Although most frequently attributed to the sinking of the RMS Titanic in 1912, the maritime tradition is that a sea captain is responsible for his ship and all those embarked upon it. In an emergency, his duty is to either save them or die trying.
For most, it’s a bit of a leap to go from protecting against the risk of life and limb to financial loss. Yet those who are a “captain” of anything—corporate CEOs, investment managers, Federal Reserve Board chairs—are presumed to have superior knowledge of and experience with the matters over which they wear the mantle (and accoutrements) of responsibility. Does not that duty carry with it an implicit responsibility to put the welfare of those under their charge before their own?
Nassim Taleb thinks so. Readers of this blog were first introduced to Taleb in our very first post, “An Enterprising Thought: Cash as an Option.” He is known as the pioneer of hedging tail risk (now sometimes called “Black Swan protection”). Such hedges intend to mitigate investor exposure to extreme market moves, the financial equivalent of hitting an iceberg.
Taleb is a former hedge fund manager and derivatives trader. His investment strategy has been to protect investors from crises by safeguarding most capital in low-risk instruments while maintaining small asymmetrical bets that reap outsized returns from rare unexpected events. Consequently, his investment management career has included several jackpots, followed by lengthy dry spells.
Taleb’s hugely successful literary career has been as rare as the Black Swan events about which he writes. His first non-technical book, Fooled by Randomness (2001), regarding the underestimation of the role of randomness in life, was selected by Fortune magazine as one of the smartest 75 books known. His second book, The Black Swan (2007–10), had sold 3 million copies already by 2011. Antifragile (2012) and his newest book, Skin in the Game (2018), are similarly worthy of high acclaim.
Skin in the Game
The concept of “skin in the game”—a euphemism for this post’s subtitle—did not make a formal appearance in Taleb’s writings until Antifragile, but then it came on with a vengeance.
He argues that when risk is dispersed throughout a system, it’s a more stable (i.e., antifragile) system since all players have skin in the game. Should one entity have the power to transfer risk unilaterally and with impunity to another, the system, whatever it is, could progress toward catastrophic failure. To put it in Darwinian terms, as one species becomes dominant to the exclusion of other species, the overall system becomes weaker. That species’ growing population or resource consumption will exceed the carrying capacity and natural synergies of the system; this is the climate crisis in a nutshell.
More contemporarily and provincially, take the example of bankers throughout history, but especially in 2007. If banks can accrue profits while quietly transferring their risk (and their losses) onto society (taxpayers), there exists a fundamental weakness in the system. Greater risks will be assumed in the pursuit of profit; the potential for systemic failure increases. Regulations can, in theory, and often in practice, help ameliorate this issue. Financial players, though, are adept at developing newer and more exotic products to circumvent those intended restraints. Similar to matter, which is neither created nor destroyed, risk is rarely eliminated, but is most often simply moved elsewhere.
Avoiding Risk of Ruin at All Costs
Cost-benefit analysis is a ubiquitous model for choosing investments. It invests on the statistical probability of an outcome given what is known of history. Its fatal flaw, however, is its ignorance of Taleb’s warning against Black Swans—statistically unpredictable events. Warren Buffett’s cardinal rule in investing is “to win, first you must not lose.” If irreversible financial ruin is possible, then the statistics of cost-benefit analysis break down. Taleb warns to “never cross a river if it is on average four feet deep” (emphasis added). The possibility of ruin disqualifies cost-benefit analysis. If you play Russian roulette once, there are five out of six chances you will win. If you keep playing, you will end up in the cemetery. Sequence matters. Conflating the probability of ruin from a one-time wager with the routine of making similar bets over time using cost-benefit analysis is a prescription for disaster.
Buffett’s success has been founded on avoiding ruinous tail risk; he doesn’t do cost-benefit analyses. Instead of using probabilities, he selects opportunities that pass through a filter of both quality and value. He, like many successful people, says no to almost everything. Regarding tail risk, the no is emphatic.
Taleb is similarly hardwired to say no to tail risk. “It doesn’t cost me much to refuse to go with my ‘refined paranoia,’ even if I’m wrong,” he says. “All it takes is for my paranoia to be right once, and it saves my life.”
Avoid Doing Business with Those Who Don’t Have Skin in the Game
How do we account for such a paucity of “refined paranoia” in the financial world? Why doesn’t everyone invest like Buffett? It may be no coincidence that the decisions of most managers of both money and business are made without skin in the game. The portfolio of the investment advisor may look quite different from that of her client. The banker may buy swaps on the loan he sells to his counterparty. The CEO may lever up the balance sheet to buy back shares at all-time highs. A manager who is majority owner of his company would certainly eschew that course.
A similar pattern may apply to the Federal Reserve Board chair and the Board of Governors. Ben Bernanke exercised the privilege of those who don’t have skin in the game. Perhaps sensing the moment of truth was approaching, he retired well before the expiration of his term. Jerome Powell seems to currently affirm the gist of Friedrich Hayek’s Nobel Prize acceptance speech: “The Pretense of Knowledge.”[1] Alan Greenspan handed the baton to Bernanke in 2006 as his “put”—still in full evidence today—added fuel to the housing bubble conflagration. Of all the words to describe Greenspan’s career trajectory after his long tour as Fed chair, contrition would not be among them.
In a system as complex as a central bank’s monetary-policy mechanism and its multitude of levers, the absence of skin in the game allows a successive passing of the baton—make that hot potato—from one Federal Reserve Board chairperson to the next. This has progressively nudged the financial system once again toward a critical state and possible ruin.
Getting closer to home, when receiving investment advice from people paid to give it, ask—at the risk of seeming ill-bred—not what they think, but what is in their portfolio. As for advice proffered by tenured professors, Taleb reminds us that in “academia there is no difference between academia and the real world; in the real world, there is.” His genius is only partly camouflaged by a uniquely impolite exterior!
Where Does a Long-Term Investor Put Money?
On the individual level, beware of investment recommendations based on long-term-return projections, unless you have infinitely deep pockets, a temperament steely enough to make Buffett envious, and an endless time horizon. An index fund has such an intemporal perspective. Life, however, is more complicated. Losses, retirement, health issues, and the like can cause the investor to withdraw capital, often at the least propitious times.
The universe of companies run by managers with skin in the game is shrinking. Primarily due to mergers and acquisitions, the Wilshire 5000 Total Market Index had shrunk to 3,618 companies by year-end 2016. Most non-founding corporate CEOs have little skin in the game. This includes, obviously, nearly all CEOs. Stock options, because they have no downside risk, are not skin, and they don’t represent a two-way alignment of interests with other shareholders. Of course, insisting on real skin in the game significantly reduces a manager’s opportunity set, particularly if you exclude the FAANGs (Facebook, Amazon, Apple, Netflix, and Google) and other leading-edge technology companies, which are typically too expensive for a value investor. Slim pickings, in other words.
The great equalizer—the woefully infrequent secular bear market and its cleansing effects—reduces, but does not eliminate, the importance of investing in companies whose quarterbacks have lots of skin in the game. A “margin of safety,” the three most important words in the investor’s lexicon, ameliorates at least some of that risk.
In closing, a metaphor from baseball, now in rebirth as Spring Training begins: Despite the boos and catcalls from the bleachers to “Swing, you bum,” Ted Williams became a Hall of Famer precisely because he resolutely remained flat-footed in the batter’s box until a pitch came across the plate in his sweet spot.
So
it is with investment advisors with skin in the game.
[1] The certainty of the physical sciences can not be so readily applied to a complex social system like the economy, as the means of cause and effect are not so easily determined.