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 & safety measures to politics and gambling (Rescher 2009). 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 viz. 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 yhe 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.
Vanguard’s move into PE may change the landscape forever
The ancients were fully aware of this incentive to hide risks, and implemented very simple but potent heuristics (for the effectiveness and applicability of fast and frugal heuristics both in general and in the moral domain, see Gigerenzer, 2010). 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.
full article via papers.ssrn