We all have some innate sense of risk-management.
E.g. FEAR.
And then we also have plenty learned methods of risk management.
E.g. DIVERSIFICATION
Alas we keep failing our “risk-management” in the modern world
FEAR fails most of the time because most our modern “threats” are NOT mortal. Therefore you actually SHOULD take more risks.
(Granted one who doesn’t fear mortal threats and risks them is a moron — and his genes deserve extinction. Fuck extreme sports)
You should take more risks. They won’t kill you. If they would — you should obviously avoid them. Few rewards are worth dying for.
So you should take more risks — but that doesn’t mean those risks are harmless.
Which means it’s not easy to appropriately manage them.
We are horrible at risk management.
That’s because previously risk was quite straight forward. Risk really was either not worth the reward — or it was small and additive, rather than multiplicative.
E.g. stealing an egg from some big dinosaur was probably not exactly worth it.
But risking some effort to light the fire was probably quite worth it. Even if you failed 100 times — it’s not like that 100th time would turn the tide and somehow kill you. You’d just get tired and go to sleep (in cold)
We are horrible at risk management because we live in a complex world
Complex world in which we MAKE PLANS.
And each plan has MANY steps.
And each step has a certain probability of succeeding (P), and certain probability of failing (1 – P)
And at best we see SUM of probabilities
We don’t see when this is a MULTIPLICATION
There’s a difference between TWO WAYS in which your undertaking can SUCCEED — and TWO WAYS in which your undertaking can FAIL.
Let’s say there are TWO WAYS in which it can succeed. One is 80% likely, other is 70% likely. What is your chance of success?
Your successful when EITHER of the venture succeeds. Therefore you succeed anytime both of them don’t fail.
= 1- (1 – 0.8) (1 – 0.7) = 0.94 = 94% of the time.
Now lets say there are two ways in which your undertaking can FAIL. Let’s say that you believe 80% of the time you get over the first obstacle, and 70% of the time you get over the second obstacle. Now what is your probability of NOT FAILING?
= 0.8 x 0.7 = 0.56 = 56%
Now you may say this is obvious that those are two completely different cases
Except when we make decisions we fall for those errors all the time
You’re not extra vigilant of all the tiny risks which could COMPLETELY put you out of business — and how those tiny risks MULTIPLY into a VERY significant risk.
Likewise you’re not extra biased IN FAVOUR of having OPTIONALITY with ways to succeed. Having BACK UP PLANS over backup plans over BACKUP PLANS
Look, here’s how it works:
-If there’s a TINY chance of you FAILING COMPLETELY — then you WILL FAIL PERIOD. BY DEFINITION. If it’s possible — it means it IS going to happen. Sooner or later
-Small risks MULTIPLY into a HUGE risk. If there’s more than 2 small risks — than that’s already a BIG risk. Can you afford it? You must ASSUME it happening — and then ask yourself if you’re OK with it. Otherwise you’re not prepared for this gamble
-If there are MANY ways in which you could succeed — that is FAR, FAR, FAR, FAR, FAR superior to “few unlikely ways in which you could fail”. You’d rather have million small fails than unlikely single fail that puts you out of business
You must be ever mindful of those 3 principles,
You must do the math when math is warranted. It’s a complex world.
And you MUST NOT DELUDE YOURSELF.
Perhaps that’s the biggest issue.
It’s not only your innate misunderstanding of how risk works.
We do in fact have SOME modern understanding of risk:
-Hence we have INSURANCE
(protection from low probability life-ruining disaster)
-Hence we have diversification
(decreasing short-term volatility by getting closer to expected value)
-Hence we like to have buffers and redundancies and abundance
(protection from things failing and incurring losses and bad luck)
It’s just that we often apply WRONG PRECAUTION to the
WRONG RISK
E.g. you diversify to different offerings in your business — but they all still hinge on the single breaking point of having someone want to BUY from you in the first place
Or you diversify measures you take to achieve certain goals — but again the breaking point happens to be the SAME for all those measures — therefore you diversified nothing
Or you INSURE yourself (literally or by putting in extra effort) to decrease many minor insignificant risks and mistakes — while ignoring the TRUE dangerous risks. E.g. nitpicking insignificant details — while failing to pay due attention to truly important problems.
Or you save money, protecting yourself from financial setbacks — except you fail to realise you are now susceptible to a new risk of opportunity cost (e.g. inflation eating your savings vs deploying that capital to produce some value, directly or indirectly)
But do you know how you learn risk-management, truly?
By TAKING RISKS.
Now some will tell you that it must be “skin in the game”, it must be truly “risky” — i.e. must have possibility of adversely impacting you — for it to count as “risk”
I tell you if you love the truth and love yourself — you will be taking risks every day.
If you love yourself and CARE about making the most out of this short life and this short day — you understand the consequences of FAILING today. You know that you are what you did today. You understand that EVERY DAY you risk WASTING day of your life, which is your life.
Therefore you wake up striving to do better. You set REAL goals in the mornings. And you answer for your results in the evening.
This is how you quickly learn WHAT WORKS and WHAT DOESN’T. When you actually want to keep your word, then you actually learn to play the PREDICTION game. If you can’t predict anything then you can’t keep your word then you can’t make any plans then you can’t tangibly improve anything today at all.
But as you get good at predicting you get good at RISK MANAGEMENT. You can’t be good at predicting without being good at risk management.
This is how you learn to manage RISK in your life.
It’s PRACTICE + those 3 principles
Let economists and statisticians and investors worry about complex risk management strategies and hidden risks and black swans and what-not
You just:
-don’t get killed, don’t go broke, don’t lose your health, don’t ever RISK anything you can’t EASILY recover
-never underestimate unlikely risks that are nevertheless huge in effect. Be paranoid then.
–develop powerful bias in favour of low-cost opportunities and optionality. Be adventurous then.
-and LEARN to APPLY all of the above by treating EACH DAY like it’s your ENTIRE LIFE — and you have to make the most out of it