I will explain what skin in the game is and its important applications in the real world,
Takeaway number 1:
- Let me explain, What exactly is skin in the game?
Consider these two persons:
A banker is selling questionable mortgage-backed securities – so-called credit default swaps. He knows that these securities possess a huge systemic risk, which may cause them to blow up in the case of a ‘Black Swan ‘ event.
However, he and his employer are making good bucks from speculating in these securities, and, by the way, if they were to blow up in the case of an unexpected event, the bank can probably expect to bail them out anyways.
So, the upside is they make a lot of money and the downside is, practically, for them, none.
Let me give another example,
A pilot is working for an airline company.
He does have a pretty good salary, and his work revolves around taking people from point A to point B in the safest and quickest manner possible.
He knows that, if anything were to happen to his customers, ie the passengers, he would literally go down with them, as well. He doesn’t have any upside like the bankers I mentioned above.
To summarise, Skin in the game is about symmetry. If you’re able to reap the benefits of a positive outcome of an event, you must also share the harm and pay a penalty if something goes wrong.
Now, who’s got skin in the game? The pilot or the Banker?
This risk shouldn’t be possible to transfer to others, like in the case we saw above, the Pilot got skin in the game. The pilot earns good money for taking people from point A to point B. Should he somehow fail in this task, he will pay a penalty for it. This risk is not transferable to someone else.
In the first example, on the other hand, the banker can reap the benefits from speculating in securities that carry a systemic risk but can transfer the risk to the government which bails them out, or the taxpayers in the case of a blow-up.
Nassim Taleb refers to this as a “Bob Rubin Trade”. It’s like flipping a coin, Heads: the banker wins. Tails: someone else loses.
Skin in the game is like the ultimate BS detector. It allows us to judge the reliability of knowledge or certain advice. It’s also about symmetry in human affairs.
Those that do not take risks should never be involved in making decisions.
Now, let’s get into three .. perhaps less obvious implications that skin in the game has in our everyday life.
Takeaway number 2:
Let me now explain, how skin in the game allows the minority to rule over the majority, how it makes you smarter, and why it turns employees into in Nassim’s words, ‘obedient dogs’.
Have you ever thought about why peanuts/coconuts (in India) are not allowed on airplanes?
Why do TV series sometimes end up getting a ban because of some ethnic slur? Or perhaps why certain dietary advice, such as veganism, has had such an impact?
It’s all due to the minority rule, which in turn comes from the skin in the game.
When there is a minority that really can’t compromise, the flexible majority will adapt to the preferences of the minority.
For instance: A person who’s allergic to peanuts won’t board a plane with peanuts on it. A person who isn’t allergic to peanuts, on the other hand, can board a plane filled with peanuts. But he doesn’t really mind boarding one which is peanut free either.
Simply put, the most intolerant wins.
Imagine the stubborn daughter who manages to convince her whole family into eating vegetarian food, only because of some environmental, ethical, or (fictional) health-related reason.
Now imagine this family going to a barbecue party.
The organizers of the barbecue know of the preferences of this family, so they are left with two options:
Cooking two separate dishes, or cooking a single meal that is vegan.
As we all know, our mind chooses the path of least resistance and in this case, it is obvious to cook vegan.
See how the most stubborn minority was able to convince the, not so stubborn, majority.
In society, it only requires a small level of such stubborn minorities, say 3%, to impose their preferences on the majority.
Nassim Taleb tells the story of how hopeless it was for him to learn about probability and statistics in school.
As soon as he got his first position as a trader though, he suddenly had skin in the game, and this made all the difference.
Unexpectedly, everything seemed clear. How come he didn’t understand this before? Adding some skin in the game actually makes you smarter.
And not only that, it turns some boring activities into quite entertaining ones.
For instance, reading financial statements.
Sure, analyzing the profits, liabilities, and cash flows of a company isn’t too interesting. But it’s a necessity to become a great long-term investor. And once you have skin in the game, and there’s a lot of money on the line, the activity becomes anything but mundane.
There’s a traders expression that goes like this:
Never buy when you can rent the three F’s:
- a. what you float,
- b. what you fly, and
- c. what you f… (it starts with an F and holds four letters).
But renting isn’t always the best solution. Here’s where the skin in the game enters the equation. Take for example hiring a contractor, which is the equivalent of renting, versus hiring an employee,
Sure, the contractor might be cheaper to have at times when your business isn’t doing much business, but the contractor is not as reliable as an employee, because the employee has skin in the game.
An employee has his reputation and typically his only stream of income on the line if he doesn’t show dependability towards you as the employer.
Clearly, an employee has more skin in the game than the contractor.
Also, employees are often more of the risk-averse type than self-employed contractors.
Take away number 3:
Inequality vs inequality
Although I’ve talked about the importance of not resenting rich people before, if you want to be rich yourself one day, I want to ask you this question:
Which group of people would you strip of their riches if you could?
Group A: the entrepreneur, the musician, the football pro.
Group B: the banker, the bureaucrat, and the chief executive (who wears a tie).
Chances are that you tolerate the inequalities associated with Group A, but resent the rich people from Group B.
Why?
Because the rich people of Group B appear to be persons just like you, with the exception that they have probably played the system and acquired privileges that aren’t warranted for their positions.
It has been shown in studies that people, in general, are more prone to resent people who got rich from salaries rather than those who made it through entrepreneurial endeavors.
Nassim Taleb suggests that what people resent, or at least what they should resent, is individuals at the top without skin in the game.
Consider the banker who earns a lot of money from taking very risky bets in the financial market, and when sh*t hits the fan, he calls: “Black Swan!” and gets a bailout.
And now compare this to the entrepreneur, who started out in his basement, coding software with no part-time job. His downside is that all the hours he spends on developing that software are in vain, and having to stay in that basement until he’s like 40-something…
Here’s another interesting take on inequality – would you say that this is a country with a lot of inequality? Well, the answer is that there isn’t enough information provided in the question to decide that.
What if the life expectancy in this country is 100 years, and what if every person gets to spend one year per lifetime in the top 1%, and 99 years in the bottom part?
Not so unequal anymore, right?
Consider that about 10% of Americans will spend at least one year in the top 1% of earners and that more than 50% will spend one in the top 10%.
Equality is not created only by raising the level of people at the bottom, but rather by creating a dynamic system where the rich can rotate.
Anyone who puts in the time and effort should be helped by the system to reach the top, and the inverse should also apply.
People who help create this system unlock the pot of gold and eventually create massive wealth in the process.
Anyone who’s at the top but isn’t contributing anymore should face the risk of losing his position in the top 1% as well.
Takeaway number 4:
Ergodicity
Consider two different games:
Game A:
Six people are invited to play Russian roulette.
You get 1 million dollars every time someone takes a shot and survives. You’ll have to pay 3 million dollars every time someone dies. The next day 6 new people are invited.
Game B:
You are invited to play a game of Russian roulette.
The deal is that you should take six shots every day.
You get 1 million dollars each time you pull the trigger and survive, but you’ll have to pay 3 million dollars each time
you put a hole through the back of your skull.
The next day, you are invited to play again. The expected value of the two games is identical – 20,00,000 per shot.
But there’s an important difference.
Game A involves so-called “ensemble probability”, or, in other words, the probability of a collective, while game B involves “time probability”, or, in other words, the probabilities of a single person through time.
Game A fulfills that which Nassim Taleb calls ergodicity.
For something to be ergodic, there can’t be an absorbing barrier, which means something that is irreversible. In game A, you’ll be able to get the long-term returns of the game, as every new day, you’ll get six new people coming to play.
Furthermore, during a single day, it doesn’t matter to play six if player five gets to bite the dust, he can play anyways. In game B on the other hand, this is clearly not the case. If you manage to blow your brains out on your fifth try, there won’t be a sixth try!
In other words, you’ve hit an absorbing barrier – you can’t play the game any longer.
Confusion arises regarding ergodicity, because it may seem that, since a “one-off” risk is reasonable, an additional “one-off” after that is reasonable too.
At the roulette table, for instance, It comes to us naturally that this is not the case. If we keep trying to double the money we’ve earned, we will eventually go broke.
In real life, it can be stealthier. Eating a bag of potato chips isn’t too bad if you do it every once in a while, but doing it consistently, every day, for many years, will make it so that you face the risk of meeting an absorbing barrier – through your own death by cardiovascular disease.
Let’s apply ergodicity to trading.
Is trading with a portfolio, always risking ₹20,000 on each bet, an ergodic strategy?
No, it’s not,
The issue is that at some point in time, you will go bust using this strategy.
There’s an absorbing barrier. Once you hit ₹0 on your account, you can no longer play the game. Unless you go outside of the game to find more money to start a new one, of course, but that’s another story.
Is trading with a portfolio that is insured so that you can never lose more than 15% of your total capital an ergodic strategy?
Yes, it is, because you never face the risk of ruin. No loss is irreversible in this situation, or, in other words, no absorbing barrier exists.
(Well, if you don’t consider the Black Swan event that you and your insurance company go bust at the same time, that is)
Takeaway number 5:
How can the investor use skin in the game to his advantage?
Skin in the game is of major importance for an investor to understand.
Not only to the passive investor, who lets his or her money be managed by someone else, but also to the active investor, who makes his own financial decisions.
Let’s examine how these two differ.
Skin in the game for the passive investor.
When it comes to financial advice, this is a good starting point:
“Don’t tell me what you think!”
“Just tell me what’s in your portfolio.”
And sure, there are differences between how risk-averse people are, what their financial situation looks like, and so on, which may have an effect on what an optimal portfolio should look like for each individual.
But knowing what your money manager truly believes in, and using that as a foundation for how to construct your own portfolio, is always a good idea.
This can also be considered when investing in actively managed funds or investing in partnerships. Make sure that the money manager has skin in the game in that he or she is allowed to reap the benefits of a positive outcome, but has to pay the price in the case of a negative outcome too.
The world’s greatest investor, Warren Buffett, applied this when he formed his first investing partnership, “Buffett Associates”. The deal was that he would gain half the upside above a 4% gain, but pay a quarter of the downside to his partners.
Skin in the game for the active investor.
It’s said that “nobody washes a rental car”.
Without true skin in the game, you cannot be sure that the executives of a company you own are acting in your best interest. So, a rule of thumb for every long-term investor is to look for companies in which the top management of the firm is also some of the largest shareholders.
A CEO who doesn’t have this kind of skin in the game could have incentives to make decisions favoring the short term over the long term, maximizing bonuses and salaries during his time of regime.
Conversely, a CEO who has a significant stake in the company is in the same boat as all the other shareholders. In other words, you can trust that he, at the very least, is trying to make the best decisions for you as a stock owner.
Among my own top investments, executives of the companies in question have all had skin in the game.
Let’s sum it up!
✓ Skin in the game is about symmetry.
✓ Reaping the benefits of a positive outcome must also be associated with paying a penalty for the negative ones.
✓ Some less obvious consequences of skin in the game is that minorities can sometimes rule over majorities, you can make yourself smarter, and employees outperform contractors in many situations.
✓ We tend to perceive inequality in situations where there’s no skin in the game.
✓ Being a top earner doesn’t bring resentment if that spot is dynamic and exposed to competition.
✓ Ergodicity highlights that there’s a huge difference between ensemble probability and time probability.
✓ One must always be extremely careful when taking risks that are associated with ruin, or, in other words, that are irreversible.
✓ Both the passive and the active investor can use skin in the game to their advantage by ensuring that people they entrust their money with are sitting in the same boat.
Muhasa, Taleb has the will go to chase you down for this