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Friday, December 17, 2010

Arnold Kling on One-Sided Bets

Here.

Money quote:
'If I offer flood insurance in New Orleans on behalf of my company, my bet might be "There won't be another Katrina in 2011." Let's say that we lose $1 billion if I am wrong, and we win $1 million (in insurance premiums) if I am right. If the chance of another Katrina is one out of 1000, that is a fair bet. But I can choose to make that bet even if the chance is 1 out of 50. The chances are 49 out of 50 that this deal will show a nice profit and I can get a fat bonus, and 1 out of 50 that I lose my job and the shareholders take big losses. A reasonable deal--at least for me.'

This sort of thing goes on in financial companies all the time. Traders make bets far, far more risky (given the payoffs) than they would if it were their own money. But you could make one of these a year for fifty years and the odds would be you're fine. Until the 51st year, when you bring down Barings.

2 comments:

  1. It would be as foolish for me to challenge your observation, as it would be for you to doubt my anecdotes about working in the dairy department of a grocery store.

    But, what if the naive free-marketeer asks, "Why do the shareholders allow this type of thing, if it's so obvious to everybody at the firm?"

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  2. I, too, worked at a dairy store.

    The shareholders do the best they can, but:
    a) These things are not obvious to everyone at the firm; and
    b) The shareholders interest in what's going on at any one of the (perhaps many) firms they hold stock in is less intense than the acute interest the managers of that one firm have in bilking those shareholders to line their own pockets.

    ReplyDelete