How Prostitutes and Paparazzi Hedge Their Risk

Returning to the concept of risk in general, you write: "The question should be, how can I take smarter risk?" instead of, "Should I take a risk?" Please explain.

The [issue] is: How can I [minimize] the downside as much as possible? [Typically] financial planners ask: "Are you a risk-taker, or are you not?" But the [better] question is: How much risk do I need to get to my goal? How much risk do I need to make sure I can fund this stream of income in the future? From there, you can hedge or insure along the way. That's taking smarter risk instead of: I'm just going to invest in the stock market and see what happens.

What are your five principles for understanding and assessing risk, as indicated in the book?

No. 1 is: No risk, no reward. People need to have a well-defined goal. The way to manage risk is to be very clear on what you need, and to define what risk means and how to measure it. No. 2 is overcoming irrationality and other behavioral biases. We all have biases that keep us from making risk choices that are supposedly in our best interest.

How do you overcome them?

The answer, partly, is having more education, especially financial literacy. You'll never completely overcome all biases, but you can do a lot better.

What are your other principles?

No. 3: Get the biggest bang for your risk buck. That happens through diversification. Don't take any more risk than you need. If you do, you get the potential for more; but you risk getting a bigger downside. No. 4 is: Use hedging and insurance for risk management. No. 5 is knowing that uncertainty happens. Things will always happen that you can't anticipate or imagine. So this is about risk planning for something you never expected.

You interviewed Ret. Gen. H.R. McMaster, a risk-in-warfare expert and President Trump's second national security advisor. What did he tell you about planning for the unexpected?

He said, in part, that you need to make sure you have flexibility to make in-the-moment decisions.

Please discuss underestimating the odds that something will occur. You write that "Crime is one example of huge risk miscalculation."

I spoke to a lot of people in prison who were like, "I never thought I'd get caught." I also talked to Sam Antar of [the defunct] Crazy Eddie electronics chain. I said, "You did a crazy thing taking your [family] criminal tax-cheat business public and selling shares on the stock market. Did you ever discuss that you might get caught?" He said no. To this day, the [Antars] think they just got unlucky and that there's no reason they should not have gotten away with it.

You encourage readers to talk with a financial planner about "How much [they] can gamble." How can anyone afford to gamble when they're funding retirement?

When you retire, the money you need for your [mortgage or rent], food, Medicare premiums [and other necessities] isn't money you should gamble with. So think of putting your retirement spending into buckets.

For instance?

How much you absolutely need every year should be invested in, for example, risk-free long-dated bonds or an annuity. But you also have to take some risk if you want to spend as much as you want. So look at expenses that you could gamble with, like taking a cruise or buying Christmas presents, and invest that money in riskier assets.

"You're exposed to more risk than you realize because the financial industry has defined risk-free wrong," you write. What, then, is your definition?

Risk is everything that might happen and the odds that they will. Risk-free in retirement is a steady, predictable stream of income, similar to what people had in defined benefit plans. Investing with that goal in mind — such as with long-dated bonds — takes a different risk-free rate than if you just want a big pot of money, as with [investing in] a T-bill.

You write: "Insurance works like magic." What's magical about insurance?

What's really cool about insurance is that unlike hedging, you don't have to give up the upside for getting rid of the downside. You pay someone to take on the downside risk for you, and you keep all the upside. To me, that feels magical. It's the idea that you can still take risks but keep the upside.

Another sort of enterprise you explored for your book was the business of a paparazzo. On a tip, you and he waited quite awhile for Alec Baldwin and wife to emerge from their NYC apartment, only to learn later that they'd left before you arrived. What did you learn about how these photographers manage risk?

Paparazzi take a lot of idiosyncratic risk in that the odds that they're going to get that great "money shot" on any given day are so random. That's why they diversify their risk by forming alliances with other paparazzi.

You also investigated risk at a stud farm and discovered that horse breeding is even riskier than investing in the stock market, you say. What makes it so?

It's more uncertain. The breeders hope the horse they get is a good racer, but they sell it after one year. So the [goal] is getting a good yearling price.

What was it like to watch a thoroughbred, Gun Runner, mate?

Very weird, squeamish, but it was over very fast. Afterward, one of the [staff] put her arm, up to the elbow, into the mare to deposit the runoff sperm, which she'd collected [after Gun Runner dismounted]. I really saw some strange things for a book about financial risk!

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