This book is about how economists understand risk. Its biggest strength is its explanation of the differences between the closely related concepts of diversification, hedging, and insurance.

Diversification, in Schrager’s explanation, means spreading out your bets across multiple risks that are loosely correlated. This reduces idiosyncratic risk (e.g. a single company failing, by investing in multiple companies) and in some cases can reduce your systematic risk (e.g. the risk that all stocks decline in value, by buying bonds). Diversification reduces the variance of outcomes.

Hedging reduces downside risk in exchange for giving up some upside risk. The costs of hedging may not be fully known in advance, since the potential upside is unknown. Hedging can reduce both idiosyncratic and systematic risk, since you are taking bets with opposing outcomes.

One reason to hedge is to allow yourself to focus, by reducing incidental risks. For exapmle, airlines often hedge their exposure to oil price changes so that they can focus on operating their core business (p. 141).

Insurance reduces downside risk by paying a fixed (or at least well-known) cost, in exchange for keeping all the upside for yourself (p. 137-8). It can sometimes be more expensive than hedging, since its benefits are more clear (p. 152). The insurer transforms idiosyncratic risk into systematic risk by diversifying its pool of customers (e.g. by insuring many homes across different cities, rather than only homes in a single geographic area with correlated risks such as earthquakes, floods, or fires).

Thinking in Bets is a complement to this book.