Embracing Risk

Taking risk is a necessary element of growth. Leaving our comfort zone is how we develop skills and find opportunities. Since the uncertainty brought on by stretching our limits can be uncomfortable, the tendency can be to stick with the status quo. But risk is present in everything we do, even if we forego making a decision.

The distinction between risk and uncertainty is an important one. Risk is the possibility of loss from an action (or inaction) and the magnitude of that loss if it happens. Uncertainty is simply the presence of doubt when something is not known for sure. Uncertainty can be stressful, and it's natural to want to reduce or eliminate it, even if doing so means closing the door on an opportunity. But It's important to realize that eliminating uncertainty may not reduce risk, and doing so prematurely can actually work against us.

We may hear of a situation being described as "risky," but what does this actually mean? Anything new we take on carries some risk, and so is "risky" by definition. What would be more useful to know is the probability of a negative outcome, as well as the impact of that outcome, both on average and in the extreme. Often though, risk isn't something that's quantified, it's something felt in the gut. This gut feeling can be useful to alert us to potential risks that should be evaluated further, but isn't sufficient on its own for making a decision.

Quantifying Risk

Morgan Housel has a highly useful framework for thinking about risk, which he calls "The Three Sides of Risk."[1] He says we need to consider three components:

The odds of getting hit (the likelihood of experiencing a negative outcome);
The average consequences of getting hit (what we lose if we experience a loss, in economic or other terms); and,
The tail-end consequences of getting hit (the worst case scenario, if everything goes against us).

Since very few things in life are certain, the likelihood of an outcome can be expressed as a percentage. This is the mental model of thinking probabilistically. Is a negative outcome 10% likely? 75% likely? We can look to our own past for data, or to the experiences of others. Our taking a new job has worked out 2 out of 3 times? 33% chance of a negative outcome. One in two restaurants fail in the first year? 50% chance of a negative outcome if we open one. The likelihood doesn't have to be exactly right, what's important that it gives us a frame of reference.

Consequences are everything that follows after taking or foregoing a course of action. The average consequences are what would be typical of our experience if we took the same risk many times. But in a single instance, our experience can vary dramatically.

Average consequences are useful as a reference point, but aren't sufficient for measuring and managing risk. To do so effectively, we need to understand the tail-end consequences. By understanding the worst case scenario, we can avoid two common traps. The first is that we underestimate it and expose ourselves to catastrophic loss if things go against us. The second is that we overestimate it and avoid risks that don't have such dire implications. Underestimating and overestimating tail-end consequences can each impede our growth and development.

Choosing Good Risks

Look for asymmetric upside

The expected value of a risk is a weighted average of its potential outcomes. Risks with asymmetric upside have positive expected values, meaning the result of taking the risk is more likely to be a gain than a loss. If a risk has asymmetric upside risk, it may be worth taking, provided that any downside risk, however unlikely, is not catastrophic.

Look for two-way doors

One of Amazon's leadership principles[2] is a bias for action. To encourage the taking of calculated risks, the company uses the concept of a two-way door as a metaphor for a decision that can be reversed if it doesn't work out. Decisions that are reversible should be made quickly, with minimum deliberation. With every risk, we learn new information about ourselves and the situation, so testing our beliefs in situations that aren't permanent is an effective way to grow.

Fire bullets, then cannonballs

In Great by Choice[3], Jim Collins describes low-risk experiments, which he calls "bullets," as a way to empirically validate what course of action will actually work. As long as the costs of these experiments are kept low enough that we don't mind if they don't work out, we can fire many of them to discover which is worth pursuing. Once we find one, we concentrate our efforts and fire a "cannonball" to achieve maximum impact. A key finding of Collins' research is that decisions which look to be genius in retrospect were often the result of small, manageable trials by error that showed through empirical evidence the best option to pursue.

The idea of risk can be unsettling, but often it's the uncertainty that gives us the pit in our stomach, not the actual risk. By better understanding the risks we face and being intentional about which we undertake, we can use risk to our advantage.

Jump Start

Think of an idea you've had about changing something in your life. Is the decision reversible with minimal consequences if it doesn't work out? If so, give it a go!

[1] https://www.collaborativefund.com/blog/the-three-sides-of-risk/

[2] https://www.amazon.jobs/en/principles

[3] Collins, J. Great by Choice. 2011. A related concept to firing bullets then cannonballs is the sizing of bets and investments. The Kelly Criterion is a time-tested approach to sizing bets to manage risk. Nick Yoder has a well-written article if you're interested in the math behind this concept. https://nickyoder.com/kelly-criterion/