Hedge Your Bets

There's an absorbing piece by Malcolm Gladwell here in the January 18th issue of The New Yorker in which he discusses the truth behind the success of entrepreneurs. Some excerpts of note:

In a recent study, “From Predators to Icons,” the French scholars Michel Villette and Catherine Vuillermot set out to discover what successful entrepreneurs have in common. They present case histories of businessmen who built their own empires - ranging from Sam Walton, of Wal-Mart, to Bernard Arnault, of the luxury-goods conglomerate L.V.M.H. - and chart what they consider the typical course of a successful entrepreneur's career. There is almost always, they conclude, a moment of great capital accumulation - a particular transaction that catapults him into prominence. The entrepreneur has access to that deal by virtue of occupying “a ”structural hole,“ a niche that gives him ”a unique perspective on a particular market. Vilette and Vuillermot go on, 'The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they sell to him or overvalue what they buy from him in comparison to his own evaluation.“ He moves decisively. He repeats the good deal over and over again, until the opportunity closes, and - most crucially - his focus throughout that sequence is on hedging his bets and minimizing his chances of failure. The truly successful businessman, in Villette and Vuillermot's telling, is anything but a risk-taker. He is a predator, and predators seek to incur the least risk possible while hunting.

. . .

People like Dassault and Eastman and Arnault and Turner are all successful entrepreneurs, businessmen whose insights and decisions have transformed the economy, but their entrepreneurial spirit could not have less in common with that of the daring risk-taker of popular imagination. Would we so revere risk-taking if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?

. . .

(Hank) Paulson's story also casts a harsh light on the prevailing assumptions behind corporate compensation policies. One of the main arguments for the generous stock options that are so often given to C.E.O.'s is that they are necessary to encourage risk-taking in the corporate suite. This notion comes from what is known as “agency theory,” which Freek Vermeulen, of the London Business School, calls “one of the few academic theories in management academia that has actually influenced the world of management practice.” Agency theory, Vermeulen observes, “says that managers are inherently risk-averse; much more risk-averse than shareholders would like them to be. And the theory prescribes that you should give them stock options, rather than stock, to stimulate them to take more risk” Why do shareholders want managers to take more risks? Because they want stodgy companies to be more entrepreneurial, and taking risks is what everyone says that entrepreneurs do.

The result has been to turn executives into risk-takers. Paulson, for his part, was stunned at the reckless behavior of his Wall Street counterparts. Some of the mortgage bundles he was betting against - collections of some of the sketchiest subprime loans - were paying the investors who bought them six-percent interest. Treasury bonds, the safest investment in the world, were paying almost five percent at that point. Nor could he comprehend why so many banks were willing to sell him C.D.S. insurance at such low prices. Why would someone, in the middle of a housing bubble, demand only one cent on the dollar? At the end of 2006, Merrill Lynch paid $1.3 billion for First Franklin Financial, one of the biggest subprime lenders in the country, bringing the total value of subprime mortgages on its books to eleven billion dollars. Paulson was so risk-averse that he didn't so much as put a toe in the water of subprime mortgage default swaps until Pellegrini had done months of analysis. But Merrill Lynch bought First Franklin even though the firm's own economists were predicting that housing prices were about to drop by as much as five percent. “It just doesn't make sense,” an incredulous Paulson told his friend Howard Gurvitch. “These are supposedly the smart people.”