is because stocks are riskier, so in order to attract the same investment, they need to promise better returns. Not just better returns some of the time, but better returns, on average, including all possibilities.

There’s a similar analogy for opportunities in your life. Many people will pick the “safe” choices, where the outcome of their effort is consistent and predictable. But there’s a lot of competition for those opportunities, so the laws of supply and demand tend to make them somewhat less attractive. Risky opportunities are less picked-over, so they offer higher average value.

This isn’t universally true. Some truly risky opportunities look like safe ones, so they have lousy returns even though there is considerable risk. Racking up hundreds of thousands of dollars in student debt for a mediocre college degree is probably one of them.

In addition, some fairly safe options are rather unconventional, so they’re hardly considered. Investing a solid month to meet new people in your industry will almost certainly produce some interesting opportunities, but very few people do this.

However, smoothing it out, this rule still holds. Risky opportunities will probably have a better average return than safe ones because the safer ones are under heavier competition.

Life is a Multi-Toss Game

Most people are myopic. The idea of investing a couple months or even a couple years into a project which might fail is deeply unsettling to many people. But that’s because they’re operating under the assumption that they’re playing a one-toss game.

Life isn’t a one-toss game. Except for the rare decisions which you can really only make once or twice in your life, almost all projects and goals are multi-toss games.

Imagine taking on a one-year project and failing. Not in a catastrophic way that would ruin your future, but in a way that would be disappointing. I’d guess many people would shy away from considering something like that again in the future, even if, in retrospect, the opportunity looked promising.

The problem with this situation is that it is looking at the one-year project like a single coin toss. If you took on the game I made earlier and lost $100, you might be discouraged to try again. However, this is exactly the wrong decision when you can play multiple times.

You probably have room for at least 20 or 30 one-year projects in your life. Maybe only one or two of them work out spectacularly and a handful of other have moderate success, with the rest being a fizzle. But if these are the right kind of projects, that can still be incredibly rewarding.

What are Good Gambles to Make?

The preceding analysis makes an important assumption: that the average value of your project is positive. Gambles at a casino have slightly negative average values, which is why casinos can make so much money from you. They aren’t taking on risk, because they’re playing a lot of multi-toss games at your expense.

In life, picking the positive-average projects is hard. Even harder is assessing whether these projects are better than their lower variance alternatives. This may be true, in general, but it’s harder to tell for a single case.

The mistake I think, is to look too deep. Trying to figure out too much in advance which projects are winners and which are losers.

I’ve been writing for this blog for nearly seven years and I’ve written over a thousand articles. Yet, even today, I have little idea which of my posts will be successful. It’s a tempting illusion that we can predict in advance which opportunities are the most promising.

A better strategy is to feel out the best class of opportunities by trying out even smaller projects. You can do a dozen one-month projects before deciding which one-year projects are worth pursuing.

Shorter projects are probably less valuable than longer ones, once again because people are myopic and likely overcrowd the easy short-term wins. But because you get more tosses, you can get a hint as to whether an opportunity is risky-smart or risky-stupid faster.

This strategy of escalating commitments to risky projects spread over a lifetime may end up being a much safer option than just pursuing one or two “safe” pursuits. Even the safest of pursuits have some risk attached, so by flipping only one or two coins your whole life the game still looks a lot more like the one-toss version above than the multi-toss version. This means that the riskiest option, in the long-term, may be to play it safe.


Posted by Scott Young on November 28th, 2012 in Personal Development | 22 Comments »