Ergodicity: Risk is Good, Unprotected Progress is Not
Originally sent to clients of Upstart Wealth Management
“It’s risky,” you hear someone say, “so be careful!”
Risk is discussed as something to be avoided, as something that causes discomfort and fear. Risk is associated with downside, failure, and loss. However, risk can also come with upside, success, and gain. Today, we’re here to say that risk is actually a good thing, and we want you to take it.
If you’re reading this, you probably feel that you have a lot of human capital. You’re probably also confident in your ability to leverage your human capital to create success. That’s to say, you’re confident that the decisions you make today will lead to good outcomes (financial or otherwise) in the future. However, it’s impossible to be 100% certain that you’re making the correct choices, or that pure chance won’t knock you off course. That uncertainty, or risk, is an inevitable part of every decision. You can only experience so much success if you don’t subject yourself to some level of risk.
A high-skill individual should expect that, on average, the risks they take lead to good outcomes. However, we know from our last two emails that the distribution of possible outcomes, not the average return, is what matters at the individual level. A good strategy can still lead to blowups. Counterintuitively, by acknowledging and protecting against blowup risk, you can actually engage in riskier behavior!
As an example, consider a video game that allows you to save when you reach a checkpoint. If the game saves right before a boss battle, the player can employ a riskier strategy in the subsequent fight. If they fail they’ll only lose a little bit of progress. If, however, they encounter the boss and haven’t had a chance to save in hours, they’ll fight more timidly, or maybe even run away. If the player never locks in previous progress, they play more conservatively as the game goes on. In turn, they miss out on the potential gains of a riskier strategy. Unprotected progress actually becomes a burden, not an asset.
The same concept applies to finances. Rather than enjoying their situation, successful people often live in fear of losing what they’ve gained. By legitimately addressing, not just fretting about, downside risks - through diversification, insurance, and other techniques - one can view their progress as an asset, not a source of anxiety. If you have an adequate backstop, you can deploy financial and human capital towards potentially more rewarding endeavors. After all, upside potential and downside risk aren’t always symmetrical; if you can eliminate unnecessary risks with small payoff potential, you increase your risk capacity to see the important bets all the way through.
Dwelling on negative possibilities that could derail your future isn’t helpful. Instead, you can acknowledge those downside risks, address them, and continue building for your future self. Not addressing risks with an honest lens is like playing a game with no save points where you risk losing what you've gained along your adventure. You have engaged in and benefited from previous risk-taking behavior - you wouldn’t be successful otherwise. With that said, be cautious of risks you cannot afford to absorb if they fail. It’s important to evaluate whether it makes sense to increase your risk capacity across all facets of your financial life. In turn, you can put your chips on the table, confident that regardless of the outcome, this next bet won’t have to be your last. Even more important, you won’t undermine everything you’ve worked hard to build so far.
