Skin in the Game

by Nassim Nicholas Taleb

  You make a few phone calls and it turns out that it is easier to find an academic economist with common sense than find another pilot—that is, an event of probability zero. You have all this equity in a firm that is now under severe financial threat. You are certain that you will go bust.

  You start thinking: well, you know, if Bob were a slave, someone you own, you know, these kind of things would not be possible. Slave? But wait…what Bob just did isn’t something that employees who are in the business of being employees do! People who are employees for a living don’t behave so opportunistically. Contractors are exceedingly free; as risk-takers, they fear mostly the law. But employees have a reputation to protect. And they can be fired.

  People you find in employment love the regularity of the payroll, with that special envelop on their desk the last day of the month, and without which they would act as a baby deprived of mother’s milk. You realize that had Bob been an employee rather than something that appeared to be cheaper, that contractor thing, then you wouldn’t be having so much trouble.

  But employees are expensive. You have to pay them even when you’ve got nothing for them to do. You lose your flexibility. Talent for talent, they cost a lot more. Lovers of paychecks are lazy…but they would never let you down at times like these.

  So employees exist because they have significant skin in the game—and the risk is shared with them, enough risk for it to be a deterrent and a penalty for acts of undependability, such as failing to show up on time. You are buying dependability.

  And dependability is a driver behind many transactions. People of some means have a country house—which is inefficient compared to hotels or rentals—because they want to make sure it is available if they decide they want to use it on a whim. There is a trader’s expression: “Never buy when you can rent the three Fs: what you Float, what you Fly, and what you…(that something else).” Yet many people own boats and planes, and end up stuck with that something else.

  True, a contractor has downside, a financial penalty that can be built into the contract, in addition to reputational costs. But consider that an employee will always have more risk. And conditional on someone being an employee, such a person will be risk averse. By being employees they signal a certain type of domestication.

  Someone who has been employed for a while is giving you strong evidence of submission.

  Evidence of submission is displayed by the employee’s going through years depriving himself of his personal freedom for nine hours every day, his ritualistic and punctual arrival at an office, his denying himself his own schedule, and his not having beaten up anyone on the way back home after a bad day. He is an obedient, housebroken dog.

  FROM THE COMPANY MAN TO THE COMPANIES PERSON

  Even when an employee ceases to be an employee, he will remain diligent. The longer the person stays with a company, the more emotional investment they will have in staying, and, when leaving, are guaranteed in making an “honorable exit.”*1

  If employees lower your tail risk, you lower theirs as well. Or at least, that’s what they think you do.

  At the time of writing, firms stay in the top league by size (the so-called S&P 500) for only about between ten and fifteen years. Companies exit the S&P 500 through mergers or by shrinking their business, both conditions leading to layoffs. Throughout the twentieth century, however, expected duration was more than sixty years. Longevity for large firms was greater; people stayed with large firms for their entire lives. There was such a thing as a company man (restricting the gender here is appropriate, as company men were almost all men).

  The company man is best defined as someone whose identity is impregnated with the stamp his firm wants to give him. He dresses the part, even uses the language the company expects. His social life is so invested in the company that leaving it inflicts a huge penalty, like banishment from Athens under the Ostrakon. Saturday nights, he goes out with other company men and spouses, sharing company jokes. IBM required its employees to wear white shirts—not light blue, not with discreet stripes, but plain white. And a dark blue suit. Nothing was allowed to be fancy, or invested with the tiniest amount of idiosyncratic attribute. You were a part of IBM.

  Our definition:

  A company man is someone who feels that he has something huge to lose if he doesn’t behave as a company man—that is, he has skin in the game.

  In return, the firm is bound by a pact to keep the company man on the books as long as feasible, that is, until mandatory retirement, after which he would go play golf with a comfortable pension, with former coworkers as partners. The system worked when large corporations survived a long time and were perceived to be longer lasting than nation-states.

  By the 1990s, however, people started to realize that working as a company man was safe…provided the company stayed around. But the technological revolution that took place in Silicon valley put traditional companies under financial threat. For instance, after the rise of Microsoft and the personal computer, IBM, which was the main farm for company men, had to lay off a proportion of its “lifers,” who then realized that the low-risk profile of their position wasn’t so low risk. These people couldn’t find a job elsewhere; they were of no use to anyone outside IBM. Even their sense of humor failed outside of the corporate culture.

  If the company man is, sort of, gone, he has been replaced by the companies person. For people are no longer owned by a company but by something worse: the idea that they need to be employable. The employable person is embedded in an industry, with fear of upsetting not just their employer, but other potential employers.*2

  COASE’S THEORY OF THE FIRM

  Perhaps, by definition, an employable person is the one you will never find in a history book, because these people are designed to never leave their mark on the course of events. They are, by design, uninteresting to historians. But let us now see how this fits the theory of the firm and the ideas of Ronald Coase.

  An employee is—by design—more valuable inside a firm than outside of it; that is, more valuable to the employer than the marketplace.

  Coase was a remarkable modern economist in that he was independent thinking, rigorous, and creative, with ideas that are applicable and explain the world around us—in other words, the real thing. His style is so rigorous that he is known for the Coase Theorem (about how markets are very smart about allocating resources and nuisances such as pollution), an idea that he posited without a single word of mathematics, but which is as fundamental as many things written in mathematics.

  Aside from his theorem, Coase was the first to shed light on why firms exist. For him, contracts can be too costly to negotiate due to transaction costs; the solution is to incorporate your business and hire employees with clear job descriptions because you can’t afford legal and organizational bills for every transaction. A free market is a place where forces act to determine specialization, and information travels via price point; but within a firm these market forces are lifted because they cost more to run than the benefits they bring. So market forces will cause the firm to aim for the optimal ratio of employees and outside contractors.

  As we can see, Coase stopped one or two inches short of the notion of skin in the game. He never thought in risk terms to realize that an employee is also a risk-management strategy.

  Had economists, Coase or Shmoase, had any interest in the ancients, they would have discovered the risk-management strategy relied upon by Roman families who customarily had a slave for treasurer, the person responsible for the finances of the household and the estate. Why? Because you can inflict a much higher punishment on a slave than a free person or a freedman—and you do not need to rely on the mechanism of the law for that. You can be bankrupted by an irresponsible or dishonest steward who can divert your estate’s funds to Bithynia. A slave has more downside.

  COMPLEXITY

&nbs
p; Welcome to the modern world. In a world in which products are increasingly made by subcontractors with increasing degrees of specialization, employees are even more necessary than before for some specific, delicate tasks. If you miss one step in a process, often the entire business shuts down—which explains why today, in a supposedly more efficient world with lower inventories and more subcontractors, things appear to run smoothly and efficiently, but errors are costlier and delays are considerably longer than in the past. One single delay in the chain can stop the entire process.

  A CURIOUS FORM OF SLAVE OWNERSHIP

  Slave ownership by companies has traditionally taken very curious forms. The best slave is someone you overpay and who knows it, terrified of losing his status. Multinational companies created the expat category, a sort of diplomat with a higher standard of living who represents the firm far away and runs its business there. All large corporations had (and some still have) employees with expat status and, in spite of its costs, it is an extremely effective strategy. Why? Because the further from headquarters an employee is located, the more autonomous his unit, the more you want him to be a slave so he does nothing strange on his own.

  A bank in New York sends a married employee with his family to a foreign location, say, a tropical country with cheap labor, with perks and privileges such as country club membership, a driver, a nice company villa with a gardener, a yearly trip back home with the family in first class, and keeps him there for a few years, enough to be addicted. He earns much more than the “locals,” in a hierarchy reminiscent of colonial days. He builds a social life with other expats. He progressively wants to stay in the location longer, but he is far from headquarters and has no idea of his minute-to-minute standing in the firm except through signals. Eventually, like a diplomat, he begs for another location when time comes for a reshuffle. Returning to the home office means loss of perks, having to revert to his base salary—a return to lower-middle-class life in the suburbs of New York City, taking the commuter train, perhaps, or, God forbid, a bus, and eating a sandwich for lunch! The person is terrified when the big boss snubs him. Ninety-five percent of the employee’s mind will be on company politics…which is exactly what the company wants. The big boss in the board room will have a supporter in the event of some intrigue.

  FREEDOM IS NEVER FREE

  In the famous tale by Ahiqar, later picked up by Aesop (then again by La Fontaine), the dog boasts to the wolf all the contraptions of comfort and luxury he has, almost prompting the wolf to enlist. Until the wolf asks the dog about his collar and is terrified when he understands its use. “Of all your meals, I want nothing.” He ran away and is still running.*3

  The question is: what would you like to be, a dog or a wolf?

  The original Aramaic version had a wild ass, instead of a wolf, showing off his freedom. But the wild ass ends up eaten by the lion. Freedom entails risks—real skin in the game. Freedom is never free.

  Whatever you do, just don’t be a dog claiming to be a wolf. In Harris’s sparrows, males develop secondary traits that correlate with their fighting ability. Darker color is associated with dominance. However, experimental darkening of lighter males does not raise their status, because their behavior is not altered. In fact these darker birds get killed—as the researcher Terry Burnham once told me: “birds know that you need to walk the walk.”

  Another aspect of the dog vs. wolf dilemma: the feeling of false stability. A dog’s life may appear smooth and secure, but in the absence of an owner, a dog does not survive. Most people prefer to adopt puppies, not grown-up dogs; in many countries, unwanted dogs are euthanized. A wolf is trained to survive. Employees abandoned by their employers, as we saw in the IBM story, cannot bounce back.

  WOLVES AMONG THE DOGS

  There is a category of employees who aren’t slaves, but these represent a very small proportion of the pool. You can identify them as follows: they don’t give a f*** about their reputation, at least not their corporate reputation.

  After business school, I spent a year in a banking training program—by some accident, as the bank was confused about my background and aims and wanted me to become an international banker. There, I was surrounded by highly employable persons (my most unpleasant experience in life), until I switched to trading (with another firm) and discovered that there were some wolves among the dogs.

  One type was the salesperson whose resignation could cause a loss of business, or, what’s worse, could benefit a competitor by bringing clients there. Salespeople had tension with the firm as the firm tried to dissociate accounts from them by depersonalizing the relationships with clients, usually unsuccessfully: people like people, and they drop business when they get some generic and polite person on the phone in place of their warm and often exuberant salesperson-friend. The other type was the trader about whom only one thing mattered: the profits and losses, or P and L. Firms had a love-hate relationship with these two types as they were unruly—traders and salespeople were only manageable when they were unprofitable, in which case they weren’t wanted.

  Traders who made money, I realized, could get so disruptive that they needed to be kept away from the rest of the employees. That’s the price you pay for turning individuals into profit centers, meaning no other criterion mattered. I recall once threatening a trader who was abusing the terrified accountant with impunity, telling him such things as “I am busy earning money to pay your salary” (intimating that accounting did not add to the bottom line of the firm). But no problem; the people you meet when riding high are also those you meet when riding low, and I saw the fellow getting some (more subtle) abuse from the same accountant before he got fired, as he eventually ran out of luck. You are free—but only as free as your last trade. As we saw with Ahiqar’s wild ass, freedom is never free.

  When I switched firms away from the proto-company man, I was explicitly told that my employment would terminate the minute I ceased to meet the P and L target. I had my back to the wall, but I took the gamble, which forced me to engage in arbitrage, low-risk transactions with small downsides that were possible at the time because the sophistication of operators in the financial markets was very low.

  I recall being asked why I didn’t wear a tie, which at the time was the equivalent of walking down Fifth Avenue naked. “One part arrogance, one part aesthetics, one part convenience,” was my usual answer. If you were profitable you could give managers all the crap you wanted and they ate it because they needed you and were afraid of losing their own jobs. Risk takers can be socially unpredictable people. Freedom is always associated with risk taking, whether it leads to it or comes from it. You take risks, you feel part of history. And risk takers take risks because it is in their nature to be wild animals.

  Note the linguistic dimension—and why, in addition to sartorial considerations, traders needed to be kept away from the rest of nonfree, non-risk-taking people. In my day, nobody cursed in public except for gang members and those who wanted to signal that they were not slaves: traders cursed like sailors, and I have kept the habit of strategic foul language, used only outside of my writings and family life.*4 Those who use foul language on social networks (such as Twitter) are sending an expensive signal that they are free—and, ironically, competent. You don’t signal competence if you don’t take risks for it—there are few such low-risk strategies. So cursing today is a status symbol, just as oligarchs in Moscow wear blue jeans at special events to signal their power. Even in banks, traders were shown to customers on tours of the firm as if they were animals in a zoo, and the sight of a trader cursing on a phone while in a shouting match with a broker was part of the scenery.

  So while cursing and bad language can be a sign of doglike status and total ignorance—the “canaille,” which etymologically relates these people to dogs. Ironically the highest status, that of a free man, is usually indicated by voluntarily adopting the mores of the lowest class.*5 It is
no different from Diogenes (the one with the barrel) insulting Alexander the Great by asking him to stand out of his sun, just for signaling (legend, of course). Consider that English “manners” were imposed on the middle class as a way of domesticating them, along with instilling in them the fear of breaking rules and violating social norms.

  LOSS AVERSION

  Take for now the following:

  What matters isn’t what a person has or doesn’t have; it is what he or she is afraid of losing.

  The more you have to lose, the more fragile you are. Ironically, in my debates, I’ve seen numerous winners of the so-called Nobel in Economics (the Riksbank Prize in Honor of Alfred Nobel) concerned about losing an argument. I noticed years ago that four of them were actually concerned that I, a nonperson and trader, publicly called them frauds. Why did they care? Well, the higher you go in that business, the more insecure you get, as losing an argument to a lesser person exposes you more than if you lose to some hotshot.

  Being higher up in life only works under some conditions. You would think that the head of the CIA would be the most powerful person in America, but it turned out that the venerated David Petraeus was more vulnerable than a truck driver. The fellow couldn’t even have an extramarital relationship. You can risk people’s lives, but you remain a slave. The entire structure of the civil service is organized that way.

  WAITING FOR CONSTANTINOPLE

  The exact obverse of the public-hotshot as slave is the autocrat.