Book review: An Economist Walks into a Brothel

I just finished reading Alison Schrager's book An Economist Walks into a Brothel. Don't let the title fool you though - this isn't a book about sex, it is a book about risk. Specifically:

This book will show you how to mindfully take a risk and minimise the possibility that the worst will happen.

The book outlines five rules for better assessing and employing risk in our lives:

1. No risk, no reward - "Risking loss is the price we pay for the chance of getting more";
2. I am irrational and I know it - "We don't always behave the way economic and financial models predict when faced with a risky decision";
3. Get the biggest bang for your risk buck - "...diversity to reduce unnecessary risk and keep your potential for more reward intact";
4. Be the master of your domain - Hedging and insurance; and
5. Uncertainty happens - "Even the best risk assessment can't account for everything that might happen".

Schrager is a financial economist and journalist, and the five rules are illustrated with a range of excellent stories drawn from Schrager's extensive research with sex workers in Nevada (for which the book is named), the paparazzi, professional poker players, and Kentucky horse breeders, to name a few. However, I found that the best chapter of all illustrated many of the concepts in relation to risk management by big wave surfers:

Instead of going into the ocean and hoping for the best, surfers are schooled in the "art" of risk: how to form calculated, informed risk assessments. The risk mitigation tools appear to be different from those used in financial markets, but they serve a similar purpose. Surfers form well-trained teams to raise the odds of a successful rescue (diversification). They monitor wave conditions, identify hazards (sharks, crowds, rocks, deep water, cold), and make probability estimates on the odds things will go wrong. This is so the surfers can make informed trade-offs about the thrill of riding a big wave safely (hedging). And they use the latest technology to rescue them when they wipe out (insurance).

This book could easily have been titled "An Economist Goes Big Wave Surfing", but perhaps that wouldn't have caught as much attention. Popular finance books are not plentiful, and those that are available are nowhere near as easy to read as this one. I really enjoyed the clear explanations of several finance concepts, especially the difference between hedging and diversification, which is something that many students struggle with. The only bit that I found really challenging was recognising what the 'risk-free' option is, and I still don't think I have a handle on it. Some more examples on that would have been welcome.

Overall, Schrager writes in an easy style, and the range of illustrative examples she uses (as noted above) enhances the appeal of this book, and I love the way that she concludes, noting that readers will have learned some financial economics by stealth!:

We all are smart risk takers in at least one aspect of our lives and have the potential to apply the same reasoning to every decision we make.

We can do this by understanding the science behind risk: how to define risk, how to measure it, how to identify the type of risk we face, and how to manage it. Financial economics is the science of risk, and it provides a structure to help us understand what makes a good risk to take.

If you want to understand a little bit of finance, a little bit about how to manage risk, or you just want to read some interesting stories about how other people manage risk in their work and daily lives, this is a great book to read. Highly recommended!