Risk/Reward Asymmetry

What do Hedge Funds and CEOs have in common?

The Good

When one is buying something, e.g., milk, one pays more for more commodity, and there is a perfect symmetry: the more one pays, the more one gets.

When one hires someone to whitewash a fence, one can usually see how well they do the job and pay accordingly, i.e., the more fence is whitewashed, the more money is earned.

The Bad

However, when one needs to have a car fixed, the situation is more complicated (there is a big incentive to rip the customer off), but if one goes to the same car mechanic over and over again, usually the incentive of repeat business overcomes the incentive to cheat, so one gets a better service for more money.

The same goes for all professional services, as the joke goes, the task of a physician is to turn an acute condition into a chronic one.

The Ugly

The situation is even worse with Hedge Funds and CEOs.

Hedge Funds

An Investor invests money with a Hedge Fund which charges a certain percentage of the principal (e.g., 2%) plus a certain percentage of the profits (e.g., 20%). This looks like a reasonable incentive for the Hedge Fund to perform well and it works just fine as long as the performance of the Fund is acceptable in the eyes of the Investor: i.e., the better the Fund performs, the more money it makes.

However, all Hedge Funds are expected to outperform the Market, so they take (and try to hedge) risks. Not all bets work out well, so sooner or later the Fund's performance sinks below the level acceptable to the Investor for, say, a couple of months or quarters.

Now the Fund is facing the following alternative: it must regain the edge very soon or the Investor will pull out. As far as the Fund is concerned, losing 100% of the principal is equivalent to breaking even because the fund will be closed either way. However, as far as the Investor is concerned, there is a huge difference between losing the whole principal investment and withdrawing it from the Fund.

Here the interests of the Fund and interests of the Investor diverge. For the (desperate) Fund, a bet with a 50% probability of making 50% in 3 months and 50% probability of losing everything might be okay, while for no Investor the expectation of a 25% loss in 3 months is acceptable.

The asymmetry here is that, while both parties share a similar "upside", their "downsides" are completely imcompatible.

CEOs

Similarly, a CEO is usually hired with an optimistic announcement of expected huge results real soon. For both the CEO and the company Owners the "upside" is similar, but not the "downsides"!

For the CEO, not meeting the expectations (sealed in options and stocks) and running the company into the ground have the same negative payoff: the golden parachute, while for the company Owners there is a huge difference between the two.

The Problem

People do not like to think about downsides, so they do not contemplate the fact that they are hiring someone (such as a Hedge Fund or a CEO) whose payoff in case of an adverse outcome is completely incompatible with their own, which may lead them (Fund/CEO) to take risks which are not acceptable to you.

The Solution

The party making life-and-death decisions should be risking one's own life in the process. Easier said than done - would you want to execute a surgeon whose patient dies?

Still, the idea is not without merits. E.g., one cause of the 2008 financial crisis was that everyone took huge risks and pushed them on the next guy. If the banks were partnerships instead of public companies (i.e., if the people running them were "all in" and risking their own entire fortunes), there would not have been such a thing as a "subprime mortgage" in the first place: who in one's right mind would lend one's own million dollars to someone who has no verifiable income?

The company Owner may require the prospective CEO to invest 50% of her liquid assets in the company. This ensures both the similar Risk/Reward situations for the Owner and the CEO and the long-term commitment of the CEO. The problem with this approach is the same problem which made the CEOs so highly paid in the first place: public companies are run by their boards which consist of CEOs of other companies. Do you think they will want to jeopardize their risk-free fortunes?

Relevant links