Different Kinds of Risk
Every decision we make comes with some form of risk. Risk is embedded in our lives, and yet many of us overlook the types of risk that we face every day. Committing to pursuing one startup idea means you can’t pursue another one at the same time, even if it is better. Taking a bet on a new form of cryptocurrency may change how you are seen by some outsiders who believe that crypto is not a safe investment. Jeff Bezos was famous for coining the term “regret minimization framework”, which he claims is where risk management starts. When you are making decisions, you should always try to minimize the amount of regrets you have. After adopting this framework, the questions become “Will I regret not pursuing this?” or “Will this be a mistake when I look back in 30 years?” which are more accurate and prompt more in-depth analysis than “Is this a good idea?”. Most of what seems risky today you will forget about by tomorrow, but in the long-term, some of those risks can have a real impact.
There are three components that make up a good risk. The first is that you should avoid decisions that you will regret, and make decisions that you will not regret, even if you fail. Secondly, the best risks you can take are those that can be easily reversed — if something goes wrong, you can go back to where you started. Finally, good risks are asymmetric and those where you stand to lose only what you have invested, but stand to gain 10x or 100x what you have invested. A good risk would be writing a book this year. Even if the book fails, you will only lose the time and energy you invested. If it succeeds, then you stand to gain a lot — a reputation as an expert in a subject, prominently. But I am almost certain that 10 years later you would regret not taking the time to write a book when you had the inspiration to do so. Before you decide to make a decision, you need to know the types of risk that you are taking.
1. Financial Risk
Financial risks are often those we plan the most for. Financial risk refers to the monetary damages which you will incur if a decision does not go your way. Let’s say that you are a public market investor. Your job every day is to make money from stocks. Therefore, you will spend a lot of time managing risk, and planning for which investment has the best risk/return ratio. If an investment has a lot of risk, is it worth the upside you stand to gain? If there is not much risk, is is still a good investment? A good rule of thumb is that guarantees or very low-risk things often yield average returns. We think the most about financial risk because if we lose money, we can realize the immediate effects of that. Our bank balance decreases, either immediately or in the near future. If we start a business and fail, we will look back on our financials to see how much risk we took that did not pay off.
Everyone has different tolerances for risk. This applies especially to financial risk, where there are managers who help counsel people on how to tolerate the risk they are taking. Some people may be willing to lose most of their money and make big bets that could pay off — young people often have more aggressive investment portfolios, as they can stand to make money back over time. Some people may want low-risk investments because they don’t have a lot of time to make their money back if their portfolio fails.
2. Career Risk
Career risks are the decisions we make that may either benefit or harm our career. Let’s say you have two job offers. This is a decision where you need to think about career risk. How will your career benefit by working for Company A? Does that company offer a lot of benefits? Does Company B offer more to you such as a higher salary and better promotion opportunities? Every decision we make in our career matters, because, although many people like to deny it, there is still a somewhat hierarchical structure in careers. If you make the decision to go to work for a bad company that does not give you the ability to showcase your full potential, then your ability to make an impact will be limited. When you are looking for another job, you may find it difficult to get anyone to reach out because you don’t have a strong track record with your last employer — even though it was because because they were not a good employer. When you make decisions about your career, think about it like this: will this help me over the long-term? Will I regret taking this job?
When we are younger we can afford to take more career risks. People often recommend that young people shouldn’t start companies. But I would argue this is the best time to start a company. If you fail, then at least you can say that you tried your hardest and that you have acquired experience in a startup environment. If you succeed, you stand to gain 100x what you have invested and may have paved the way for success in your future career — you have built new networks and so on which will help you move on, if you even want to. As your career progresses, you can afford to take fewer risks because your risk parameters will change and you will have a lower tolerance for risk.
3. Reputation Risk
Reputation risk is often understated, but is a critical part of measuring whether or not a decision is worth making. Let’s use the example of pursuing a career in cryptocurrency. If you started back in 2015, there was a significant amount of skepticism around the industry. Financial opportunities were not clear and the investments appeared risky. People didn’t understand crypto and so people often discarded the idea altogether. And it took a lot of time to learn about the industry. In this instance, you took a few risks. Firstly, you took the financial risk of pursuing a career that may not pay off. You also took a career risk because if crypto failed, future employers would likely see you differently. But most importantly, you took a reputation risk. If things didn’t work out, you would look stupid. People would ask “Why did you pursue crypto when everyone knew that it didn’t make sense and didn’t pay off financially?” for a long time.
But if you were to succeed in pursuing crypto, then your reputation would realize significant benefits. Your work may have led you to become an expert in some specialization of cryptocurrencies, which allowed you to capitalize on the growth of the overall industry. I took a reputation risk by pursuing a career in researching Income Share Agreements. Some people think that the agreements are like indentured servitude, and others think they could offer more prospects for discriminating against students.
If ISAs failed, I would look dumb — “why did he pursue that when most people knew they were risky and dangerous?”. But if they succeeded, I would be in a great position to advance my career. I would be seen as an early expert, and be rewarded for taking the risk of pursuing that career early. It’s worth noting that career risks in this sense become less risky over time, as an industry becomes more developed. But because the industry has more traction, the pay-offs will not be as high. It will be harder to become an expert. There will be a lot of people ahead of you who got in early. You will need to make some unique contribution to a market where so much has already been done, or have your own competitive advantage. It’s not impossible, but it is more difficult.
Reputation risk goes the other way, too. Sometimes it is worth making a bold move. After all, the best ideas have been generated by those who were willing to completely discard the status quo. Ask yourself “In 10 years, would you regret not pursuing a career in crypto?”. If the answer is yes, then pursuing a career in crypto may be the best idea. A big mistake people make is that they are afraid to look dumb in the short-term, which makes them overlook opportunities that could yield massive upside in the future. Safe paths cap downside and upside. Don’t be afraid to look weird for a short while if you believe in an idea or an industry. Also, reputation risks are temporary. People will likely forget about your failures quickly, unless you took a risk that you shouldn’t have and that nobody else understands.
4. Opportunity Risk
The final type of risk that I think is important to understand is opportunity risk. When you make a decision about how to use your time, you can’t use that time for anything else. Let’s say that you decide to watch television for an hour before you fall asleep. You can’t also fully focus on a book at the same time — your mind is consumed with the television show in the background. You could have used that time to read your book though, and acquire new knowledge. In order to make an informed decision, you must first consider all other options and ask yourself “Does option B work out better for me?”. If you rush to a decision and choose option A because it was the first option that came to mind, then you miss out on all of the upside that option B could have yielded. One way to mitigate opportunity risks is to make decisions that are easily reversible, as aforementioned. However, many decisions will require your full commitment, and so this is not always an option.
I am pursuing a career in research and writing right now. That means I also can’t pursue a career as a coder at the same time. I could not give my best effort to pursuing two careers at once. I had to make a choice. After careful consideration, I was confident that my pursuing research would yield more upside and give me access to a lot more opportunities. In hindsight, this was a great decision. But if I had chosen to become a coder, I wouldn’t have been able to realize all of the benefits I have experienced by being a researcher and a writer. Opportunity costs can hurt. If you make a decision to do something one way, you can’t make a decision to do something another way at the same time. Before making any decision, you should first evaluate whether pursuing this opportunity will lead to more opportunities in the future, or whether the other option is better for you.
5. Bonus: Second-Order Consequences
Second-order thinking is not a type of risk, but is something that you should consider when making decisions. Second-order thinking refers to what will happen after a consequence is realized. Let’s say you start a business and take out a loan. In the immediate future you will have the money you need to cover costs and scale your business. This is a first order-consequence. But if your business fails, you may have trouble paying of your debt. This is a second-order consequence. When you are thinking about risk, you should consider the secondary effects of your taking that risk. Your career may be harmed in the interim if a decision doesn’t pay off, but over the long-term you will realize significant benefits. Your bank balance may be harmed immediately after taking a risk, but it may be hit even more down the line. Think about what will happen after the immediate effects. The best way to do this is to ask “And then what?” after considering your initial options. Then plot out which one has the best first-, second-, and third-order consequences, et cetera. Consider the second-order consequences.
Evaluating risk requires some combination of short- and long-term thinking. The effect of most financial risks can be realized almost immediately. But the effect of reputation risks can take longer to realize. People may call you dumb for a few years, but in the long-term they may call you one of the smartest people they know because you took a risk on a new opportunity that paid off. When you are making decisions, you need to consider what the short- and long-term effects of that decision will be. Can you handle an immediate financial hit, if it would yield to a significant boost in your finances over time? Would you be willing to look dumb for a few months, if you could become an expert over the long-term? Always try to balance risk between your present self and your future self. There is more to risk than just the immediate consequences.
Risk management can be confusing. But when you break it down into what you will regret the most, it becomes easier to think through your decisions. You should think about regret in the context of the above types of risk — financial, career, reputation, and opportunity. If you use this framework, you will be able to mitigate more risk and make more informed decisions. It’s also worth noting that some risks you take will not pay off, even if you do everything you can to mitigate risk. There is a chance that you will feel bad, no matter what you do. But if you don’t recognize that some of your risks may not pay off at all, no matter what time and money you invest, you will be hurt even more. Therefore, the best thing we can do is to work hard to mitigate risks, and plan ahead. Even if they don’t pay off, planning is always a good idea.