TIB 17: There is no such thing as bad risk, only miss-priced risk

TL;DR - There is no such thing as bad risk, only miss-priced risk, which means that life is like a poker game. The goal should be to size our bets appropriately depending on how much information we have available to us. Sizing (or pricing) our bets is the most important thing we can do to maximize the potential benefit to us, whether it is in our career, our investments or in our personal life.

Risk, its everywhere!

Especially if you are someone who is interested in managing finances, the term “risk” is thrown around more times than you can count. You have countless people coming out of the woodwork offering to help you “manage” your risk. A lot of people will argue that there is good risk and bad risk, and that you should lean towards taking good risk and avoiding bad risk at all costs.

I think all of these people are missing the point here. There is no such thing as good risk and bad risk, only miss-priced risk.

The one caveat here is if you are doing anything illegal, it is most definitely BAD RISK (so like, don’t sell drugs no matter how good the return on investment might be).

This begs the question: how do we price risk? The answer to that question might lie in learning how to play poker.

Life is more like poker than chess

As you might have realized, there is uncertainty all around us. We are rarely making decisions based on perfect information, and because of that, we are essentially making "bets” with every decision we make.

When we decide to cross the street, we make a bet that we can cross safely without getting run over by a car. When we decide to invest in something we are making a bet based on imperfect information.

No matter what risk we take, we are taking the risk of not knowing what the future will look like. The amount of money we are willing to risk on any given bet should be determined by how much variance there could be in the eventual outcome.

Said differently, we have a much higher confidence in what the state of the economy might look like in ten years than we do what Netflix’s revenues will be. We should size our bets accordingly (i.e., allocate a greater percentage of our portfolio to future outcomes that we have more information on and more confidence in the range of outcomes).

To use a poker analogy, investing in Netflix five years ago was like betting when you haven’t seen the dealer flip over any cards yet.

Investing in the S&P 500 is like making a bet when the dealer has dealt all of his cards. In the first instance, there was a lot of uncertainty (that is why people don’t normally go all in before any cards are dealt).

In the second instance, there is way more certainty, so the amount of money you risk at that time is relatively larger.

If you think you are holding a winning hand when the cards are first dealt, then the goal should be to size your bets such that you can (i) see your bet to conclusion and (ii) make as much money as possible given the circumstances.

Sizing it too large at the outset might put you in the position to risk too much given the uncertainty and force you to fold your hand before all the cards are on the table.

Sizing it too small will allow you to see your bet to conclusion, but you might forfeit the chance of making as much money as you should have when the odds were in your favor.

You should look to size it in such a way that if you win, it makes a difference, and if you lose, you don’t lose your entire pot on one hand.

For more on this philosophy check out Annie Duke’s “Thinking in Bets”.

Is rat poison risk that we can price?

Now before I go any further, I want to make very clear that while I will be discussing the Bitcoin ETF that just launched a few weeks ago, NOTHING IN THIS ARTICLE IS A RECOMMENDATION TO BUY BITCOIN, CRYPTO, OR ANY OTHER FINANCIAL INSTRUMENT, DIGITAL ASSET OR OTHERWISE. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS. DO YOUR OWN RESEARCH.

Ok, now that we have that out of the way, let’s continue.

As I mentioned above, a number of Bitcoin ETFs were approved a few weeks ago, which could signal an institutionalization of an asset that had long since been bucketed by mainstream financial services as “bad risk”.

Actually, that is one of the nicer phrases that have been used to describe Bitcoin. Our dear friend Charlie Munger used to refer to it as a “noxious poison” that was “partly fraud and partly delusion”. Munger once called it “rat poison”, only to have his partner Warren Buffett double down and call it “rat poison squared”.

While I admire and continue to learn as much as I can from both of them, if you had listened to them re: Bitcoin, I think it might have been an example of confusing bad risk with miss-priced risk.

Historically, the two things that Bitcoin has been are;

1. an extremely volatile asset in the short term; and

2. an asset that has performed well over longer term holding periods. Take a look at any four year period for Bitcoin and I think many of you will be surprised at its performance.

The question with Bitcoin and anything else in life is “how do I price this risk” if I have done the work and think that it is a worthwhile risk to take.

Given the volatility that I mentioned before, putting all of your net worth in Bitcoin would have been asinine.

That is what we would call miss-priced risk. The volatility would have made anyone sell out at the worst possible time and you would have likely not been able to see your bet through to completion.

On the other hand, if you had allocated a small portion of your net worth to it in an otherwise well diversified portfolio and committed to holding for the “long term” (which usually means five years at least in financial terms), then chances are that you were better off five years later even though you included “noxious poison” into your portfolio.

Playing devil’s advocate, even if Bitcoin had gone to 0 and fulfilled all of mainstream finance’s prophecies, if the portion you allocated to it was small enough, then you would not have suffered a catastrophic loss putting you into financial ruin (unlike the person who put their entire net worth into Bitcoin).

Even though the two people took the same risk (i.e., they both invested in Bitcoin), their outcomes were completely different depending on how each person priced that risk.

What we can learn from a fellow TIB member

Just this weekend I met one of my readers at a party, and for the last few years, whether he has realized or not, he has done an excellent job of pricing the risk around his career.

He has always been very passionate about music, he is a fantastic guitarist, and thus far he has pursued that passion and talent without “risking it all” and devoting himself to music full time.

He has wisely kept his day job, working diligently to make sure he has money to live the life he wants to live while playing in a band in his free time. The exciting news is that his band is just starting to take off after a lot of hard work and a little bit of luck!

They are booking more gigs and he is starting to realize that he might be able to live every aspiring musician’s dream: to make music his life’s work.

He says that he is constantly working these days, either at his day job or on music, and at some point something will have to give. He might have to make a choice sometime soon as to whether he wants to pursue his dream of making it as a musician full time.

By deciding to keep a steady job, our fellow TIB member bought himself time so that he could see his bet on his music career through to its conclusion.

He bought himself time to see what card the dealer was going to flip over next. Now he might be ready to bet a little bit more given the new information he has available (the interest in his band, the money that they could make in the future based on the interest and the momentum, etc).

There is no way of knowing how this would have turned out had he devoted himself full time to music at the outset, but my guess is that he might not have been able to see his music bet through to the end had he decided against keeping his steady job.

He didn’t have enough information available to him; he hadn’t seen enough cards yet to make a bigger bet.

Now that he has a lot more information, he will need to figure out how to size his next bet to maximize his chances of success. While it is impossible to know what the future holds, I am betting on his success because he clearly understands how to manage risk in his life.

Final thoughts

Dealing with an uncertain future is never easy but it is something we all must learn to do, whether it is with our finances, our career or in our personal lives.

Getting comfortable with being uncomfortable is important to our growth as individuals, because without risk there is no reward (two cliches in one sentence must be a record for me).

The goal shouldn’t be to avoid risk altogether; it should be to price the risk in our lives in a way that maximizes our potential return. As we have discussed before, the best way to maximize your potential return on any bet you make in life is to make sure you avoid catastrophe.

Whether it is in a game of poker, figuring out how to invest in a volatile asset class, or deciding whether you have what it takes to be a professional musician, the only thing we can do is to price the risk appropriately.

If life’s a game of poker, just make sure you don’t lose it all on one hand.

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