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philmophlegmHere's another simple little concept that is often overlooked, but can help to explain the behaviour of companies and individuals.
Consider this...
You are given a choice of two bets. The first bet gives you a 50% chance of winning £10 and a 50% chance of winning £20. The second bet gives you a 99% chance of winning nothing and a 1% chance of winning £1,500. Which would you take?
Some people will take the first bet, some will take the second. The strict mathematical expected winnings of both bets is £15.
(0.5 x 10) + (0.5 x 20) = 15
(0.99 x 0) + (0.01 x 1500) = 15
In a very simple way, this sum demonstrates how different people will have different attitudes to risk. Studies have shown that if you tweak the numbers and the percentages, you can get surprising results. Fewer people will take the second bet if the 99% chance is a 99% chance of paying £10, even if the £1,500 is replaced by a much higher prize. Some economists spend a lot of time doing this sort of study.
In any case, the simple point is that some people are more risk-averse than others. (The more complicated "It's more complicated than that" point is that people are more risk-averse in different situations, depending upon any number of factors.)
So far, so interesting. But is this of any relevance to the real world?
Well think about this. Let's say you are 59 years old, and you're going to retire next year. You have a pension which your employer has invested in shares. You are probably quite risk-averse when it comes to your pension. But what about the people who run the companies that your pension is invested in? Are they quite so risk-averse? Maybe not. Or maybe they are, but other people in that company making important decisions affecting the value and profitability of the firm are real risk-lovers. This becomes a problem, because the attitude to risk of our pensioner-to-be is not matched by the people whose decisions and actions affect how well-off he is going to be in retirement. He wants his pension to be rock-solid in giving him a nice retirement income rather than give him a chance of being a millionaire but also a chance of being broke.
This really becomes a problem when you combine it with the problem of individual wants conflicting with group or societal wants. Consider this: this time, you're a successful investment banker. After several successful years and big bonuses, you have essentially all the material goods you could want. You could always buy a second Veyron, but what's the point? Anyway, achievement, success, status etc in your world comes from being the guy who pulls off the big deal and makes the big returns. But to get the big returns, you need to take big risks. And sometimes those big risks don't come off. Just ask Nick Leeson.
Now the people who sit on the remuneration committee of that investment bank need to come up with a remuneration structure that gives you, as the hot shot trader, the incentive to make your deals to suit what the shareholders want, not what you want. That's tricky enough in a company that makes widgets, but when it comes to banks and traders who are already very rich and work in a high-risk, high-reward culture, that becomes very difficult indeed.
Consider this...
You are given a choice of two bets. The first bet gives you a 50% chance of winning £10 and a 50% chance of winning £20. The second bet gives you a 99% chance of winning nothing and a 1% chance of winning £1,500. Which would you take?
Some people will take the first bet, some will take the second. The strict mathematical expected winnings of both bets is £15.
(0.5 x 10) + (0.5 x 20) = 15
(0.99 x 0) + (0.01 x 1500) = 15
In a very simple way, this sum demonstrates how different people will have different attitudes to risk. Studies have shown that if you tweak the numbers and the percentages, you can get surprising results. Fewer people will take the second bet if the 99% chance is a 99% chance of paying £10, even if the £1,500 is replaced by a much higher prize. Some economists spend a lot of time doing this sort of study.
In any case, the simple point is that some people are more risk-averse than others. (The more complicated "It's more complicated than that" point is that people are more risk-averse in different situations, depending upon any number of factors.)
So far, so interesting. But is this of any relevance to the real world?
Well think about this. Let's say you are 59 years old, and you're going to retire next year. You have a pension which your employer has invested in shares. You are probably quite risk-averse when it comes to your pension. But what about the people who run the companies that your pension is invested in? Are they quite so risk-averse? Maybe not. Or maybe they are, but other people in that company making important decisions affecting the value and profitability of the firm are real risk-lovers. This becomes a problem, because the attitude to risk of our pensioner-to-be is not matched by the people whose decisions and actions affect how well-off he is going to be in retirement. He wants his pension to be rock-solid in giving him a nice retirement income rather than give him a chance of being a millionaire but also a chance of being broke.
This really becomes a problem when you combine it with the problem of individual wants conflicting with group or societal wants. Consider this: this time, you're a successful investment banker. After several successful years and big bonuses, you have essentially all the material goods you could want. You could always buy a second Veyron, but what's the point? Anyway, achievement, success, status etc in your world comes from being the guy who pulls off the big deal and makes the big returns. But to get the big returns, you need to take big risks. And sometimes those big risks don't come off. Just ask Nick Leeson.
Now the people who sit on the remuneration committee of that investment bank need to come up with a remuneration structure that gives you, as the hot shot trader, the incentive to make your deals to suit what the shareholders want, not what you want. That's tricky enough in a company that makes widgets, but when it comes to banks and traders who are already very rich and work in a high-risk, high-reward culture, that becomes very difficult indeed.
