Risk and Variance
Risk isn’t just “bad things happening.” It’s the range of possible outcomes: and your exposure to the ones that matter.
Key Distinctions
Risk vs. Uncertainty
Frank Knight’s foundational distinction (Knight, 1921):
| Type | Definition | Example |
|---|---|---|
| Risk | Known probabilities | Coin flip: 50/50 |
| Uncertainty | Unknown probabilities | Will AI take my job? |
You can calculate risk. You can only estimate uncertainty.
Variance vs. Expected Value
Expected value: The average outcome if you repeat something many times. Variance: How much outcomes scatter around that average.
Same expected value, different variance:
- Option A: Always get $100
- Option B: 50% chance of $0, 50% chance of $200
Both have $100 expected value. Option B has higher variance. Which is “better” depends on context.
Tail Risk
Most outcomes cluster around the average. Tail risks are the rare extremes that can be catastrophic.
| Domain | Tail Risk | Mitigation |
|---|---|---|
| Health | Cancer, accident, chronic disease | Screening, insurance, safety habits |
| Wealth | Job loss, market crash, lawsuit | Emergency fund, diversification, insurance |
| Social | Relationship breakdown, reputation damage | Maintenance, boundaries, integrity |
| Meaning | Burnout, depression, crisis of purpose | Rest, connection, professional help |
Rule: Avoid ruin. You can recover from bad outcomes. You can’t recover from catastrophic ones (Taleb, 2012).
Cross-Domain Risk Framework
Evaluate Before Acting
- What’s the expected outcome? (average case)
- What’s the variance? (range of outcomes)
- What’s the worst case? (tail risk)
- Can I survive the worst case? (ruin check)
- Is the upside worth the downside? (asymmetry)
Seek Asymmetric Bets
Good asymmetry: Limited downside, unlimited upside
- Learning a skill (time cost, career upside)
- Starting a side project (small investment, potential big return)
Bad asymmetry: Unlimited downside, limited upside
- High-leverage speculation
- Ignoring health for work
Decision Criteria
Take more risk when:
- You’re young (time to recover)
- Downside is capped
- You have margin (emergency fund, health buffer)
- Upside is large relative to downside
Take less risk when:
- Failure means ruin
- You’re responsible for others
- Recovery time is limited
- You’re already exposed
Related
- Tradeoffs : Risk is a cost
- Asset Allocation : Managing financial risk
- Constraints : Risk tolerance as a constraint
The goal isn’t to eliminate risk. It’s to take the right risks: ones with asymmetric upside and survivable downside.