As a financial professional, my main function is that of a risk manager. I primarily view things through the lens of risk versus reward. However, there is another dimension that also deserves attention, but it takes a bit more effort to see it clearly. The concept that I am referring to is called optionality.
All of us have options. We choose what to do each day, what to eat, where to go, etc. Most of these options are pretty benign, with little impact on our lives overall. When I talk about optionality as a framework, I’m talking about the specific trade-offs we make when deciding to take an action or not. Options give us the ability to do something, but not the obligation to do so. In the right context, that can be powerful.
In finance, options are well-defined instruments. They are contracts that can be bought or sold and give the holders certain rights (but not obligations) related to financial securities. In economics, real options are often discussed. These are economically valuable rights that pertain to tangible property, like land or equipment. Holders of real options can choose to start, expand, or end a project. Perhaps the most obvious examples of real options are in industries such as energy. In that industry, a company might buy the rights to explore and develop resources on a piece of land if it becomes economically viable at some point in the future. Here, they are just paying for the potential and do not have to commit to starting the project. These types of real options and their value are not unique to business and can be found in our everyday lives.
An arbitrary example shows how these types of options can be seen in many of our decisions. Consider shopping for phone or internet service. Often if you agree to a longer term of service, the monthly cost is lower (i.e., a 12-month contract might be $100 per month, but a 36-month contract might be $75 per month). Generally, this is viewed as a positive, as you can make a longer commitment and save money. However, that decision could also be viewed as selling your option to change phone or internet service for $25 a month (the difference in contract prices). For a lot of people, it is worth giving up this flexibility to change providers or plans for the $25 per month, but we should recognize it as an explicit decision we are making to do so. It isn’t that hard to imagine a number of scenarios where it would be worth $25 per month to retain the option to change, such as improving technology driving prices down, or moving out of a service area.
Knowing that these types of options are everywhere in our lives, the key is watching out for the most valuable ones. The characteristics of the most valuable options are conditions of high uncertainty and asymmetric payoffs. When there are a large number of potential outcomes, the flexibility to do something only if it turns out to be favorable, or to avoid something only if it turns out to be unfavorable, is a huge benefit.
Asymmetry of payoffs simply means that small, fixed costs can translate into very large benefits. These are actually more common than you might think. Things like reading books, networking and maintaining relationships, eating right and exercising all have fairly small commitments of time or energy, but have the potential to deliver life changing results.
Once you start thinking about decisions through the lens of optionality, you can leverage that understanding. Whether it is in investing, your career, or personal life, you should strive to increase your options and gain as much exposure as you can to those that have the highest positive asymmetric payoffs.