Options, Antifragility, and Social Fairness

Options, Antifragility, and Social Fairness

The stock market: the greatest, industrial-sized, transfer of antifragility in history—due to a vicious form of asymmetric skin in the game. I am not talking about investment here—but the current system of packaging investments into shares of “public” corporations, with managers allowed to game the system, and of course, getting more prestige than the real risk takers, the entrepreneurs.

A blatant manifestation of the agency problem is the following. There is a difference between a manager running a company that is not his own and an owner-operated business in which the manager does not need to report numbers to anyone but himself, and for which he has a downside. Corporate managers have incentives without disincentives—something the general public doesn’t quite get, as they have the illusion that managers are properly “incentivized.” Somehow these managers have been given free options by innocent savers and investors. I am concerned here with managers of businesses that are not owner-operated.

As I am writing these lines the United States stock market has cost retirees more than three trillion dollars in losses over the past dozen years compared to leaving money in government money market funds (I am being generous, the difference is even higher), while managers of the companies composing the stock market, thanks to the asymmetry of the stock option, are richer by close to four hundred billion dollars. They pulled a Thales on these poor savers. Even more outrageous is the fate of the banking industry: banks have lost more than they ever made in their history, with their managers being paid billions in compensation—taxpayers take the downside, bankers get the upside. And the policies aiming at correcting the problem are hurting innocent people while bankers are sipping the Rosé de Provence brand of summer wine on their yachts in St. Tropez.

The asymmetry is visibly present: volatility benefits managers since they only get one side of the payoffs. The main point (alas, missed by almost everyone) is that they stand to gain from volatility—the more variations, the more value to this asymmetry. Hence they are antifragile.

To see how transfer of antifragility works, consider two scenarios, in which the market does the same thing on average but following different paths.

Path 1: market goes up 50 percent, then goes back down to erase all gains.

Path 2: market does not move at all.

Path 1 can be more profitable to managers if they can cash in their options during the rise. The comparison depends on that opportunity: options valued only at the same final market level would not gain merely because the route was more volatile.

And of course society—here the retirees—has the exact opposite payoff since they finance bankers and chief executives. Retirees get less upside than downside. Society pays for the losses of the bankers, but gets no bonuses from them. If you don’t see this transfer of antifragility as theft, you certainly have a problem.

What is worse, this system is called “incentive-based” and supposed to correspond to capitalism. Supposedly managers’ interests are aligned with those of the shareholders. What incentive? There is upside and no downside, no disincentive at all.