Economic progress and prosperity go hand in hand. Both pivot on payoffs. However, this arrangement can create undesirable side effects.
The framework of investing a dollar and then earning a succession of pennies is ubiquitous. But it has limitations. The underlying probability distribution has a negative skew: The chance of a significant loss, although small, is real.
Sometimes unforced errors in judgment undermine this framework. At some point, unethical practices may become interwoven into the processes. The potential for cheating increases in tandem with the probability of losses. Large-scale mega blow-ups are rare. But when they occur, many carry with them a hedonic mixture of greed and deceit.
The banking scam that hit India hard last month is an instructive case in point.
Reportedly, a flamboyant globe-trotting Indian entrepreneur engineered a fraud that swindled India’s second-largest lender out of US $1.8 billion, or about 1.5% of the bank’s assets. The scheme involved fraudulently persuading the lender to issue credit lines without any underlying real assets. New credit was allegedly used to pay off old credit. Some of the money that went overseas through the scam was roundtripped back through illegal channels.
The fraud went undetected for seven years. One of the masterminds — the entrepreneur perpetrator’s uncle — has run a 30-year-old company. Coincidentally, the firm was listed around the same time that the scam began.
Given its long lifespan, the fraud may have begun with a negatively skewed pattern of risky, perhaps legitimate, outcomes. But as the operation evolved, the fraudsters lost control of the changing risk profile and eventually became victims of their own success.
Obsessive focus on payoffs and negative skews are not limited to criminal operations. Some of the best minds in the world created Long-Term Capital Management (LTCM). LTCM’s failure is a popular case study of these types misjudgments. Separately, Jim Collins, in How the Mighty Fail, illustrates how large corporations set themselves up for catastrophe through the undisciplined pursuit of more.
Payoffs and their probability distributions bring up interesting questions. In addition to the asymmetry in payoff patterns, the utilitarian demand that these incentives can serve is often taken for granted.
It is easy to forget that the utility function is foundational to everything we do. An aspirational desire has a different utility function than an urgent existential need. Utilitarian awareness collapses when managers profess to generate payoffs by managing another person’s money.
There is no “skin in the game” for managers in such transactions. Mechanisms that closely align interests create symmetrical payoffs. The desire to cheat, too, vanishes. According to Nassim Nicholas Taleb, such structures automatically keep human hubris in check.
Interestingly, “skin in the game” behavioral thinking is ethical by nature. It is perhaps the only smart choice available for risk takers to maximize the returns they seek.
Here are some more readings you may find interesting. Happy weekend.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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