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.
- “Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?” (Journal of Behavioral Finance)
- “Great Investors Think in Terms of Probabilities” (Pragmatic Capitalism)
- “Investing and Gambling Aren’t the Same” (Livemint)
- “Skin in the Game by Nassim Nicholas Taleb Review — How Risk Should Be Shared” (The Guardian)
- “Avoiding Unforced Errors in Investing” (Abnormal Returns)
- “BlackRock to Offer Clients Ways to Opt Out of Gun Stocks” (Financial Times)
- “Will SEBI’s Latest Plan to Curb Algo-Trading Backfire?” (Livemint)
- “The Deepening Crisis in India’s Banking Sector” (Business Standard)
- “Is Technology Hurting Productivity?” (Project Syndicate)
- “Will Mid-Tier Indian IT Companies Sink or Swim in the Era of Digital Automation?” (The Economic Times)
- “The Many Pieces of Putin: Russia’s President Is as Defensive as He Is Aggressive” (Times of India)
- “Value Investors Brave Brexit Noise in Bargain Hunt” (Financial Times)
- V. Prem Watsa — Fairfax annual letter (Fairfax Financial Holdings)
- “Facebook Data Woes Drag Down Tech Sector” (Financial Times)
- “Stephen Hawking, Scientist, 1942–2018” (Financial Times)
- “Economic Survey 2017–2018” (Ministry of Finance, Government of India)
- “Physicists Are About to Attempt the ‘Impossible’ — Turning Light into Matter” (Science Alert)
- “Why the Rhino’s Sad Extinction May Not Mean Extinction for His Species” (NBC News)
- Ethics and India (CFA Institute)
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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.
Image credit: ©iStockphoto.com/Ellica_S
Shreenivas Kunte, CFA, CIPM, is director of content at CFA Institute, where he contributes financial market insights about India and the developed world. Previously, he taught at and managed SP Jain’s Trade and Applied Research lab, which he helped found. Kunte also served as a country trading strategist at Citigroup’s Tokyo office. He actively contributes to the development sector in India and is an external research scholar at the Indian Institute of Technology Bombay.
Beyond the easier to understand, important codes of conduct, “Ethics” for me is awareness; an endeavor for right thought and action.