Scaling the Heights of Corporate Greed: Chafkin and Lo on Risk

Andrew W. Lo, who teaches at M.I.T. and is director of its Laboratory for Financial Engineering, has contributed to this blog before. Here he is joined by co-author Jeremiah H. Chafkin, president of AlphaSimplex Group (where Lo also serves as chairman and chief scientific officer) for a guest post about the best (and worst) ways to manage risk.

Scaling the Heights of Corporate Greed
A Guest Post
By Jeremiah H. Chafkin and Andrew W. Lo

In Laurence Gonzales‘s riveting book Deep Survival, he gives a sobering account of four mountain climbers who successfully scaled the 11,249-foot peak of Mount Hood in Oregon — considered a “beginner’s” mountain — only to fall disastrously during their descent.

The climber in the top position — a veteran of much more challenging climbs — felt that belaying (the laborious process of anchoring a climber’s rope to the mountainside to arrest a fall) was an unnecessary precaution in this case, so when he lost his footing and fell, he yanked his three tethered colleagues, and five climbers below them, off the side of the snow-covered mountain. Three men died in this unfortunate incident, and the question posed by Gonzales is what leads some individuals to such tragic ends, while others faced with the same circumstances survive?
The answer, which forms the major thesis of Deep Survival, may also be the ultimate explanation for the current financial crisis:

The climbers on Mount Hood were set up for disaster not by their inexperience, but by their experience. It was the quality of their thinking, the idea that they knew, coupled with hidden characteristics of the system they had so often used. The system … was capable of displaying one type of behavior for a long time and then suddenly changing its behavior completely.

In other words, their mental model of this beginner’s mountain did not match the reality on that fateful day, resulting in their tragic accident.
The remarkably consistent performance of the U.S. residential real-estate market over the decade from 1996 to 2006 may have had the same effect, leading many experienced businessmen to conclude that such growth was likely to continue indefinitely. And despite all the protections that were available to these captains of industry — analytics that showed large potential losses in the event of a downturn in housing prices, leverage constraints imposed by regulatory capital requirements, and warning signs from the hedge-fund industry in 2005 and 2006 — they charged ahead anyway, with the single-mindedness of a well-funded expedition hell-bent on conquering a mountain. Their mental models apparently did not match reality either.
Much of neoclassical economics is based on the assumption that individuals act rationally and that markets fully reflect all available information, i.e., markets are informationally efficient. So powerful and far-reaching are the implications of this hypothesis that we sometimes forget it is meant to be an approximation to a much more complex reality. Recent advances in the cognitive neurosciences have radically altered our understanding of human decision-making, underscoring the importance of emotion, “hardwired” responses, and neural “plasticity” (the adaptability of neural pathways) in producing observed behavior (see Lo 2004, 2005). These breakthroughs show that decisions are often the result of several distinct components of the brain — some under our direct control and others that work behind the scenes and below our consciousness — that collaborate to yield a course of action best suited to achieve our immediate goals. On occasion, those immediate goals may conflict with larger and more important goals, like survival.
One illustration of this mismatch is the typical response to the following question: what is the primary objective of any mountain-climbing expedition? If, like most individuals, you answered “to get to the summit, of course,” you may be suffering from the same mental blinders as those climbers who fell from Mount Hood. A more risk-aware response might be: “to get to the summit, and then descend successfully.” Sometimes, we are so focused on one objective — to the exclusion of all else — that we neglect the obvious.
Risk-taking in corporate contexts is surprisingly similar, except that the height of the mountain is measured in units of earnings-per-share, return-on-equity, and share price. CEO’s are richly rewarded for the speed of their ascent during times of growing demand and easy money, but not necessarily for safely navigating the descent to the bottom of the business and credit cycles. While “greedy” CEO’s are easy scapegoats, the main object of everyone’s attention — the stock price — is often driven by shareholders looking for short-term profits, not long-term capital appreciation. And competition for shareholder dollars is akin to having many climbers competing to reach the same peak first. In both cases, the rewards — either bragging rights or bonuses — are proportional to the difficulty of the climb (barriers to entry) and the speed of the ascent (growth rate). A well-planned and successful descent is usually not on the list.
Now it can be argued that descending safely goes without saying, and most serious climbers are extremely well-prepared for both legs of their journey. But if it goes without saying, it sometimes goes without detailed planning, and then without doing, especially by those lucky climbers who have never experienced any setbacks or accidents. Similarly, corporate profits are rarely generated without taking some risks, yet the current culture, compensation structure, and shareholder and analyst objectives surrounding the modern corporation are all focused mainly on the race to the summit.
So what is the business equivalent of a well-crafted plan for descent? One possibility is for a corporation to appoint a chief risk officer (CRO) who reports directly to the board of directors and is solely responsible for managing the company’s enterprise risk exposures, and whose compensation depends not on corporate revenues or earnings, but on corporate stability. Any proposed material change in a corporation’s risk profile — as measured by several objective metrics that are specified in advance by senior management and the board — will require prior written authorization of the CRO; and the CRO can be terminated if a corporation’s risk profile deviates from its pre-specified risk mandate, as determined jointly on an annual basis by senior management and the board.
Such a proposal does invite conflict and debate among senior management and their directors, but this is precisely the point. By having open dialogue about the potential risks and rewards of new initiatives, senior management will have a fighting chance of avoiding the cognitive traps that can lead to disaster. Imagine if one of the four ill-fated climbers on Mount Hood had been assigned the role of the “designated skeptic” in advance, in which capacity he would be expected to raise every reasonable objection he could think of to a quick descent. We will never know if this would have been enough to have prevented their fall, but it would certainly have given them pause, and an opportunity for further reflection.
Mountains must be scaled, businesses must be built, and risks imply that occasionally, losses will be severe. But it would be even more tragic if we compounded our mistakes by failing to learn from them.