Why Take Risk?

Risk taking, I argue, is uncompensated on average. There is no simple form of risk taking such that, if you can tie yourself to some intellectual mast and bear this psychic pain you should expect a higher return. There is a mistaken syllogism at the bottom of portfolio theory, as just because you have to take risk to get rich, or if you take risk you might get rich, this does not mean if you take risk you will become richer on average.

In some aspect, this is obvious. A lot of people would be willing to put their funds in some blind risky trust at a young age, if they could then know with statistical certainty this would maximize their wealth at retirement. If this were so investing would be a lot simpler. Also, think about other distasteful activities, such as cleaning septic tanks. Indeed, Keynes compared risk taking to working in ‘smelly’ occupations, noting such activity would require a premium. Yet septic tank work does not pay really well, and the Untouchables in India have long had a monopoly on cleaning sewers manually without much compensation.

So, if there is no extra return, why take risk? Roy Baumeister makes an interesting argument. He notes that historically 80% of females have reproduced, while only 40% of males passed on their genes. The rest of the males, historically, have been genetic dead ends. Historically a female could play it safe because there were always men willing to impregnate them, whereas a male who remained meek was elbowed out of sexual trysts. Males have to beat out other men to get access to females. Thus, men built ships and traveled to far-off lands because those were the guys who had more children, whereas a bunch of women could bear children just as easily staying put. Everyone’s male ancestors have been disproportionately bold risk takers; not taking risk, over generations, is certain doom. We take risk, therefore, because not taking risk is genetic suicide, at least for the gender that generally takes such risks.

Currently selection is not so pressing, perhaps even opposite to our past, but our instincts are not shaped by the welfare state. Men are driven to take risks, improvising, which is why we see so much greater jazz improvisation by men, or risk taking in any area. Baumeister states it isn’t the ability, so much as the drive to excel that leads them to create technological and cultural achievements.

Risk taking is the best way to find your comparative advantage, your alpha, because something you do well is something that requires more than just doing what anyone else can do, by definition. You need to take a risk not merely to inform yourself of some specialized competence, but to signal to others you would be a good person to assume greater responsibility in that area. Organizations are always looking for the best people for parochial tasks, and those who have taken risks are prime candidates.

Risk takers dominate our lives via their disproportionate effect on our genes, and their influence on our technology and culture. They did not become successful, however, merely by taking some abstract ‘risk’ that is the same for everyone, and then enjoy the higher rewards that come with it. They instead took the right risks, those consistent with their unique strengths, and reaped rewards consistent with mastery of something important. Like a golfer with a long drive, you can shoot at the green as opposed to laying up, and that risk is a good one for you, but only because you can hit the ball farther than average.

Modern finance is profoundly misleading when it suggests that reward is merely a function of our ability to withstand some abstruse risk (ie, the covariance with the as-yet-unidentified stochastic discount factor), and chance. Skill, effort, and learning play no part in this sterile world. In contrast, people should see risk taking as a process of self-discovery, of becoming the best you can be, and that playing it safe is, for males at least, a path of oblivion. The payoffs to risk-taking are partially chance, but if you want to take risks intelligently you will gravitate towards risks consistent with your skills, and get better and better at them. If some risk demands nothing of you, merely jumping at it is surely foolhardy because risks do not generate higher-than-average-returns as a general rule, and suggests whoever is selling this opportunity is a modern snake-oil salesman.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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