Andrew W. Lo, who teaches at M.I.T. and is director of its Laboratory for Financial Engineering, has contributed to this blog before. Here he is joined by co-author Jeremiah H. Chafkin, president of AlphaSimplex Group (where Lo also serves as chairman and chief scientific officer) for a guest post about the best (and worst) ways to manage risk.
Scaling the Heights of Corporate Greed
A Guest Post
By Jeremiah H. Chafkin and Andrew W. Lo
In Laurence Gonzales‘s riveting book Deep Survival, he gives a sobering account of four mountain climbers who successfully scaled the 11,249-foot peak of Mount Hood in Oregon — considered a “beginner’s” mountain — only to fall disastrously during their descent.
“Sometimes, we are so focused on one objective — to the exclusion of all else — that we neglect the obvious.”
The climber in the top position — a veteran of much more challenging climbs — felt that belaying (the laborious process of anchoring a climber’s rope to the mountainside to arrest a fall) was an unnecessary precaution in this case, so when he lost his footing and fell, he yanked his three tethered colleagues, and five climbers below them, off the side of the snow-covered mountain. Three men died in this unfortunate incident, and the question posed by Gonzales is what leads some individuals to such tragic ends, while others faced with the same circumstances survive?
The answer, which forms the major thesis of Deep Survival, may also be the ultimate explanation for the current financial crisis:
The climbers on Mount Hood were set up for disaster not by their inexperience, but by their experience. It was the quality of their thinking, the idea that they knew, coupled with hidden characteristics of the system they had so often used. The system … was capable of displaying one type of behavior for a long time and then suddenly changing its behavior completely.
In other words, their mental model of this beginner’s mountain did not match the reality on that fateful day, resulting in their tragic accident.
The remarkably consistent performance of the U.S. residential real-estate market over the decade from 1996 to 2006 may have had the same effect, leading many experienced businessmen to conclude that such growth was likely to continue indefinitely. And despite all the protections that were available to these captains of industry — analytics that showed large potential losses in the event of a downturn in housing prices, leverage constraints imposed by regulatory capital requirements, and warning signs from the hedge-fund industry in 2005 and 2006 — they charged ahead anyway, with the single-mindedness of a well-funded expedition hell-bent on conquering a mountain. Their mental models apparently did not match reality either.
Much of neoclassical economics is based on the assumption that individuals act rationally and that markets fully reflect all available information, i.e., markets are informationally efficient. So powerful and far-reaching are the implications of this hypothesis that we sometimes forget it is meant to be an approximation to a much more complex reality. Recent advances in the cognitive neurosciences have radically altered our understanding of human decision-making, underscoring the importance of emotion, “hardwired” responses, and neural “plasticity” (the adaptability of neural pathways) in producing observed behavior (see Lo 2004, 2005). These breakthroughs show that decisions are often the result of several distinct components of the brain — some under our direct control and others that work behind the scenes and below our consciousness — that collaborate to yield a course of action best suited to achieve our immediate goals. On occasion, those immediate goals may conflict with larger and more important goals, like survival.
One illustration of this mismatch is the typical response to the following question: what is the primary objective of any mountain-climbing expedition? If, like most individuals, you answered “to get to the summit, of course,” you may be suffering from the same mental blinders as those climbers who fell from Mount Hood. A more risk-aware response might be: “to get to the summit, and then descend successfully.” Sometimes, we are so focused on one objective — to the exclusion of all else — that we neglect the obvious.
Risk-taking in corporate contexts is surprisingly similar, except that the height of the mountain is measured in units of earnings-per-share, return-on-equity, and share price. CEO’s are richly rewarded for the speed of their ascent during times of growing demand and easy money, but not necessarily for safely navigating the descent to the bottom of the business and credit cycles. While “greedy” CEO’s are easy scapegoats, the main object of everyone’s attention — the stock price — is often driven by shareholders looking for short-term profits, not long-term capital appreciation. And competition for shareholder dollars is akin to having many climbers competing to reach the same peak first. In both cases, the rewards — either bragging rights or bonuses — are proportional to the difficulty of the climb (barriers to entry) and the speed of the ascent (growth rate). A well-planned and successful descent is usually not on the list.
Now it can be argued that descending safely goes without saying, and most serious climbers are extremely well-prepared for both legs of their journey. But if it goes without saying, it sometimes goes without detailed planning, and then without doing, especially by those lucky climbers who have never experienced any setbacks or accidents. Similarly, corporate profits are rarely generated without taking some risks, yet the current culture, compensation structure, and shareholder and analyst objectives surrounding the modern corporation are all focused mainly on the race to the summit.
So what is the business equivalent of a well-crafted plan for descent? One possibility is for a corporation to appoint a chief risk officer (CRO) who reports directly to the board of directors and is solely responsible for managing the company’s enterprise risk exposures, and whose compensation depends not on corporate revenues or earnings, but on corporate stability. Any proposed material change in a corporation’s risk profile — as measured by several objective metrics that are specified in advance by senior management and the board — will require prior written authorization of the CRO; and the CRO can be terminated if a corporation’s risk profile deviates from its pre-specified risk mandate, as determined jointly on an annual basis by senior management and the board.
Such a proposal does invite conflict and debate among senior management and their directors, but this is precisely the point. By having open dialogue about the potential risks and rewards of new initiatives, senior management will have a fighting chance of avoiding the cognitive traps that can lead to disaster. Imagine if one of the four ill-fated climbers on Mount Hood had been assigned the role of the “designated skeptic” in advance, in which capacity he would be expected to raise every reasonable objection he could think of to a quick descent. We will never know if this would have been enough to have prevented their fall, but it would certainly have given them pause, and an opportunity for further reflection.
Mountains must be scaled, businesses must be built, and risks imply that occasionally, losses will be severe. But it would be even more tragic if we compounded our mistakes by failing to learn from them.
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A chief risk officer sounds great, although after 12 years in a multinational company I have noticed that presenting a fair and balanced view is seen as negative, and only those who are consistently upbeat move up.
“CEO’s are richly rewarded for the speed of their ascent during times of growing demand and easy money, but not necessarily for safely navigating the descent to the bottom of the business and credit cycles.”
Actually CEO’s are usually rewarded very well even when companies descend to the bottom of the business and credit cycles. It is called a “golden parachute”…
As for the climbers, the experience of the 1st one did cause their accident. It is practice even when not needed that makes one react as needed when situations arise.
This is much the same as a frequent flier businessman who does not review the safety information of a specific plane because he assumes all plane exit procedures are the same and he has heard the warnings / information many times. Yet he is tripped up when a situation does occur since he hasn’t counted rows to the exit door while an infrequent flyer has read the information and counted rows to the exit door.
I wonder how things would change if CEO’s (and perhaps a larger set of senior company officers) had a one-strike, you’re out policy. Any bankruptcy, bailout, etc., and they would be barred for life from holding senior corporate positions, board memberships, etc.
Would that be enough to counter the tremendous incentives towards risk-taking?
I’ve thought about this recently when playing (and reading about) tournament poker. All the books advise (and many players follow) a strategy where they take more risks early in tournaments where they can “re-buy” (in other words, pay again and start over) compared with those that freeze them out (no re-buy). The idea is that only the top few places pay a lot, so it is worth risking busting out (and re-buying) to have a chance at going into the later rounds with a near-top chip stack. Seems far too much like being a CEO ….
So much of what neo-classical economics teaches is that people act rationally. However, every person rational thinking is largely defined by their own experiences and who they are genetically as people. Most research in other fields has indicated that people have a lot less free will then most economists seem to assume. This example was merely a case of someone discounting a risk, because they had overcome worse odds several times before. Without this sort of thinking, we would probably have very few great men and women. However, we also must realize that there are inherently losers built into this system, and it doesn’t really do anyone any good to punish them excessively for a completely natural result. In this country, we tend to make sure CEOs and Lawyers have the proper safety equipment to deal with those failure. Unfortunately, the same is not true for many working class Americans.
The strategy proposed here parallels the practice of the Vatican in appointing a “devil’s advocate” during decisionmaking on canonization.
But unfortunately in both cases, the institutional design remains susceptible to groupthink — just as the board has been unable to cabin CEO discretion, the CEO will be unable to cabin CRO discretion as drift in cultural norms sets in across the industry. The devil’s advocate doesn’t often win in the Vatican.
Another parallel to executive compensation problems can be found in the selective breeding of chickens either by the cage or as individuals. Experiments demonstrate that group selection favors in-group cooperation, which is ultimately more socially productive, then individual competition.
http://brokensymmetry.typepad.com/broken_symmetry/2008/09/profitability-metrics-as-group-selection-criteria.html
A simplification of accounting rules that would remove CEO and CFO discretion by requiring a full-report of raw data (perhaps with a uniform time-delay) might result in less CEO-CEO competition and more company-company competition.
While I entirely agree with the general theme of the post, I feel the analogy is lacking.
What does a safe decent look like in the business world?
The economy is a complex web of forces but each business is only worried about there own ascent, simply because they only have explicit incentives to worry about themselves and not the broader economy.
What does “risk” mean to a business? I’ve been lead to believe that risk simply means a drop in profit. I think until there is a shift in this area we will continue to see problems in the broader economy.
I’m for a more holistic view of risk analysis.
I thought the role of regular, public or private, was to serve as the risk mitigator, with an understanding that the companies simply could and would not complete manage it themselves.
Imagine if the founders had created the judicial branch as a senate committee. It simply wouldn’t work.
Until and unless you shift the commodity valued by the market from pure point in time stock value to stability, I don’t see why companies would value this internally.
I think the entire social corporate responsibility “movement” has shown this quite well. Sure, everybody wants to cover their butt when it comes to environmental impact, but until doing so can be linked to the bottom in a transparent way, Boards and CEOs will not value those efforts nor listen to the internal staff who champion them.
Socialism is arguably a bridge too far, undermining the creative power of profit through excessive emphasis on stability, but I think there are examples from which we can learn.
I love this post! It is almost a perfect example of the contentless business consulting culture. First, we have financial engineers. For some reason, financial masseurs might have sounded a little less, well, butch, although of course that is the only engineering going on – massaging numbers. Then the power point analogy. Imagine the pause when our f.e. says: “what is the primary objective of any mountain-climbing expedition? ” Oh, the portentious pause. The goal is to – survive! Wow. What is the goal of cooking? Not only to eat, but later, to excrete what you eat. That a one off mountain climb and the continuing enterprise of actually producing a good or a service are not at all analogically compatible can be overlooked – because aren’t our CEOs men? Of course they are. Burly, tough, rugged individualists. They are really mountain climbers, in spite of having risen to the top through a locked in labor market and the kind of in-dealing that erodes all integrity and throws the conniving and pathetic oligarchs up to the top, as we can see today. Heroes, every one of them.
Then, of course, the platitudes and idiocy. After 25, 000 years of homo sapien existence, we find – ta da! that not everybody acts rationally (by which economists mean, like a greedy pig). This is the kind of thing that would make Sinclair Lewis’ Babbit proud – it is Babbitism of the highest order. It is also of course the reason our corporations, while making those wonderful profits, have long stopped innovating, or producing a social benefit for the country. Cause in their mind, they and their financial engineers are mountain climbing.
This is really a keeper, a postcard from the age of the mediocre and the corrupt. Thanks for sharing this!