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Skin in the Game as a Required Heuristic for Acting under Uncertainty

By Constantine Sandis, Nassim Nicholas Taleb | July 25, 2013

CREDIT: Samantha Evans (CC).

INTRODUCTION: Acting under Uncertainty

The chances of informed action and prediction can be seriously increased if we better comprehend the multiple causes of ignorance. The study of ignorance, then, is of supreme importance in our individual and social lives, from health and safety measures to politics and gambling. But how are we to act in the face of all the uncertainty that remains after we have become aware of our ignorance?

The idea of skin in the game is crucial for the well-functioning of a complex world. In an opaque system there is, alas, an incentive for operators to hide risk: to benefit from the upside when things go well without ever paying for the downside when one's luck runs out. There is no possible risk management method that can replace skin in the game—particularly when informational opacity is compounded by informational asymmetry, namely the principal-agent problem that arises when those who gain the upside resulting from actions performed under some degree of uncertainty are not the same as those who incur the downside of those same acts.

For example, bankers and corporate managers get bonuses for positive "performance" but do not have to pay out reverse bonuses for negative performance. This gives them an incentive to bury risks in the tails of the distribution, particularly the left tail, thereby delaying blowups. Similarly, the concept of bankruptcy is an asymmetry introduced into our legal system with the explicit aim of encourage risk-taking by removing the entrepreneur's skin in the investment game.

The ancients were fully aware of this incentive to hide risks, and implemented very simple but potent heuristics. About 3,800 years ago, Hammurabi's code specified that if a builder builds a house and the house collapses and causes the death of the owner of the house, that builder shall be put to death. This is the best risk-management rule ever. The ancients understood that the builder will always know more about the risks than the client, and can hide sources of fragility and improve his profitability by cutting corners. The foundation is the best place to hide such things. The builder can also fool the inspector, for the person hiding risk has a large informational advantage over the one who has to find it. The same absence of personal risk is what motivates people to only appear to be doing good, rather than to actually do it. The problems and remedies are as follows:

First, consider policymakers and politicians. In a decentralized system, say municipalities, these people are typically kept in check by feelings of shame upon harming others with their mistakes. In a large centralized system, the sources of error are not so visible. Spreadsheets do not make people feel shame. The penalty of shame is a factor that counts in favor of governments (and businesses) that are small, local, personal, and decentralized versus ones that are large, national or multinational, anonymous, and centralized. When the latter fail, everybody except the culprit ends up paying the cost, leading to national and international "austerity."

These points against "big government" models should not be confused with the libertarian argument against states securing the welfare of their citizens, but only against doing so in a centralized fashion that enables people to hide behind bureaucratic anonymity. Much better to have a communitarian municipal approach: In situations in which we cannot enforce skin-in-the game we should change the system to lower the consequences of errors.

Second, we misunderstand the incentive structure of corporate managers. Counter to public perception, corporate managers are not entrepreneurs. They are not what one could call agents of capitalism. Since 2000, in the United States, the stock market has lost (depending how one measures it) up to 2 trillion dollars for investors, compared to leaving their funds in cash or treasury bills. It is tempting to think that since managers are paid on incentive, they would be incurring losses. Not at all: There is an irrational and unethical asymmetry. Because of the embedded option in their profession, managers received more than 400 billion dollars in compensation. The manager who loses money does not return his bonus or incur a negative one. The built-in optionality in the compensation of corporate managers can only be removed by forcing them to eat some of the losses.

Third, there is a problem with applied and academic economists, quantitative modelers, and policy wonks. The reason economic models do not fit reality is that economists have no disincentive and are never penalized by their errors. So long as they please the journal editors, their work is fine. We use models such as portfolio theory and similar methods without any remote empirical reason. The solution is to prevent economists from teaching practitioners. Again this brings us to decentralization by a system where policy is decided at a local level by smaller units and hence in no need for economists.

Fourth, the predictors. Predictions in socioeconomic domains don't work. Predictors are rarely harmed by their predictions. Yet we know that people take more risks after they see a numerical prediction. The solution is to ask—and only take into account—what the predictor has done (what he has in his portfolio), or is committed to doing in the future. It is unethical to drag people into exposures without incurring losses. Fifth, to deal with warmongers, Ralph Nader has rightly proposed that those who vote in favor of war should subject themselves (or their own kin) to the draft.

We believe skin in the game is the heuristics of a safe and just society. Opposed to this is the unethical practice of taking all the praise and benefits of good fortune whilst disassociating oneself from the results of bad luck or miscalculation. We situate our view within the framework of ethical debates relating to the moral significance of actions whose effects result from ignorance and luck. We shall demonstrate how the idea of skin in the game can effectively resolve debates about (a) moral luck and (b) egoism vs. altruism, while successfully bypassing (c) debates between subjectivist and objectivist norms of action under uncertainty, by showing how their concerns are of no pragmatic concern.

Note that our analysis include costs of reputation as skin in the game, with future earnings lowered as the result of a mistake, as with surgeons and people subjected to visible malpractice and have to live with the consequences. So our concern is situations in which cost hiding is effective over and above potential costs of reputation, either because the gains are too large with respect to these costs, or because these reputation costs can be "arbitraged," by shifting blame or escaping it altogether, because harm is not directly visible. The latter category includes bureaucrats in non-repeat environments where the delayed harms are not directly attributable to them.

External Link: CONTINUE READING: Skin in the Game as a Required Heuristic for Acting under Uncertainty

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