Optionality as a Mental Model

Mental models are frameworks for thinking and shape our understanding of the world. One of those models is optionality, which can help to simplify complex decisions in uncertain situations. It’s a lens through which we can focus on non-linearity and asymmetrical returns, and apply them to business and life (but more on that later).

Optionality is not a new concept – it has been in use in the finance world for decades – but it has become more well-known over the last few years, and for good reasons.

Probably the first popularization came through Nassim Nicholas Taleb’s Antifragile, where optionality and “barbelling” are discussed extensively. Recently Richard Meadows also published a book on optionality, which is a good synthesis of Taleb-esque strategies and thinking applied to real life.

The below is a quasi-discussion of the book, but mostly an exploration of the concept of optionality itself.

What is optionality?

But first, what exactly is “optionality”? On a basic level, something has optionality if it gives the right, but not the obligation, to do something.

In finance, an option gives a buyer the opportunity to buy something at a future point in time (but again, without the obligation to do so). If your thinking is right, you enjoy the benefits; if your thinking is wrong, you’re shielded from a big downside.

This shows right away the most important property of optionality: non-linearity, or asymmetry in payoffs. If something has positive optionality it means there is a limited downside and an unbounded upside. (Or, at the very least, a non-linear return – the pros outweigh the cons.)

Things can have negative optionality as well if they remove opportunities and/or if they have unbounded downsides. For example, excessive debt load, or drug addiction.

The last category would be cases with no major returns in either direction.

In a graph these asymmetrical properties could look like this:

Graph - Asymmetrical returns of optionality.
Positive (continuous line) and negative (dashed line) asymmetrical returns.

So while originally from the financial world and applicable to investments, optionality can also be used to assess other situations in which there is uncertainty, unpredictability, or randomness.

For example, in The Strategy Paradox Michael Raynor writes that “[f]or a company to take strategic uncertainty seriously, it must avoid making commitments in the face of uncertainty and instead create strategic options that can be exercised or abandoned depending on how those uncertainties are faced.” Firms might not know what the future will bring, but that doesn’t matter as long as they have options in place that can benefit from uncertainty and randomness.

Likewise, in Optionality Richard Meadows takes the same concept and applies it to careers, side hustles, knowledge, skills, and even relationships.

Thinking in options

The main takeaway from these books – whether on business or our personal lives – is not so much the type of applications of optionality, but rather about viewing things through the lens of optionality. It’s a mental model that can guide decision-making in unpredictable environments, like business or, well, life in general.

If we can’t accurately forecast events in the future – and most of the time we can’t – what will give the greatest potential reward over the next decades? Which commitments or investments can be pivoted or applied to multiple scenarios? Which skills are transferable and will remain relevant? Instead of looking at the immediate payoff, which options will open multiple doors at a later stage? What will you learn or develop that could open up more profitable avenues in the future?

The most important characteristic of optionality is the implication of asymmetry. But when we usually think about options, we probably think about what to eat for dinner, or what type of vehicle to buy. These choices, however, don’t have any option value; they’re consumer choices and we simply pick from what’s offered to us.

Option value is created through potential asymmetrical rewards over time (again: high upside, low downside). Choosing a cereal brand is not going to give you that. It’s only through creation, exposure, or skin in the game that non-linear returns are possible.

What does that include? Let’s have a look at a few of the applications.

Optionality in life: some applications

Careers

Let’s say you get a job offer – on which criteria do you make your decision whether to accept it or not?

Salary? Benefits? Commuting time? Yes, yes, and yes – but most likely you will also consider the skills you will develop, and what future opportunities it might open up.

This is taking into account optionality.

Careers are an obvious case for optionality, and most likely this is something that you’ve considered yourself.

That’s not to say that seeking optionality in a career is always positive. There is also a negative angle, as in the situation where you continue to work in a position that you don’t enjoy purely because it opens up more options.

Look at it this way: is it safer to spend some time at a corporate firm before following your dream of opening an artisanal bakery?

Arguably, yes. Having this experience means that if things go wrong in the future, your resume is padded with an experience that will help find a new job in the future. So while it might open up more options in the future, it’s sacrificing the short term to do so.

“Side hustles” and projects

While optionality exists in the 9-to-5, it’s perhaps more potent in the projects we pursue on the side. In fact, side hustles – even though I think the term itself is terrible – can be the perfect venue for creating options in life. It’s permissionless, open to everyone, and usually carries a low cost as well.

In the book, Richard Meadows makes a good distinction between the things worth pursuing on the side or not. For example, if you have a full-time job, then it’s probably not worth the effort to start driving for Uber as a side hustle or to do some other hours-for-money type of exchange. You most likely already have a decent salary from your main job, something that provides you stability in life. The income earned from doing traditional side hustles is purely incremental and probably not worth your time.

It makes much more sense to focus on the unlikely but exponential.

That is: looking for non-incremental asymmetrical payoffs. Instead of driving for Uber, create a website or write a book on a topic you’re knowledgeable on. Instead of flipping things on eBay, create a podcast, code an app, or start a small webshop.

The success rate of these examples will obviously be low. But – and this is key in the optionality framework – they also have limited downsides and asymmetrical upsides.

What are the chances of writing a bestselling book? They are very, very slim. But the chance of having an asymmetrical upside from writing a book? Those are much higher. Just think about building expertise, helping with a career change or jump, consulting or speaking opportunities, et cetera.

These rewards are not calculable at the start; the only thing we know is that there is a potential for non-linear rewards and that the downsides are low. So rather than exchanging time for a small amount of money, exchange time for a potentially large and life-changing venture.

Investments

Since optionality originates from the financial world, it’s no surprise that the main application has been investments. Even if you don’t want to touch financial instruments like options, you can still create optionality in an investment portfolio in different ways.

How? Well, for instance by applying what Nassim Nicholas Taleb calls a barbell strategy: a large share of conservative investments, a tiny share of highly speculative investments, and no “moderate risk” investments.

This allows for asymmetrical upsides, while also protecting from catastrophic downsides.

The big issue with this strategy, for the average person, is the difficulty to construct such a portfolio. Not only does it usually require financial instruments you might not want to touch, but also many of the investments on the speculative end of the barbell are only are available to accredited investors.

Meadows proposes to build a “bastard’s barbell” instead, consisting of broad market index funds as the “conservative” part of the portfolio, and things like cryptocurrency, startup or (local) business investments on the speculative end. This is probably not what Taleb intended, but at least it’s applicable for a large(r) group of people.

Knowledge

On a more abstract level, you could consider knowledge and skills as providing optionality as well. This is true in at least two cases: 1) specialized, or rare, knowledge and skills, and 2) a rare and valuable combination of knowledge or skills.

The latter is essentially Scott Adams’ talent stack idea: combining a few average skills into a combination that has value. If you’re an average graphic designer, but also an average public speaker, and an average writer, then the sum of those skills has more value than the individual components (e.g. an option could be to write an instruction manual, or create a course).

Looking at the former, you will find many skills or types of knowledge that are relatively rare, and that will probably become more valuable over time. A good example here is COBOL coding skills. Although the language is completely archaic, many corporate and governmental systems still run on software from decades ago. Not surprisingly there aren’t that many people interested in learning how to keep old systems up and running and, as a result, it’s becoming increasingly difficult to find coders. So this is a skill set that, at least for the foreseeable future, will increase in value.

Finally, you could even see books or courses as options as well. Reading has a low downside (a small cost, plus an investment of time), but the ideas and skills picked up can have a major upside.

The good: why optionality is mostly beneficial

These are only a few of the areas in which optionality can be used as a mental model to determine what to focus on and what is valuable. (Meadows lists a lot more in the book.) But even these few cases show the benefits of pursuing optionality; it considers the long-term, the non-linear, and the best thing is that it doesn’t even require accurate forecasts and goals.

Thinking in options is like casting out fishing lines – you know there’s something in the waters and in the best case you will catch something soon, but most likely nothing will happen for a while. There’s no point in forecasting when something will bite, you just need to be patient and let serendipity do its thing.

It’s a bit of an oversimplification to say that luck is being in the right place at the right time. A better way to conceptualize luck is maybe to think of it as exercising optionality; it’s reaping the upside from options. So one benefit of creating optionality is being able to get lucky. You need to participate in order to win, which means you need to have some options in place.

That’s not to say that options are free (they’re not) and that you should participate in as many things as possible (you shouldn’t). Beware of the ludic fallacy – life is not a game. Participating in the lottery every month might have a high potential upside with a low downside, but the net return of playing the lottery is always negative. In other words, the house always wins.

True options are in the domain of the black swan: events that impossible to predict and that have a non-linear reward (positive, hopefully).

The bad: why optionality has downsides as well

Optionality as a mental model has its uses, but like all models, it’s a simplification and cannot be applied to all situations carelessly. There are downsides to optionality, most of which relate to excessive use of options and trying to avoid any risk at all.

In short, optimizing for maximum optionality can be a recipe for disaster.

For a start, many things in life require commitment. The optimization of optionality will, in theory, present you with a lot of choices. In practice, however, it can reduce appetite for risk-taking and committing yourself to a single venture. Put differently, optimizing for optionality often equals postponing important decisions and changes.

Let’s take a common example. There is probably a massive discrepancy between the number of people who dream to become a consultant and the number of people who actively pursue a consultancy position.

Why? Well, one of the main reasons has to be because it provides options. Having a prestigious consultancy on your resume means that – once you leave after two, three years of service – more doors will open up for you in the future.

But while this provides optionality, there is a hidden risk to this approach as well. Let’s go back to the earlier example of opening up an artisanal bakery. You might think you have a profitable business case, but you can never be certain – there is always a risk you will fail.

Would you be willing to give up the golden handcuffs of the corporate world to try this?

In one of his aphorisms, Nassim Nicholas Taleb states that a monthly salary is one of the most harmful addictions in life. Golden handcuffs are very real, and the comfort that a steady paycheck brings can make it seem too risky to make a drastic change. (Not to mention that, in the meantime, you’ve probably picked up additional responsibilities in the form of a family and/or a mortgage, which adds to the perceived risk level.)

As a result, ambitions will slowly turn into pipe dreams – always in the back of your mind, but never to be fully realized.

Mihir Desai writes about this problem in a good piece on the downsides of pursuing optionality: “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.” Some people might escape the lure of acquiring more safety nets; the majority will probably be locked into a comfortable position of quiet desperation forever.

So there is a certain path dependency of optimizing for optionality. Creating some options is good, but creating more and more safety nets, and deferring to exercise options is bad (not to mention pointless, and wasteful). The more you travel down the path of optionality, the more difficult it can be to change directions.

Society

A related problem, described by Peter Thiel in Zero to One, is the optimization for optionality on a societal level. What happens when everyone pursues well-roundedness, having several career options, being good at multiple things?

As he aptly discusses in the book, nobody gets into a top-rated school anymore by being good at just a single thing – unless, of course, that thing is throwing a ball.

Well-roundedness is an entry ticket, but does this also lead to higher payoffs (in the form of, let’s say, wealth, career satisfaction, or well-being)? As discussed earlier, some form of commitment or investment is usually necessary for high payoffs.

Having too many options – which necessarily means not being able to exercise all of them – can prevent this. Hence Thiel’s argument is that rather than “pursuing many-sided mediocrity,” an individual should pick a single thing and excel at it.

Counterpoints

In Optionality, Meadows discusses some of these issues as well. The start of the solution is a distinction between times of exploration and times of exploitation – moments in which it’s better to see what’s out there, and moments when we need to decide and act.

But how do you know when to do what? Well, two factors are of importance are 1) the time frame, and 2) the volatility of the domain. If the time frame is long then it makes more sense to explore, whereas exploitation is better if there isn’t a lot of time. Also important is the volatility: if nothing changes in the domain, then there’s no need to explore what’s out there.

The key thing to realize is that optionality, in the end, only has real value by exercising and exploiting it.

As for people advising to focus on commitment rather than optionality, Meadows argues that the most vocal opponents of optionality are usually people who already have a lot of options in their life. That is, the venture capitalists, business owners, or professors – but for the average person, without any options, seeking some optionality is a good thing to pursue.

Using optionality as a mental model

Taking all of this into account, what is then the best way to view and use optionality? Remembering that we want to avoid having zero optionality and that optimizing for maximum optionality serves little purpose. That is: we want to reap the asymmetrical rewards that optionality can bring, but avoid the downsides of postponement, deferment, and being too well-rounded.

As with many things in life, moderation seems to be the key, and perhaps it’s best to view optionality as existing on a continuum. Having no options means no potential asymmetrical payoffs, having too many options equals stretching yourself thin and lacking commitment. Between these two points there is a sweet spot – a place where we bet on some low-risk, high-reward options, but avoid participating in others.

Optionality is a means to an end, not the end itself (nor is it a value judgment).

Also, consider that there are many choices in life that drastically reduce optionality but that are still preferable in the long run. Settling in a single place, starting a relationship, having kids; all reduce the number of options you have available, and yet most people would probably list them as major contributors to their happiness.

Okay, so what does this all mean?

The most important thing is always to the avoid risk of ruin, and in the long-term winning often equals not-losing. Charlie Munger, as usual, put it very well: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Protect the downside before you focus on the upside.

In finance and investments, this means looking for opportunities with high rewards but making sure that the majority of your portfolio is in “safe” assets. In a career, be open to take risks and start new ventures, but preferably only when you have some experience or money – avoid being a starving artist. With ambitions or side hustles, write that novel, or start that business, but preferably part-time so you can see initial results before taking the plunge.

Also remember that there is a time to explore and a time to exploit, and that simply hoarding options is a recipe for disaster. There are windows of opportunity for all options in life: moments when a person is in the right place, at the right time, with the right skill set or assets, that enable him or her to make use of optionality – but only in that singular moment. After that, the option expires.

Finally, consider that most of the things we do exist on a quadrant with two axes: the size of the reward, and the probability of success. There are things with a high payoff and a high probability, but they are extremely rare; there are things with a low(er) probability but still a high payoff, but most of what we do probably falls into the low reward side of the quadrant. This is the side that doesn’t invoke serendipity and optionality. It doesn’t allow for moonshots. Having some eggs in the high payoff basket is important, there is (usually) no reward without having some skin in the game.

And who knows? Maybe with a bit of persistence and a bit of luck, our options might come to fruition in the future. Using optionality as a mental model helps to shape our understanding and guide our thinking on this.


If you want to learn more about optionality I recommend that you pick up Richard Meadows’s Optionality: How to Survive and Thrive in a Volatile World. Many of the ideas presented in the book are “Taleb-esque” in nature and so Nassim Nicholas Taleb’s Incerto series – specifically Antifragile: Things That Gain from Disorder – is also highly recommended.


Photo: by Nick Fewings (Unsplash)

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