Theme: Skin in the Game

Nassim Nicholas Taleb says that in situations where there is risk (particularly the potential for low probability/high negative impact events), and asymmetric information regarding that risk (so a select group of individuals have a better understanding of the probabilities and impacts of that risk), then there is the danger of potentially catastrophic risk-taking. This is the scenario wherein a more-informed individual takes advantage of a less-informed individual, benefiting from the positive events but leaving the less-informed individual to bear the risk of the rare but incredibly damaging negative events.

His solution? The notion of Skin in the Game. Here’s the motivating idea:

About 3800 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.

In essence, decisions makers with an informational advantage in such risky environments should only be trusted if they have skin in the game:

One should be the first consumer of one’s product, a cook should test his own food, helicopter repairpersons should be ready to take random flights on the rotorcraft that they maintain, hedge fund managers should be maximally invested in their funds.

After all, wouldn’t I want to invest my money in the same place where my fund manager has his money invested? Taleb describes this heuristic as bottom-up: anyone is able to make use of this type of “simple contract between willing individuals: ‘I buy your goods if you use them,’ or ‘I will listen to your forecast if you are exposed to losses if you are wrong.'”

Despite the challenges in implementing such contracting in areas like finance or politics, the sentiment is dead on. There must be accountability for decision makers who take risks and pass the downsides of those risks onto others. How do we make this happen?

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2 comments

  1. I would recommend his most recent EconTalk interview as well: http://www.econtalk.org/archives/2013/09/taleb_on_skin_i.html

    The other previous interviews with him are great too.

    I see the advantages to SITG, but I’m not sure that all insulation from risk is necessarily “bad”. I’m not sure that is necessarily the argument he’s making though?

  2. He is discussing a particular scenario where a) the exact nature of the risk is difficult to ascertain; b) those with full information of the risk insulate themselves from the risk, while c) exposing those without full information to greater risk. Or, more particularly, those without full information are disproportionately exposed to the downsides of risk, especially low probability but high negative impact events. If everyone could be fully informed of the exact distribution, and have equal opportunity to insulate, there wouldn’t be a problem.

    So, there’s an asymmetric information element here as well.

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