Thursday, October 29, 2009

Nuclear Plants and Banks

How lucky can you be. Author Nassim Nicholas Taleb writes The Black Swan: The Impact of the Highly Improbable in 2007. According to Taleb a Black Swan is a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was. One year after the publication of his book we get the Black Swan of our generation - the subprime meltdown and economic implosion.

Taleb is the Distinguished Professor of Risk Engineering at New York University's Polytechnic Institute and a principal of Universa Investments, a firm in Santa Monica, California. In the October 2009 issue of Harvard Business Review, Taleb writes:

One of the myths of capitalism is that it is about incentives. It is also about disincentives. No one should have a piece of the upside with a share of the downside. However, the very nature of compensation adds to risk. If you give someone a bonus without claw back provisions, he or she will have an incentive to hide risk by engaging in transactions that have a high probability of generating small profits and a small probability of blowups [I don't necessarily agree with this portion and his language is a little confusing]. Executives can thus collect bonuses for several years. If blowups eventually take place, the managers may have to apologize but won't have to return past bonuses. This applies to corporations, too. That's why many CEOs become rich while shareholders stay poor. Society and shareholders should have the legal power to get back the bonuses of those who fail us. That would make the world a better place.

Moreover, we shouldn't offer bonuses to those who manage risky establishments such as nuclear plants and banks. The chances are they will cut corners in order to maximize profits. Society gives its greatest risk-management task to the military, but soldiers don't get bonuses.

Remember that the biggest risk lies within us: We overestimate our abilities and underestimate what can go wrong. The ancients considered hubris the greatest defect, and the gods punished it mercilessly. Look at the number of heroes who faced fatal retribution for their hubris: Achilles and Agamemnon died as a price of their arrogance; Xerxes failed because of his conceit when he attacked Greece; and many generals throughout history have died for not recognizing it Achilles' heel is fated to die because of it.

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