“My losses were only THIS big.”

It seems to hap­pen far too often, doesn’t it? Finan­cial com­pa­nies make bad choices on invest­ments, lead­ing them ulti­mately to implode. Of course, it’s not the com­pa­nies mak­ing those deci­sions; despite what some would have you believe, they’re not peo­ple. No, it’s employ­ees of those com­pa­nies mak­ing those decisions.

Yet, in order for those employ­ees to have con­trol over enough money to make head­lines (such as JPMorgan’s two bil­lion dol­lar loss last week), they need a good enough track record to merit such broad con­trol. How do they get it?

The answer may just sur­prise you.

Let me start by describ­ing an old scam that’s quite effec­tive. You receive an email every day for a week, from Sun­day through Thurs­day. Each day, the sender tells you that a par­tic­u­lar stock will close higher or lower the fol­low­ing day. Amaz­ingly, the emails’ pre­dic­tions are cor­rect, every sin­gle time. At the end of the week, the sender tells you that, by giv­ing him some sig­nif­i­cant sum of money, he’ll be able to grow the funds at a tremen­dous rate, because he knows the direc­tion of that stock every sin­gle day. You give him the money, and never hear from him again.

The big ques­tion is…how does he know which direc­tion the stock is going to go? And, if he does, why on earth is he not richer than Mitt Romney?

The answer is that you weren’t the only recip­i­ent of the email. On Sun­day, he sent the email to 32,000 peo­ple. To 16,000 of them, he pre­dicted the stock would go up. To the other 16,000 he pre­dicted the stock would go down. On Mon­day, he sent email only to the 16,000 who got the cor­rect pre­dic­tion; 8,000 got a pre­dic­tion that the stock would rise, while the other 8,000 received an email pre­dict­ing the stock would fall. This repeats through the week, with half cut out each day, until there are only 1,000 left when the mar­ket closes on Fri­day. If he only gets one per­cent of those to then bite, he’s got ten suck­ers. Nat­u­rally, with the low cost of email, this scales very well.

How does this scam play in at the finan­cial com­pa­nies? It’s a sim­i­lar game of large num­bers. Large num­bers of peo­ple enter the firms. The ones who do bet­ter than the oth­ers, even if only by chance, rise to the top, and are given larger purses with which to work. They don’t have to win every sin­gle time; they merely have to do sig­nif­i­cantly bet­ter than aver­age. With enough peo­ple com­ing in, such an out­come is inevitable for some of them. In that regard, it’s lit­tle bet­ter than win­ning the Mega Mil­lions lotto, except that few peo­ple con­sider the win­ners to be bril­liant for their choice of numbers.

I’m exag­ger­at­ing the sim­i­lar­i­ties here, but not by all that much.

So why on earth do the finan­cial firms do this? One rea­son is that it’s extra­or­di­nar­ily dif­fi­cult to tell the dif­fer­ence between some­one who has a bril­liant finan­cial mind and some­one who merely “chose the right lotto num­bers”. The out­comes look the same, and since the employee is never going to claim that he sim­ply got lucky, the illu­sion of hav­ing bet­ter knowl­edge becomes indis­tin­guish­able from the real thing.

But why would the employ­ees them­selves take such risks? This is where it starts to get really inter­est­ing. Remem­ber “The Dark Side of Per­sonal Respon­si­bil­ity”, where I talked about moral haz­ard? Pro­vided they’re not doing any­thing ille­gal, the worst thing that can hap­pen to these employ­ees is to get fired. Such employ­ees will end up with no salary, and no bonus, but (pro­vided the loss wasn’t too high pro­file) can sim­ply go work for another com­pany. And they typ­i­cally do. On the other hand, the pay­off for suc­cess can be huge. And they’re all told, from man­age­ment and from peers, about how great those rewards are.

So, no mat­ter how much of the employer’s (or, more accu­rately, the employer’s investors’) money the employee loses, the employee isn’t on the hook to cover it. But the employee gets a cut of any win­nings. Remem­ber what I said in “The Ide­ol­ogy Gam­ble” about how it’s worth it to have many small losses if they’re more than com­pen­sated by a few large wins? This is an exam­ple of such a sce­nario at work.

So you can see why the employ­ees do it. And you can see why man­agers are unable to dis­cern whether they’re good or just lucky. But why would the com­pa­nies (or, more pre­cisely, the com­pa­nies’ senior man­agers and share­hold­ers) sup­port this?

First, it’s worth not­ing that some finan­cial com­pa­nies do this. Many don’t. We read sto­ries in the press about the ones that do, and nat­u­rally con­clude that it applies across the board. In any case, those com­pa­nies with high-​​risk invest­ments at their core are run by peo­ple who are look­ing for the big pay­out. Typ­i­cally, senior exec­u­tives at these com­pa­nies get con­tracts that pay them hand­somely for the big win, but still pay well even if they lose big (there are many rea­sons for this, but it’s a topic for a future arti­cle). With a down­side that looks good, and an upside that looks amaz­ing, of course they’ll shoot for the moon. It’s a “heads I win, tails you lose” proposition.

More­over, while the invest­ments are pay­ing off, the ledgers look great, and the company’s stock reflects this. Share­hold­ers are happy, senior exec­u­tives are happy, the peo­ple directly man­ag­ing the risky invest­ments are happy…why on earth would any­one change anything?

Are these com­pa­nies really stu­pid? Cer­tainly if they want to be around in the long run. But this is a clas­sic exam­ple where every­one act­ing indi­vid­u­ally in their own best inter­est causes a great deal of col­lat­eral dam­age. It’s a rea­son pure laissez-​​faire isn’t as rosy as its pro­po­nents believe.

And it is one (but only one) of the fac­tors that led to the Great Recession.

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