taleb as miseducator (part 4)
an ending, for now
And so we come to the end of this series (for now), with the misuse of the concept of “Skin in the Game”.
I had previously come up with what I thought was the best possible motivating example of how people have picked up this phrase and run with it, while not really appreciating the point of Taleb’s concept. Which was to consider the decision (apparently currently being “mulled”, as the New York Times might say) over whether the boxer Tyson Fury should retire.
The point would be that Mr Fury is unlikely to get good or unbiased advice. For the simple reason that there are plenty of people in the room whohave aligned their economic interests to his, and who may even take seriously their fiduciary duty, and want to maximise his earnings potential. But there is absolutely nobody in the room who is going to be taking ten per cent of the punches to the head.
“Skin in the Game” isn’t just a rehash of the economics literature on the principal/agent problem – a core theme of the whole “miseducator” series is the tendency for economists to take a look at something which appears to be covering the same ground as part of the economics literature, and presume that it’s covering exactly the same ground, and then usually dismiss it in the manner of apocryphal Koranic scholar as being necessarily either superfluous or erroneous.
The common theme of the “Incerto” quartet is of epistemology – fat tailed distributions, limited knowledge and the gap between the wild variety of the world and the representation of it in the smaller and more manageable models we carry around. Skin in the game is about that too. It’s specifically about participation in the downside risks, and beyond that in the worst case scenarios. A two-and-twenty hedge fund compensation structure has no skin in the game, but even if you require the manager to invest half their net worth in the fund, they will still live to fight another day if it all blows up.
A frequent rejoinder to Taleb when the book came out (and one I made myself a couple of times) is that SITG is often undesirable, because you want some decision makers to be disinterested and objective. (For example, a CEO might take too few risks if they had “too much” skin in the game). But this objection only works if you take a view of risk which is completely different from Taleb’s.
If you’re hiring someone to place bets at the racetrack for you, then you might want incentivise them to bet on longshots. This might even work in the context of portfolio investment (although Taleb thinks it doesn’t). But in real world applications and interesting decisions, you don’t know the odds and you might not even know the payoffs in a lot of possible outcomes. In those cases, the point of a lot of the mathematical appendixes (and the Precautionary Principle) is that it never makes sense to take risks of the sort that can fundamentally impair your ability to come back. That’s what SITG is about; not aligning payoffs between parties across the distribution, but ensuring that the person making the decision lives with all the consequences.
Which was brought home to me when a friend, in a discussion about something else, made a point that’s actually a much better example than the Tyson Fury one, because it’s a much more everyday situation. A certain kind of social conservative likes to say that there’s a very wide community of interest in the decisions of a pregnant woman – husbands, relatives, society as a whole and so on. For some purposes, that might be a fair enough thing to say. But if the pregnancy is carried to term, there’s only one person who’s going to feel the contractions.