>The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster.
I think this claim contains a pretty elementary mistake. No bonus is a disincentive, because base salaries can be relatively low; not receiving a bonus is a large opportunity cost. If I could get a 400k salary, but I instead opt for a 200k salary with a 400k expected bonus, then if I don't get my bonus I'm 200k behind where I could have been if I just took the salary.
This is true, but the downside is capped: a bonus can't go below zero. Thus traders may become insensitive to the amount of money they lose and thus increase risk.
Edit: To clarify (since someone downvoted me), you are making a true statement, but I don't see how it is in conflict with anything I'm saying, or what other point it supports.
What Taleb is saying is still true. If I have a 400k market salary and I give up 200k of it for the right to 1% of the profits I generate, then I still maximize the expected value of my compensation that year by maximizing the size of my bets. I could bet a billion dollars on a coin flip, get 9.8 million (after recouping foregone salary) on heads and lose 200k on tails. Moreover, there is a well established history of traders that lost large amounts of money finding gainful employment regardless. See Boaz Weinstein, for example.
Based on those figures, earning a profit worth a bonus of 400,000 and losing far more the following year breaks even with respect to salary, so there's hardly an incentive to ensure consistent trading success to average well above market salary. If you can adopt worse trading strategies than martingaling a roulette wheel and still come out far ahead on salary, the incentive scheme isn't well designed.
You miss the point. It's possible to make huge returns on risky investments and get paid huge bonuses for several years until the investment fails. The the worst that happens is that you don't collect your bonus that year.
there are lots of bonus structures that mitigate this risk. some things you can do:
1. clawback clauses. when investments underperform, you take back bonus money. this goes well with:
2. long term vesting. you don't collect the entire bonus up front. you get it spread out over an extended period of time (say, 10 years), contingent on continued success / your bank still existing.
in fact, many banks and hedge funds already implement these ideas. of course, if you're writing a newspaper article, you can get a lot more pageviews by papering over this fact and saying the most populist thing you can think of.
I agree. The real problem he's describing is the bonuses reward short term success regardless of the long term risks. Bank shareholders who are long term investors should demand bonuses that incent long term success, rather than short term.
Wow yeah traders should really be the first thing we think about when we want to save the world economy because traders are improtend, I mean what would we do without traders?
>I think this claim contains a pretty elementary mistake. No bonus is a disincentive, because base salaries can be relatively low; not receiving a bonus is a large opportunity cost. If I could get a 400k salary, but I instead opt for a 200k salary with a 400k expected bonus, then if I don't get my bonus I'm 200k behind where I could have been if I just took the salary
Say my bonus is, I dunno, 2% of profits.
I go put 100 billion dollars on a single hand of blackjack. If I win, I make 2 billion. If I lose, I'm out 400k. Easy choice. Do it!
The Black Swan is an interesting book. You might disagree with Taleb's claims, but he's not making elementary mistakes.
Suppose there is a bet that has an 80% chance of success (a payout of 100), but a 20% chance of catastrophic failure (a loss of 500, which results in a bail-out). On average, this bet loses 20; it should not be made at all.
But suppose you make a bonus of 20% of your gains, and no bonus for losses. Would you make this bet? Is opportunity cost a sufficient disincentive, or is that an elementary mistake, since the expected return seems to be 16?
I think this claim contains a pretty elementary mistake. No bonus is a disincentive, because base salaries can be relatively low; not receiving a bonus is a large opportunity cost. If I could get a 400k salary, but I instead opt for a 200k salary with a 400k expected bonus, then if I don't get my bonus I'm 200k behind where I could have been if I just took the salary.