Evaluating Risks and Rewards

In our past posts on making mistakes and experimentation, we both advocated for taking risks as long as the risks were not too large. In this post I wanted to dig into that more and talk a little about the framework I use for evaluating the major risk / reward decisions in my life.

Almost all opportunities come with some degree of risk. Buying a home exposes you to the risk of dropping real estate prices or increasing interest payments. Asking someone out on a date comes with the risk of rejection. It’s an advantage to be able to evaluate the risks and rewards of any opportunity presented, but developing this skill takes practice. Here are some tips for improving your evaluation:

Time value of risk and rewards

Some opportunities allow us to quantify the risks and rewards involved either in money or in time. If you’re making an investment you’re usually risking some amount of money (either at present or over time) for the possibility of some return on that investment. If you’re buying a car, perhaps you might weigh the amount of money you’ll spend on it against the time it’ll save on your commute. 

In each case, I like to convert all of these quantities into some unit of time. For costs or money at risk, I like to think in terms of how much time it would take me to earn back that amount. For potential gains or reward, I like to think in terms of how many fewer days or months I’ll have to work in the future as a result. This way, I can put all of these quantifiable decisions on the same footing.

For example, imagine you are thinking about getting a car and the cost of ownership is $450/month, including car payments, insurance, maintenance, gas, etc. If you are earning $15/hr after taxes, you’d have to work 30 hours to pay this off. One step in evaluating whether the car is worth it for you is to ask if the benefits of owning the car are worth 30 hours a month of your time. Will it save you 30 hours a month in commuting, or doing errands? Are there other benefits that might make the price worth it? Could you accomplish those things at a lower total cost or would you be giving up some other benefit that’s important to you?

Include the non-quantifiable

It’s not enough to stop at just considering the quantifiable risks and rewards. Most opportunities, even the financial ones, come with some qualitative risks and rewards. If you’re investing the stock market for the first time, you might receive the qualitative reward of learning more about finance. If you’re buying a home, you might consider the satisfaction you’ll gain from the new lifestyle afforded by home ownership or the risk of losing the flexibility to change locations every few years. It’s often difficult to balance these non-quantifiable risks against the quantifiable ones, but I like to think in terms of present and future happiness. How many hours of satisfaction will I accrue now or in the future as a result of my decision? How many hours of stress could I expect? These aren’t perfect measures, and in fact, happiness and stress are things that can change a little with attitude, but at least this gives me some metric to include the non-quantifiable in my decision.

Seek asymmetry

If you go through the above exercise, you’ll quickly realize that you’re usually only making the very roughest kinds of estimates. Because these estimates are necessarily very noisy and highly error prone, they’re most useful when the risk/reward ratio is highly asymmetric. 

Take the scenario of applying for your dream job. You might be risking some time (in prep and at the interview), stress, and the possibility of rejection. But, if successful, you could earn significantly more money in the short term, or have a better work-life balance, or even be put on a better career trajectory long into the future. Under that kind of asymmetry, even if your chances of success are low (say 10% or lower), it might still be well worth taking a shot at that dream. In general, if an opportunity seems to provide an asymmetric reward, it may be worth exploring.

Protect your downside

There is a caveat, though, which is that, if possible, you should avoid risks that, even if unlikely, might completely ruin your life. Examples of these abound, but let’s start with the relatively simple case of a financial risk. Imagine you are nearing retirement and have saved up a nest egg of $100,000. Suppose someone comes to you and offers to let you flip a coin. On a heads, they’ll pay you $110,000 more but on a tails you lose all of your money. Even though, on average, you would earn more than you would lose, it’s probably not a good idea to take the bet. Your risk of ruin is far too high. 

A rule of thumb I try to follow, for financial decisions, is to only ever allocate 10% of my money for high risk opportunities. And when evaluating each opportunity within that 10%, I still use the Kelly Criterion to avoid putting all of that budget into a single risky play.

For non-financial decisions, again, I avoid those opportunities which come with the downside risk of my spending many years (or perhaps the rest of my life) in misery. Opportunities that risk my health, my family, or my freedom (e.g. through crimes) are never entertained in the above framework.

How do you go about evaluating your decisions, NC? Do you use a similar framework or something else entirely?

One Reply to “Evaluating Risks and Rewards”

Leave a Reply

Your email address will not be published. Required fields are marked *