Investment Philosophy / Personal Finance

Seeking Optionality: Lowering Risk While Benefiting from Uncertainty

Most of us have heard of "stock options", but it turns out that formal, structured options (especially those that involve pre-determined amounts of money and signed contracts) are the exception, rather than the rule. We don't usually label it as optionality, but it abounds all around us -- and much of the time it doesn't cost a thing.

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The first time I heard the term “optionality” was in business school, where it’s typically taught in two kinds of classes:

(You’ve probably also heard of employee stock options in the context of startups, and those are another form of financial instrument.)

But it turns out that formal, structured options (especially those that involve pre-determined amounts of money and signed contracts) are the exception, rather than the rule. We don’t usually label it as optionality, but it abounds all around us – and much of the time it doesn’t cost a thing.

What is Optionality?

At its core, an option is precisely what you’ve always known it as – a choice. It’s something you can do, but you don’t have to. And in the very best cases, you delay making that choice until you have more information about which decision is better.

When I was growing up, if the phone rang, you never really knew who was calling until you answered. The worst was the dreaded telemarketer – but since it might also be a friend calling with good news, you risked missing out by not answering (especially in the days before “answering machines” were widely used). So when Caller ID came out, it seemed downright magical to be able to see who was calling before you answered. Now you could get the upside of talking to friends and family while drastically reducing the downside of unwanted sales pitches. Put another way, Caller ID increased my household’s optionality.

That ability to benefit from good news while minimizing the effect of bad news increases your optionality, and it comes up all the time in your financial life, even if you’ve never owned a stock option in your life:

  • You can look at your mortgage through the lens of optionality: you have the right – but not the obligation – to pay off your mortgage in full whenever you want. If your home has increased in value, you can sell it and keep all of the upside – you don’t need to split any of it with the bank, even though in most cases the bank put up a lot more cash than you to buy the house.
  • Credit cards and other lines of credit are another form of optionality. You have the right, but not the obligation, to borrow money under certain conditions.
  • A restaurant reservation is a free option, conferring the right, but not the obligation, to have a meal there.
  • Tickets and reservations in general are fundamentally options, with some costing more than others – there’s no penalty at all for reserving a rental car, while with an airplane ticket you’re not obligated at all to take the flight, but except for the most expensive fares, you certainly will still pay for it (here’s a more nuanced look on View From the Wing at why rental cars are free to cancel, but airfare isn’t).

Optionality Leads to Future-proofing

Optionality is a recurring theme in Nassim Taleb’s book, Antifragile, where he offers an eloquent explanation of how much of its value comes from relieving you of any need to know what’s going to happen in the future:

If you "have optionality,” you don’t have much need for what is commonly called intelligence, knowledge, insight, skills, and these complicated things that take place in our brain cells. For you don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)

And while a lot of technologists (as well as the popular technology press) will gleefully prognosticate given the opportunity, Taleb succinctly explains that in fact it’s trial and error (and specifically the low relative costs of those trials and errors) that’s behind most of tech’s biggest successes:

The largest generators of wealth in America historically have been, first, real estate (investors have the option at the expense of the banks), and, second, technology (which relies almost completely on trial and error).

Most books that discuss formal financial options trace their origin to ancient Greece and the story of Thales, who used relatively small deposits to pre-book the local olive presses well before anyone knew whether the harvest would be good or bad; when it was a boom year and farmers were lining up to press their olives, Thales could now charge a hefty premium for the capacity, much much more than he’d paid for his “options”. Importantly, the benefit from being right was far greater than what he put at risk if he’d have been wrong. Via Business Insider:

A critical attribute of Thales's arrangement was the fact that its merit did not depend on his forecast for a good harvest being accurate. The deposit gave him the right but not the obligation to hire the presses. If the harvest had failed, his losses were limited to the initial deposit he paid. Thales had purchased an option.

Hunting for Optionality

Options are all around us, but like any skill, spotting them takes some practice. Fortunately most of us already have an instinctive eye for optionality, it just takes some work to hone it. You’re looking for situations where there’s some large potential benefit that only requires a small outlay – ideally only of your time, not your money.

Industry conferences are one useful example of optionality, worth relatively more (or less) depending on what you’re doing there:

  • It’s why informal hallway conversations and cocktail hours are so popular among most attendees. If you’re already there, it’s a low-risk way to at add some business cards to your network, but not-infrequently leads to a new job, customer, or deal
  • It’s also one reason speaking at conferences can be so valuable – lots more of those potential new connections will seek you out, and in many cases afterward you’ll hear from people you didn’t even meet, often with offers to speak or consult. (But there’s a limit to this, once someone is already famous/rich/successful enough, the marginal benefit of networking opportunities is too low to justify the opportunity cost.)

When it comes to investing, optionality can have a big impact on your potential returns. I’m a fan of P2P lending, but am mindful that it’s still an example of what Taleb is talking about when he refers to “negative optionality” – the upside to making any loan is at best that you get all of your money back plus the agreed interest payment, but the downside risk is that the loan defaults and you lose a bundle. It’s true that you can diversify across a bunch of loans, but that can only minimizes your possible loss.

Compare that to an early-stage venture investment: the downside risk is also that you lose all of your investment, but if the company is acquired or goes public, the upside is essentially infinite. (And here again, it’s all about diversification – even fancy VC people don’t really know ahead of time what will work (anyone else remember Ning?), so they place lots of smaller bets across many companies, and the ones that take off more than make up for the losses on the rest.

Finally, and this should go without saying, but gambling in a casino or a lottery is not optionality – the chances and amounts for upside and downside are governed by the laws of mathematical probability; even though that lottery ticket “only” costs $1, that’s still overpriced given your actual chances of winning. (To be clear, I have nothing against gambling as entertainment, but it’s not optionality.)