Fun is like life insurance; the older you get, the more it costs.
—FRANK MCKINNEY “KIN” HUBBARD, AMERICAN CARTOONIST, HUMORIST, AND JOURNALIST
The word “insurance” does not normally conjure feelings of excitement. Often we think of agents in ill-fitting suits selling life insurance, or an actuary working in a windowless room calculating when we might die. But insurance does something wondrous: it reduces the cost of a risk gone wrong, while allowing us to enjoy the upside of risk taking. With hedging we must give up the gains if things go better than expected, but with insurance we get to keep them. This is why, in many ways, insurance can seem just like magic.
Ten times a week in a dark and dingy apartment in the thick of the Hell’s Kitchen neighborhood of New York City, Belinda Sinclair performs magic too. On the day I am there, her audience is fewer than twelve people. She serves tea and connects with everyone, picking up on their thoughts, desires, and skepticism and tailoring her distinctly feminine show to their personality.
One of a few female magicians who perform shows, she describes the noble history of women in magic. We usually associate magic with men, but women have a long, underappreciated contribution to the dark arts. Often it was women who worked as healers and mystics, mixing potions and telling fortunes. In nineteenth-century New York, women hosted small gatherings like Sinclair’s in their parlors and performed magic tricks. It was around the time of Houdini when men were associated with performing illusions for large audiences and women were relegated to the assistant role.
Sinclair says we are drawn to magic because it suggests humans have powers that give them order and control in a world that is often harsh and unpredictable. A magician can defy the cruel randomness of nature. Believing in magic suggests there are humans who have the ability to control gravity, time, space, and even death. If they can do it, perhaps we all can too, or we can pay for the services of someone who possesses these special gifts.
Of course, this order is an illusion, a con. Conning is what magicians do and what you pay to experience. They make you feel comfortable and trusting, then they do something that appears to defy all laws of gravity and human consciousness. It is no coincidence that successful magicians tend to be both strange and exceedingly likable. Pulling off a magic trick requires fooling your target, and that means directing what they see and feel. Sinclair achieves that by being totally attuned to her audience’s every emotion. When you interact with other people, they usually aren’t so aware of your emotions most of the time, because they are invested in what they need to get out of the interaction. When someone is so aware of you and your needs, he or she has power over you and you feel safe and trusting. This is what magicians need from their audience.
Sinclair’s parlor is tricked out with mirrors and wires, and she seats her audience strategically by height so she has some control over what they see. She is constantly observing everyone, like the middle-aged man whose face lights up like a small boy’s when she retrieves the card he printed his name on. She wins over the hardened skeptic dragged there by his wife when she makes a coin float above his palm. She plants words in your head and then guesses the one you’re thinking of.
Sinclair speaks with a warm affect; in her midfifties, she has the complexion of a thirty-five-year-old, her face framed by very long, graying, curly hair. It is no surprise she was a model in her youth. Sinclair has had many careers. She still lives within a few blocks of where she grew up in New York City, surrounded by a large extended family.
Sinclair was a child actor and went to a performing arts high school. But after college, she aspired to become a doctor and studied medicine. Part of her training included working with sick children in a hospital. One day the hospital asked Sinclair to put on a show for the kids since she had a background in theater and clowning. She was such a hit that a parent offered her $100 to come to her house for her child’s birthday party.
Sensing a regular source of income to supplement her studies, Sinclair went to a local magic shop to buy supplies, where she found many of the tricks overpriced and not very good. The men at the shop dared her to do better, so she went home and made her first trick, which she won’t reveal. The magic men were so impressed with her artistry they offered Sinclair work illustrating their catalog, which included all the tricks they sold and drawings of how they worked. After five years of illustrating, Sinclair gained an encyclopedic knowledge of how magic tricks work: “I learned firsthand . . . how the eye works when it sees a trick, how the hand works, how the redirect works. . . . Magic forces you to stop, observe, and anticipate how the client reacts. There is an art to being prepared for action and reaction.”
She eventually dropped out of medical school and used her background in theater to start working with magicians and producing their stage shows. When she was twenty-nine, Sinclair started her own magic act.
She practices close-up magic that includes card and coin tricks. Sinclair is confident enough in her sleight-of-hand skills that she explains to me how she can pick a particular card out of a deck. Because holding the card makes it warmer than the others, it bends ever so slightly, so she can find it in the deck. Another tip: it takes at least seven shuffles to change the order of most cards, so she asks her guests to shuffle three times. Learning and performing each trick can take more than a year of practice. It requires a certain dexterity of the hand; for each trick, Sinclair builds up her hand muscles to palm the card just so.
When I ask her if tricks go wrong, Sinclair gives me a sly smile and says, “All the time.” But her tricks don’t fail.
“At that point you redirect,” she says. “It is not really conning—it is redirecting their attention. If I can’t find the card, I hand the deck back to them and say, ‘Check the deck; make sure your card is still there.’ The key word is ‘still.’”
The audience thinks this step is part of the act, but it gives Sinclair the opportunity to figure out where the card is. All that practice and years of study ultimately come down to mastering a backup plan to make sure the trick goes well. No matter what it is—a mirror in the corner, distracting your audience for a second, or redirecting—having that extra insurance in your back pocket can save a show. A single flop can destroy the trust that is necessary to pull off an illusion.
Sinclair’s most critical skill isn’t her deep knowledge of magic or her ability to palm a card; rather, it is her ability to save any trick and still awe the audience even if things go wrong. All successful magicians must master the art of the save. Some will even share how their tricks are done. But the secret they all keep is how they insure themselves. For Sinclair, in a small room, up close, where her audience can see anything, the time and energy she spends attending to you so you trust her before she redirects is her insurance.
Insurance works like magic. It reduces your risk, just like hedging does, but with one important difference. With hedging you must take less risk; you give up the extra upside of your potential reward in exchange for lessening the risk that something goes horribly wrong. If you risk less, you get less. Insurance appears to pull off the unimaginable: downside protection with unlimited upside.
For example, suppose you decide to become a commercial crab fisherman, one of the world’s most dangerous jobs. The odds of getting killed or disabled are much higher than they are for accountants. But all the risk can pay off. You can make up to $50,000 a month during crab season, more than most accountants get paid in a year. Hedging risk in this case would be avoiding the most dangerous fishing areas, like the Bering Sea, which has the roughest weather and also the biggest crabs. You take on less risk and also give up the potential for big earnings; maybe you make only $30,000 a month instead of $50,000 but you reduce the risk of being maimed or killed.
Insurance deals with risk in a different way. You buy life or disability insurance because providing for your family matters most to you. If something bad happens to you on the dangerous seas, your family will still have income, but at the same time you preserve the potential to reap big returns in the most perilous waters.
You can insure just about anything you can imagine: your house, your life, your ability to work, your car, or your vacation. A model can even insure her legs; Dolly Parton insured her breasts. These are all examples of someone else taking on another person’s risk for a price.
But this security is not free. You pay someone else a premium, and in exchange they take on your downside risk. The upside is still yours, minus the cost of the insurance premium. And just as with magic, people are often skeptical of what they are paying for. They might doubt the premium is worth the protection; some may even think they are being conned.
Often insurance is a good deal. Like magic, insurance can make some risk disappear. That’s because transferring risk to an insurance company is efficient. Suppose a model wants to insure against breaking her leg and losing months of income. If she self-insured, she’d need to put aside all that lost income, just in case something bad happens, because she bears all that risk on her own. But if she buys insurance, she only has to pay an insurance company a fraction of that lost income because it sells the same policy to hundreds of other models, and most of them won’t ever need their insurance since the odds of breaking a leg are pretty low. This is how insurance companies diversify risk: they pool all the premiums the models pay together and use this money to pay for that one unlucky model who will need to make a claim. The risk is reduced, though not eliminated. Say there is a freak accident at a fashion show and more than one model breaks her leg. The insurance company must bear the tail risk and compensate the injured models for their lost income.
Buying insurance is more efficient than bearing the risk ourselves. But when there is no market for our risk, we find a way to insure ourselves in our daily lives. Paying a price for a contingency plan is a form of insurance, whether it’s putting down a deposit for an alternate location if your wedding is rained out or carrying the weight of extra water on a hike in case you get lost and dehydrated.
Sinclair cannot buy insurance against a magic trick failing. Perhaps one day magicians will form an alliance and rescue one another’s tricks, but that day is not here yet. So instead Sinclair has devoted years to learning how to connect with her audience and control what they see so she is able to save her tricks if something goes wrong. Her time spent honing the skill to rescue tricks and the trust she builds with her audience are her insurance. She can enjoy the unlimited benefits of a great magic show without the worry of tricks failing.
Even if we can’t buy it, commercial insurance, in addition to reducing risk, serves another important function. Insurance policies are bought and sold. In order for these transactions to happen, the value of eliminating downside risk needs a price. Even if we don’t buy insurance, the price helps us gauge risk and understand which situations are riskier than others.
There is insurance on financial assets too. You can pay someone a premium to insure against the price of a stock falling too far. This kind of insurance is a financial instrument called a stock option, a contract stipulating you can buy or sell a stock for a certain price within a few months or years, depending on the terms. For example, if you buy a put option, you pay a premium and someone promises you can sell them stock at a particular price in the future. Suppose you buy Facebook stock for $200 a share. You are optimistic about the company’s future but a little worried that it shares stories from dubious news sources, which might pose a risk that the stock price will fall one day. You can buy a put option that gives you the right to sell Facebook for $150 any time during the next six months. A put option offers insurance against the chance that Facebook’s stock price will tank.
Here’s another example: If you buy a call option, you pay a premium and someone promises you can buy a stock for a certain price in the future, no matter what the market price turns out to be. Say it’s the day after the 2016 U.S. election. The new president’s preferred method of communication is Twitter, so you anticipate a Trump victory will make it a more valuable company. You think the price of Twitter stock will go up from $19 to $40 in the next six months but don’t want to make a financial commitment to that prediction just yet. You could buy a call option for $2 that guarantees you can purchase Twitter stock for just $30. Six months from now you plan on exercising your option, buying Twitter for $30 and then selling it for $40 and making a nice profit.
Of course, no one knows what will happen six months from now. By April 10, 2017, the price of Twitter stock fell to $14.30 a share and it never got above $26 that year. If your option was only good for six months, it turned out to be worthless; you paid $2 for nothing. Investors use put and call options to make bets on what will happen to the stock market.
Options reduce risk by offering a payoff if a certain thing happens, just like insurance offers you money if your house burns down or you break a leg. In the same spirit, options deliver money when a specified event happens, like a stock price falling or rising (depending on the contract). If you insure against a stock price falling, you reduce the risk of losing money but still get the unlimited benefit of the stock price going up, minus what you paid for the premium you paid for the option.
Options are a form of insurance, but if you own one you don’t have to exercise it. The option may be to sell or buy a stock at a certain price before the specified date, pay your mortgage back early, or even keep dating your partner without committing to marriage. You don’t have to make a commitment now—for a small fee you can wait and see what happens before you act. And there is no cost to waiting (perhaps your partner will get fed up, but you’ll still have your stock portfolio to keep you warm at night) because you are certain to buy or sell at the price in your options contract, no matter what happens to the actual price.
You can use options just like hedging or any other risk reduction strategy to amplify rather than reduce risk. For example, you can bet big on an upswing in the stock market and take on more leverage to enhance your wager. If you’re wrong, you can end up losing even more than if you’d just bought shares of a single stock that crashed.
Maybe you decide to take a chance on Twitter stock going from $19 to $40 in the next six months. Instead of buying one share of the stock, you could buy ten call options for $2 each, which gives you the right to buy Twitter stock for $30 anytime in the next six months. If the price does go to $40, you’ll make $80 ($80 = ($40 – $30)*10 – $20). That’s much more than the $21 you’d make if you just bought one share of Twitter, but there is also more risk. If the price falls to $17, your call options are worthless, and you lose the full $20 you spent on them. If you bought one share of the stock, you would have lost only $2. Options can magnify gains and losses, similar to borrowing money to make a risky bet.
Most people assume financial derivatives like options are a modern invention that has infected markets and made them riskier. But options have been traded for thousands of years, and people have been wary of them just as long. Aristotle, who thought poorly of people who chased wealth, wrote disapprovingly of how the philosopher Thales made a killing by buying options on olive presses when he anticipated a good harvest.
In the past, it was hard to put a price on how much we valued risk. This changed in the 1970s, when the finance professors Fischer Black and Myron Scholes developed a formula to price options. Around the same time, Robert C. Merton, another finance professor, came up with a robust way to solve for an option’s price. His model offered a quick, objective way to price risk based on a few characteristics that were easy to observe and measure.
At first, their work on options pricing seemed like another academic curiosity with lots of esoteric math, but the papers written on the Black-Scholes model and its solution turned out to be some of the most influential financial research ever published. People traded options before the 1970s, but they tended to be created for specific transactions, in the same way Thales approached the owners of olive presses looking to make a deal. But the world had become a riskier place and the demand for insurance had grown, so this method wouldn’t cut it much longer. As the economy grew and became more interconnected, there was more demand for ways to insure against the risk of investing in foreign markets. Demand also grew because the world became riskier, the certain exchange rates from the Bretton Woods agreement* were no more, and oil prices and inflation had spiked. More individuals and institutions were seeking ways to deal with this risk. The options market needed a reliable, consistent, and replicable way to price risk in order for it to grow to meet the new demand.
Coincidentally, soon after Black, Scholes, and Merton published their papers, the Chicago Board of Trade started an exchange on which options could be bought and sold in large volume. The Black-Scholes model provided pricing everyone could agree on. As it happened, at the same time, advancements in electronic calculators made it possible for the model to be programmed into traders’ calculators. In 1973, the first day the exchange was in operation, only 911* call options changed hands. A year later, the average daily volume had grown to 20,000 contracts traded, and by 2016, on average more than 4 million options contracts changed hands each day on just that one exchange.*
The price of insurance can tell us how risky a situation is, but how can we know if the price of insurance is worth it or if we are being conned? By helping us to better understand what makes one situation riskier than another, the Black-Scholes model is a tool we can use to distinguish a bargain from a trick.
The price of an option (a put or a call) depends on only four different parameters. How much each of these factors matters can tell us a lot about how much risk we face. In the Black-Scholes model these relationships are called the Greeks.
The first thing you should look at is the range of possibilities. Chapter 4 described risk measurement, the range of things that might happen. We generally focus our risk concerns on the range of things that are most probable, called volatility. The bigger this range is, the more risk we face. And generally, the larger your volatility is, the more you have to give up to protect yourself from bad outcomes.
The riskier any situation is, the more we must pay to insure ourselves. If there is construction on the highway to the airport, the range of possible travel times is bigger, and we need to budget more time to get there.
Next you need to worry about the odds something will go wrong. Even if you compare two scenarios with the same amount of volatility, sometimes one is more likely to need insurance than the other. And the more likely you are to need insurance, the more expensive it is.
Hurricane insurance costs more for a house in Florida than it does in Arizona because Floridians are more likely to need this kind of insurance. Insurance companies charge high-risk customers more—people who are more likely to be sicker or to drive recklessly, or companies that don’t practice good cyber hygiene. The commercial fisherman in the Bering Sea will pay bigger life insurance premiums than an accountant will.
The last time you bought an airline ticket, odds are you also sold an option and didn’t even realize it. As discussed in chapter 1, airlines reserve the option of kicking you off the plane if the flight is overbooked. The lower your fare class, or the cheaper your ticket, the higher you are on the list to be bumped off your flight. Your cheap ticket is so cheap, in part, because you sold an option to take a later flight if the plane is full. The more likely you are to be bumped, the more valuable the option is to the airline, so the bigger the discount on your plane ticket.
Another consideration is how long the risk will last. Is there a risk of something going wrong for the next month or the next year? The longer you are at risk, the more risk you face. And the longer an insurance contract covers you for, the more expensive it is. There is a common misconception that the more time you have before the risk is realized, the less risky it is.
For example, you are often told it’s less risky to invest in stocks when you are young because if the stock market drops you have years to make it up. This is what financial economists call the “fallacy of time diversification” because that assumption is wrong. It is true there’s a good chance the market will recover in a decade or two; often time will wipe out a big loss. But that does not necessarily mean there’s less risk, because twenty years of investing means there’s also the possibility of twenty years of bad returns. If you are only investing for two years, that possibility doesn’t exist. Depending on how you look at it, a longer time in the market can mean more risk.
The same is true if you hope to increase the odds of being happily married. Women face pressure to marry young or get “left on the shelf.” But your odds of finding someone to marry remain high well into middle age (and even beyond), and your odds of getting divorced fall dramatically the older you are when you marry. That’s not only because you have fewer years of marriage when things can go wrong but also because people who marry older are more stable and fully formed. Marrying young is a risk. You’ll have more financial stress, and the person you marry may grow into a different person.
Often taking a risk is a choice. You can sit at home and watch Netflix on a rainy night, or you can go on a blind date. How appealing the safe option is matters. Before Netflix, TV choices were more limited. You might be more inclined to go out no matter what because staying in wasn’t so tempting. Now, thanks to streaming, the risk-free option is better, and the dating stakes are higher. How much we value risk—and, by extension, how much we are willing to pay to reduce it—often depends on what the safe alternative offers.
In finance, the value of a safe asset plays many important roles in the pricing of assets and derivatives. It is how much you earn without taking on any risk at all. There is no need to take a risk if the no- or low-risk option is almost as good. In this case, taking a risk is just not worth it. Risk-free also represents how much it costs to finance a risky bet (recall the 5 percent second-mortgage interest rate in the postage stamp arbitrage in chapter 9).
This value of the safe option also drives many aspects of risky decision making. For example, it explains why some economists now believe mass incarceration may have caused more crime than it prevented. You’d think putting more people in prison would reduce crime. After all, we are taking criminals off the street. But mass incarceration went too far and sent many nonviolent offenders to prison. Even if you are a lightweight criminal, going to prison can change you. You learn lawbreaking skills and gain connections in the criminal world. Once you get out of prison you have more opportunities in crime.
What really matters is that the safe option—staying away from crime—is less valuable than it was before you went to prison. Once you are released, your options in the legal world are limited. It’s hard to get a job if you are a convicted felon.
Or to put it another way, crime can be even more attractive after you’ve been in prison, especially when compared with a law-abiding life, the risk-free choice. This explains, in part, why about 76 percent of criminals reoffend.
In almost all practical ways, magic is very different from insurance. Magic is an illusion, a con, and insurance contracts are legal documents. If you get into a car accident, or a stock price falls below a certain level, or another insurable event happens, you aren’t left hanging the way you would be in the middle of a magic trick gone wrong. Someone is legally obligated to pay you.
Despite what many people assume, insurance cheats you only some of the time. Magic always cheats you, which is what you expect when you go to a magic show. Many people are wary of insurance contracts because sometimes they are complicated, expensive, and opaque, like the option you unwittingly sold on your plane seat. The terms of your options contract are hidden in your ticket’s small print. Odds are you’ll be angry, and rightly so, if you are involuntarily bumped and physically dragged off the plane.
Simple life annuity contracts are another powerful and valuable risk mitigation tool (see the discussion in chapter 3); they are insurance against living for a long time. No matter how long you live, an insurance company pays you. They can even increase your spending in retirement because you pool your risk with that of other retirees. If you are afraid of outliving your savings, this can be extremely valuable insurance. Unfortunately, some types of annuities, often peddled by third-party brokers, got a bad name on account of fees hidden in the fine print.
Insurance contracts have many variants, and when the world of risk gets more complicated, so do contracts. Many offer valuable risk protection, but some contracts aren’t worth the paper they are printed on, let alone the large premium you pay.
As a consumer, you must ask two questions when you buy insurance:
What does the insurance cover exactly?
What is your goal, and are you actually insuring against something that threatens it? Often it is tempting to buy insurance to cover a risk we aren’t worried about or one we are already insured against; for example, buying insurance for a car rental when we already have credit card insurance, or buying insurance in case our TV falls off the wall when we keep it on a stand.
How much does it cost?
We can use the Greeks from the Black-Scholes model to figure out if the value of insurance is worth paying a premium: Are you facing a high-risk situation? What are the odds you’ll need insurance? How long does the policy last? How much would you save if you avoided risk instead?
Since the 2008 financial crisis, financial derivatives and the models like Black-Scholes that facilitate them have been widely criticized. One critique is that there is no reliable way to price risk and the model creates a false comfort that emboldens risk taking. Like one of Sinclair’s tricks, it’s all an illusion.
Magic is an illusion that appears to suggest humans have control over the cruel randomness of nature. Some would say the same of options pricing, and there are parallels. Robert K. Merton, the father of Robert C., was a very serious amateur magician who dreamed of being a professional. The name Merton was Robert K.’s adopted stage name, a play on Merlin; the original family name is Schkolnick. A magic career didn’t work out for Merton senior. Instead, he became a renowned sociologist; “self-fulfilling prophecy” and “unintended consequences” are two of the well-known concepts he developed. Aspects of Merton’s theories are relevant for understanding risk pricing.
Sinclair believes that magic, even if it is an illusion, unlocks people’s potential: “It opens up a sense of wonder. Our potential is greater than we think it is.” The wonder you experience in a magic show can propel you to take more risk and realize you are truly capable of bigger things. The magic becomes a self-fulfilling prophecy if it unlocks a sense of possibility and bolsters your confidence to rise to your potential, enabling something that usually wouldn’t happen to become possible. In some sense, the magic becomes real. Sinclair explains, “I make [people] feel confident, comfortable, and safe. Then they can enjoy and play; if they feel better about themselves, then magic has happened.”
Of course, that magic never existed, and in the same way there may be no true price of risk. Options pricing is merely an estimate of risk in an uncertain market. But the fact that risk price is never a precise truth misses the point of risk models and any price derived from them. Any map is inaccurate because it does not include every small road and tree, but that does not make the map worthless. Its purpose is to direct you by helping you to understand how certain features relate to each other. That is also what a financial model like Black-Scholes does: it offers a consistent, transparent, easy-to-use method to understand how different factors—current price, volatility, time—relate to the price of risk in a way everyone can understand and agree on. That’s what makes it so valuable. Once everyone agrees on how prices are to be calculated and uses the same model, the price is deemed to be right, which creates some order in a chaotic market.
An aura of magic surrounds financial options. In the worlds of both magic and finance, a sense of control can embolden us to take more risk. Taking more risk can be positive; it is how we move forward in life and achieve great things. Options are insurance contracts, and insurance can give us a sense of security, but sometimes that means we take on more risk than we should.
That’s not all. Risk-reducing technologies like options can be flipped around to amplify risk. For example, options can be used to make bets on the stock market, creating more risk instead of cutting it. People in the financial industry often use options to take more risk instead of reducing it.
The trade-off between risk and security is tricky, but on balance the insurance provided by financial derivatives reduces most risk; however, if a systematic blowup like the Great Recession occurs, the cost can be steep (though, thankfully, infrequent).