Economist Allison Schrager joins City Journal editor Brian Anderson to discuss her new book, An Economist Walks Into A Brothel: And Other Unexpected Places to Understand Risk.
Risk is a universal fact of life, but some of us manage more of it than others. Schrager examined how a broad cross section of people handle it: horse breeders in Kentucky, members of an elite tank unit during the Gulf War, paparazzi who stalk celebrities, prostitutes in Nevada brothels. She lays out five principles for dealing with risk and explains how financial tools can help guide people through uncertainty.
Brian Anderson: Welcome back to the 10 Blocks podcast. This is Brian Anderson, the editor of City Journal. Coming up in the show today I talk with economist and writer Alison Schrager about her wonderful new book, An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk. Just a couple of announcements though before we get started. The City Journal team is very sad to announce the loss of a dear friend to the magazine and to the Manhattan Institute: The great, indeed legendary criminologist, George Kelling, the originator with James Q. Wilson of the broken windows theory of public order, which is something City Journal has written about quite extensively over the years. You can find a comprehensive piece on George Kelling on the City Journal website by our own Heather Mac Donald, talking about his contribution and his life. Lastly, let me also announce next week's episode of 10 Blocks, which you should stay tuned for. Kay Hymowitz, our longtime contributing editor will join me to discuss her latest piece from the magazine. It's on the epidemic of loneliness, afflicting not just Americans, but people in developed societies across the world. I'm sure you'll find it interesting. That's it for now. After the break, we'll start my conversation with Allison Schrager. We hope you enjoy.
Brian Anderson: Hello again everyone. This is Brian Anderson, the editor of City Journal. Joining us in the studio now is Allison Schrager. She's an economist, a personal finance specialist, a writer at Quartz, and cofounder of LifeCycle Finance Partners. You can follow her on Twitter at @AllisonSchrager, that's s-c-h, Schrager. And she's here today to talk about are fascinating new book, An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk. It's published by Portfolio Books. You can find it on Amazon and we'll link to it in the description. Allison, thanks for joining us.
Allison Schrager: Thanks for having me.
Brian Anderson: Now your book is about risk management and how people working in various surprising fields exemplify the concepts of financial economics. What was the most surprising example of this in your research?
Allison Schrager: I think it must've been the surfers. I had a hypothesis going in that people really understand risk better than we give them credit for. And that risk is fundamental to all markets. But I didn't expect big wave surfers to be so intellectual about it or that they have a conference, an annual risk conference where they really are discussing the same issues that you've see it financial economics conference full of Nobel Prize winners. They're really debating the same issues. The intellectual tenor is definitely equal to it.
Brian Anderson: And you attended some of these, or one of these...
Allison Schrager: I went to one and it's a trip being there because you know, you're on the north shore of Hawaii and you're in this windowless conference room at a hotel and it's all these like dudes with like board shorts and they're tan and they're all wearing like flip flops. I mean it looks cooler than a pension conference, but then they start talking and there are slides with numbers and there's debates about who bears the regulatory burden for systemic risk. And all of a sudden it's like you could be at a pension conference.
Brian Anderson: And the big risks there, I guess, are you're going to be crushed by a wave if you handle it incorrectly and...
Allison Schrager: Yeah, dying mostly. But I mean much like, you know, in financial markets it's possible to use technology to lever up and take bigger risks. And when you do, you might pose risks to others. And that's why one of the reasons why they have this conference.
Brian Anderson: I see. Now one of the depressing stories you tell in your book, and it involves your research, in a brothel, a legal brothel. You talk about the "girlfriend experience," and how this explains why legal brothels are so expensive. Could you elaborate on it a bit because that captures something about risk?
Allison Schrager: It does. So legal brothels are a lot more expensive because effectively they're offering what is risk-free sex. It is, first of all, like if you're going to visit a sex worker in the illegal market, which is a much larger market in America, you know, you'd pay a lot less, but you risk a Robert Kraft situation, or possibly a disease or you could get blackmailed or you don't know what's going to happen. So, but if you go to the Bunny Ranch, you'll pay a lot more. But you know, there'll be no repercussions. The women are screened for diseases. You can pick amongst the different women. But you pay for that again and it's all legal so you don't have to worry about law enforcement. And even the most popular service there in its own way is what you pay. What is the most expensive service too is also a risk premium. It's called the girlfriend experience, which is, you know, rather than just have sex with a sex worker, she'll talk to you, you're going to dinner, she'll stroke your hair, talk about your feelings, you, she actually connects with you. She gives you the sense of intimacy. Of course it's false. You're paying for that. But it gives people the sense of intimacy. And I think, you know, there's a push certainly in the UK and it already is the case in Scandinavia. This idea that sex work is this terrible thing that needs to be criminalized. And unlike here, they prosecute the customers. And I think that seen as this enlightened view is like these women are victims. So let's go after the people who are exploiting them. But I think when you go to the brothel and you actually meet the customers, you realize how inhumane that is too. Because you, you meet all kinds. You meet all kinds of sex workers, you meet all kinds of customers. But a lot of them, the customers at least, or just really lonely people, a lot of people crave intimacy but fear it or are incapable of it for whatever reason. So what the girlfriend experience does certainly within the Bunny Ranch is it gives you this sense of connection and safety anyway, even if it's false, although you pay a large premium for that.
Brian Anderson: Now your book has a fascinating chapter on irrationality, that's a big field of economic research these days with behavioral economics. How are we irrational when it comes to risk? And you know, in this context you profile a very cantankerous figure, the poker player of Phil Hellmuth or Hellmuth, however he pronounces it. Talk a little bit about that, because I found that very interesting.
Allison Schrager: Well. So there's a couple of different behavioral biases that behaviorists have uncovered. The big one is loss aversion, which is a traditional economics assumes that we're consistently risk averse, like we prefer.... and this is the foundation of financial markets that we will like, in the brothel, you paid a reduced risk because you know, would rather avoid it. But they found that when faced with loss people actually take more risks because people fear loss so much they become risk-loving. Like they'll take bigger risks to avoid loss, when they're down, but risk averse when they're up. And you can imagine in poker, this is a huge issue because when you're losing, you play a lot more aggressively. And when you win, you play a lot more carefully. But really like your odds of winning or losing individual hand are completely independent of whether or not you're up or down. So you shouldn't do that. That's irrational. That will on average lead to worse outcomes.
Brian Anderson: So you gotta take your emotions out of it as much as possible...
Allison Schrager: Exactly. So what was fascinating about Phil is he's such an emotional guy. I mean this is his brand. I mean he has YouTube montage is on his website. If I'm having a temper tantrums, he is not someone you would think of as in control of his emotions, particularly when he loses, you think who else would suffer from worse loss aversion but he doesn't because he's spent.. he's one of the most successful poker players of his generation.
Brian Anderson: He's made millions.
Allison Schrager: Yes and he's won a lot of very important tournaments like the World Series of Poker. But it's because he keeps his emotions in check and he's trained himself over years and has a lot of tricks to behave more consistently.
Brian Anderson: Now, horse breeding is another subject in the book and it shows how the financial economics idea of diversification, which we often hear a lot about these days is at work outside of your retirement account. So could you describe what went on in the horse breeding industry and how that reflects a diversification?
Allison Schrager: Well it's a lack of diversification.
Brian Anderson: Lack of diversification in this case, yes.
Allison Schrager: So, horse breeding used to be traditionally you would have these gentlemen-breeders who would breed horses with the intention of racing them. And so their objective is make a horse that will do well at the racetrack. But then it's still a long shot. I mean the odds that a horse is going to win the Kentucky Derby, it's like winning the lottery. So you can do some things, but it's really a crapshoot. So for a lot of years, horse breeding became a really popular tax haven where. Because odds are you're going to lose money. But then after 1986 tax reform, it killed the tax incentive or killed it as a tax haven. So a lot of the investors left and everyone else left standing was bearing this huge amount of risk because it's expensive to breed a horse to train it. And then the odds are it's going to never make significant money at the race track. I think it's like 8% of horses will place in a stakes race. So the incentives changed where to reduce their risk. A breeder started selling at the yearling stage when it's one year old, but the problem is you don't quite know whether the horse is going to be good racer at one year, because it hasn't started running yet.
Brian Anderson: When do they start running? Two years? Three years?
Allison Schrager: They start running some races at two years in the big races, like most Kentucky Derby racers are three or four years old. So three or four years is where the money is made. They kind of start at two, you have some, even at two years, you don't have complete information. At one year, really all you know is who his parents are. So that put, you can imagine what this did is like parentage became super important. And you know, while a mare can only bear horse at a time, a stud can... Nothing stopping him from breeding hundreds of times a season. So you ended up with being this huge premium on a small amount of studs. It's actually the superstar economy apparently even applies to horses. But that also means is that... you had a lot of inbreeding, right? Because you have this very small amount of studs who are fathering all the future generations. So you've seen this big uptick in inbreeding, which has consequences because inbreeding is a lot like under under-diversifying your stock portfolio. And that, you might get lucky. You might, because I learned that like Secretariat-level of race horse is sort of a genetic freak. They have all these quirky things and they all line just so, but the problem is you breed... Secretariat was not a successful sire because those weird quirky things, if they don't line up just so, you end up with this sort of not-great racehorse. So you just have this really wide distribution of things that could happen as opposed to if you crossbred more and bred horses, not just with the same four fathers, you would probably have something that typically works better. Although you give up that sort of upside of the next Secretariat. And it's very similar to investing and that, you know, everyone thinks they're going to pick the next Apple, but if you just bet on one stock, most of the time you're going to do worse than if you just bought an index fund.
Brian Anderson: Right, which reflects your own background, right? You worked for an index fund company?
Allison Schrager: I did, an index company that's quite militant about efficient markets.
Brian Anderson: Hedging and insurance are often conflated in people's minds, but they're distinct ideas in mastering risk, right?
Allison Schrager: Yes.
Brian Anderson: Could you explain to our listeners what the difference between those two things are and how do you, how does one apply insurance in one's career or life without taking out an insurance contract?
Allison Schrager: Well, there's three different ways you manage risks. There's diversification which we just talked about. And that's also different from hedging and people often confuse all three of these. So diversification gives you this optimal, if you diversified properly, you have the optimal risk portfolio, which means you're not taking any more risk than necessary. From there, you're supposed to hedge. And hedging, or insure, hedging is like this balance between risky and risk free. So if you were investing in the stock market, you know you'd have a stock index fund, you would hedge by going a little bit into bonds. So what you are giving up is upside. So if the stock market goes up 20% one day and you're only, you only get 10% of that. Say if you're only invested partially in stocks and you gave up some of that upside by investing in bonds. Of course if the stock market crashes, you lose that. So you give up upside in exchange for reducing downside. Insurance is a little different in that you, you pay someone and they take away your downside for you. So it'd be like if the stock market, if you had like portfolio insurance, although that's controversial, but just bear with me, you would say, all right, if the stock market goes up, I keep it, but if the stock market crashes you will give me a certain amount of money so you keep the upside. We get rid of the downside. Of course you have to pay a fee for that. And whether or not that fee is worth it is where insurance gets complicated. Now, you mean you could think about this as true as well for your career because your lifetime earnings or an asset in the same way your investments are. And so one of the best insurance methods for your earnings is education. Because if you think about it, you see that earnings volatility is lower if you're more educated, the odds of being unemployed are much lower. Even at the peak of the recession. People with a college education at a much lower unemployment rate.
Brian Anderson: That's people who are graduating? Yeah,
Allison Schrager: Yeah. Assuming you graduate and it's a reasonable university, right.
Brian Anderson: Another distinction you make in the book is between idiosyncratic risk and systemic risk. What are those things exactly? And how do you use, in the book I found this interesting, I think our listeners will as well, hanging out with the Paparazzi, to describe that difference.
Allison Schrager: All right, so idiosyncratic risk is, in financial markets, the risk that individual stock will rise or fall. So it was like if you buy Facebook and Mark Zuckerberg says something horrible in front of Congress, like your stocks' going to tank. Now you can reduce idiosyncratic risk by diversification. Like we were talking before with the breeders. Now that you can imagine the paparazzi. So idiosyncratic risk is just any risks that unique to an individual asset. And the paparazzi face a ton of idiosyncratic risk in terms of themselves. In that if you're a paparazzo in your wandering the streets of New York, the odds that you're going to get that money shot happen upon Gigi Hadid doing something really crazy and getting that exact right angle of her is pretty random. So they face a lot of idiosyncratic risk on their earnings. So they manage it the same way anyone does or you would in the stock market, just they form these alliances of other paparazzi to share tips, sometimes royalties depending on the arrangement. And that reduces their idiosyncratic risk. Of course, because you get so much extra money if you have an exclusive shot that, they're always cheating on their alliances. They always fall apart. But that's not even the worst risk for them. The worst is the systematic risk, which is the risk in stock market that the whole market will crash like it did in 2008. So that's always a much harder risk to manage. So, what you, the only thing you can really do in finance is find these rare and often very valuable assets that provide, they're called like a low-beta asset, which provide a good hedge against the stock market crashing. So something that goes against, doesn't vary much with the stock market. And to some degree of the paparazzi do this, but they have to seek out these very sort of big event photos. So like a low-beta celebrity photo would be like the picture of a new celebrity baby. But I mean they'll invest like two or three weeks stocking a pregnant star waiting for that first baby shot.
Brian Anderson: And so the systemic risk for the paparazzi was technological. It was the change in the market, right?
Allison Schrager: Yeah, exactly. So the ad market actually goes in cycles. There was something called the "Gold Rush Era," which is the Britney Spears, Lindsay Lohan heyday. Where they would get, like $15,000 for a picture of Lindsey Lohan getting coffee. Now that kind of picture will get $5. And that reflects, one the recession when people stopped buying glossy mags, and two moving online where now everyone consumes their celebrity photos on websites. It just destroyed the market for them. So that's the systematic risk that they're having much more trouble managing.
Brian Anderson: Now your book is aimed, it has a kind of practical aim, which was to make us better risk takers. How we define risk, how we measure it, how do we identify the kind of risk we face. Now there are programs to teach people about financial planning and budgets out there. Should we have similar initiatives in your view to start educating people about smarter risk-taking, and for an individual what, you know, what is your best advice in terms thinking about risk?
Allison Schrager: I think it's recognizing that risk is important, but there are techniques you can do to increase the odds that a risk will go well. I think better risk literacy certainly could be included in financial literacy right now. For some reason it's not. Or even I think in high school education there are definitely should be more of a premium on it. We don't really, people always complain, people don't learn statistics. But really the foundation of statistics is probability theory, basic probability theory, which is often not taught. So it's able to think probabilistically. There's evidence that when you train people, they actually can do it. We always complain, people don't understand probabilities, but we don't really teach them. And certainly even you think of your typical financial literacy class where they'll teach you about compound interest, but they don't mention you get a higher rate of return if you take more risks. Like that tradeoff seems to be missing. So I think it certainly has a place in all levels of education and in financial literacy. I mean, I think it's popular. There's a curious backlash, which I'd really don't understand right now against mindful-spending and financial literacy. The idea being that because, there's so much inequality, life is just unfair, so just screw it, buy coffee. And don't bother learning basic financial literacy as if, because you're not going to get rich anyway. And it's just madness to me. Like, I think, it certainly is not going to make you Jamie Dimon, but it's also going to really help you from being poor.
Brian Anderson: Right. Thank you very much, Allison. It's a fascinating book so don't forget to check it out. It's called, An Economist Walks Into a Brothel. You can find it on Amazon. We'll link to it, as I mentioned earlier, in the description, you can follow Allison on Twitter @AllisonSchrager. You can also find City Journal on Twitter @CityJournal. And always if you like what you've heard on the podcast. Give us a rating on iTunes. Thanks for listening and thanks very much, Allison, for joining us.
Allison Schrager: Thanks for having me.