24 Mar Don’t confuse optionality and safety nets
In 2007, as a newly minted Vice President at Blackrock I bought a “junior 1 BR” (aka studio) in the East Village. A friend, in a similar situation bought his first place too in Williamsburg. It was a dizzying time in New York. The finance and hedge fund industries were booming and few knew about the lurking crisis. We were two single guys who had worked hard and saved diligently; easily seduced by flashy brokers, with their floor plans and architects’ renderings of these unbuilt condos. And “all” you needed to reserve your spot was a 10% down payment.
Not long after cutting the brokers these sizable checks, Bear Stearns and Lehman went under. Markets tanked, people got laid off in droves. My friend and I survived this and anxiously wondered what this would mean for our apartments. They were experiencing their own construction delays and finally, two years after we had put down the deposits, the apartments were ready. It was time to close and lock in sizable mortgages (90%) and monthly payments. But, we each had the option to close. I chose to close. And he chose to walk.
An option vs. an obligation
Options are powerful financial instruments that can be used to take or mitigate risk. If you buy an option you make a payment (or series of payments) for the right (but not the obligation) to buy something at a fixed price, at a later date. In our apartment example, the deposit was an option (albeit an expensive one). Two years after this option was acquired, the world changed. The apartments had definitely declined by more than 10% in value. More importantly our job prospects and earnings potential had dramatically changed and our diverging decisions represented differing views on risk. (TLDR, I sold my apartment six years later at a wash, net of fees. Eleven years later, we both should’ve held on.)
Options are everywhere
Options aren’t always so mathematically rigid, in fact whether you’re a hedge funder or high schooler, you’re constantly making decisions about options in your daily life. The premium payment often isn’t financial – it can be time, access to your relationships, opportunity costs, or cognitive burden. For example, my double major in CS and Econ (payment: time, payout: job opportunities in multiple industries); buying life insurance (payment: annual premiums, payout: a large lump sum, should the unthinkable happen); taking a networking meeting with an important person who is an a-hole (payment: time, payout: the possibility that the person could help in the future); receiving advisor shares in a startup (payment: time, payout: upside, should the company sell).
The most clichéd example of optionality can typically be found in the 20-something Wall Street male, obsessed with “keeping his options open” when it comes to dating and marriage. I never dated in the Tinder age (thankfully or regrettably, I wistfully ask myself) but I confess that in my twenties, I knew that the right combination of text messages, date nights, and well-timed compliments were a useful arsenal in simultaneously dating multiple women in New York’s dating “gray zone.”
Low cost options – a manna from the heavens?
People in finance love collecting options, especially low-cost options. Intuitively, this makes sense. As Harvard Business School Professor Mihir Desai explains in (emphasis mine):
I’ve lost count of the number of students who, when describing their career goals, talk about their desire to “maximize optionality.” (…) Options have a “Heads I win, tails I don’t lose” character —what those in finance lovingly describe as a “nonlinear payoff structure.” When you hold an option and the world moves with you, you enjoy the benefits; when the world moves against you, you are shielded from the bad outcome since you are not obligated to do anything. Optionality is the state of enjoying possibilities without being on the hook to do anything. (Read more on optionality)
Don’t forget, options aren’t free
Optionality is one of those tenuous instances where financial optimization falls short when applied to the messy complexities of our daily lives. For starters, we underestimate the cost – especially the non-financial cost. Returning to the example above, the advisor share work is never just “a couple hours a month.” Requests arise such as reviewing decks, helping interview a candidate, attending an event – not to mention the friction in setting up all those communications and the opportunity costs (such as hobbies, spending time with family, exercise – or god forbid, sleep!). And on the dating side, I can’t tell you how many of my single male friends are burnt out (like literally, physically exhausted) and financially depleted from the never-ending Tinder, Bumble, and Hinge dates.
Options can be stressful
Next there’s the paradox of choice. The great thing about options is that you don’t need to commit. The possibilities are endless. But too much choice is also stressful. In his critique of higher education , former Yale professor William Deresiewicz describes how students at elite universities “can be anything in the world, so they try to delay for as long as possible the moment when they have to become just one thing in particular. Possibility, paradoxically, becomes limitation.” One of his students adds:
Options require risk taking
But the biggest blind spot in the optionality mindset actually is directly related to the math of options. Options increase in value when there is volatility or risk (Finance geeks: I know they’re not the same, but bear with me). For example, let’s say you bought a fancy car and the requisite insurance. You may be apprehensive to take it around town – it could get keyed, dinged in the lot, or even worse, there’s always the possibility of an accident. But you wouldn’t consider leaving the car in the garage, where it never risked a single blemish. Driving the car comes with risk. It’s an active risk decision that is mitigated by the option (i.e. the insurance).
Let’s extrapolate this back to careers. Desai adds:
Creating optionality can backfire in surprising ways. Instead of enabling young people to take on risks and make choices, acquiring options becomes habitual. You can never create enough option value—and the longer you spend acquiring options, the harder it is to stop. The Yale undergraduate goes to work at McKinsey for two years, then comes to Harvard Business School, then graduates and goes to work Goldman Sachs and leaves after several years to work at Blackstone. Optionality abounds! This individual has merely acquired stamps of approval and has acquired safety net upon safety net. These safety nets don’t end up enabling big risk-taking—individuals just become habitual acquirers of safety nets. The tool that was supposed to lead to more risk-taking ends up preventing it. (Read more on optionality)
Why do we become habitual acquirers of safety nets? What prevents people from taking risk? Fear. Fear of commitment. Of social critique. Of failure. Deresiewicz adds that it starts with the high expectations that are placed on students:
The prospect of not being successful terrifies [students], disorients them, defeats them. They have been haunted their whole lives by a fear of failure—often, in the first instance, by their parents’ fear of failure. The cost of falling short, even temporarily, becomes not merely practical, but existential. The result is a violent aversion to risk. You have no margin for error, so you avoid the possibility that you will ever make an error.
Becoming an entrepreneur comes with risk. So does getting married. No one is advocating for either of these, nor willy-nilly risk taking. Risk taking requires a self-awareness around the true costs and outcomes, sprinkled wth a modicum of confidence and faith. Options play a key role in risk taking, and when used correctly the returns can be spectacular.
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