Hedge fun

This chart was not drawn to scale, nor does it constitute financial advice.

Despite being an above-average driver, I actively buy auto insurance. This ensures that in the (hopefully) low likelihood I get into a car accident navigating Austin’s gridlock, I’ll be able to (again hopefully) count on USAA to cover the cost. Paying this protects against what could be a financially catastrophic event.

What if everyone driving in downtown Austin were to simultaneously wreck their cars? Everyone’s below-average driving aside, USAA would be prepared for that. They pay a reinsurer, a company that insures insurance providers, to protect against what could also be a financially negative event.

What if the financial markets melt down and the world ends? Nassim Nicholas Taleb and Mark Spitznagel in particular have built their careers on hedging against the financially catastrophic events that are never as “rare” as one may expect (much like those dark-colored pond-dwelling birds). They buy options that become valuable when the small and large crises take place, protecting against financially unfavorable events, albeit temporary ones. Assuming one doesn’t sell everything at the bottom, in which case they could be catastrophic.

If insurance and hedging feel inherently pessimistic, it’s because they are. It requires one to lose small amounts of money on a regular basis, and becomes valuable when bad outcomes happen. I’m extremely happy when I drive and don’t get into a car wreck, but the additional peace of mind that insurance brings does have a cost.

It’s not difficult to find the pessimistic hedges — what I’m continually seeking are the optimistic hedges. The ones that aren’t just unprofitable on a regular basis and worth multiples upon multiples of their cost from time-to-time, but only occur after desired outcomes. Emerging technologies fit that description: companies of all sizes are building for a future that, if not more positive, will be radically more advanced than the present. Finding those very best venture opportunities is extremely difficult though — most investors aren’t able to, due to access-constraints or simply their own mindsets on investing and the world. And of course, the vast majority of venture opportunities do not breakout and return multiples upon multiples of their cost. They are truly options on the future.

Power laws, convexity, black swans — all point to us living in a world that is less than normal. Even if we accept that as fact, insuring ourselves for both the bad and the good is insanely difficult, as it costs not just money but time. One needs to play this game though, for as Fred Wilson wrote on uncertainty and risk:

The thing about risk is that it is correlated with return over time. It is very hard to make money without taking risk. And those who tell you that they have a low risk/no risk way to make money are either lying to you or lying to themselves.

Insuring for the bad, the good, the extremely unexpected? That’s not risky. Choosing not to pay USAA every month while relying on the skills of every driver around me? Now that is.