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Assuming risk

One topic that has been on my mind a lot for the past few months has been the notion of who bears risk. For example, Social Security is a system that insures people who have worked throughout their lives from living in abject poverty when they reach retirement age. The argument is whether the costs of Social Security are worth the risk it mitigates.

Leaving government programs aside, Mark Nottingham has an interesting post on who bears risk in the world of business. Conventional wisdom is that shareholders are the main risk bearers when it comes to firms, but there’s an alternative argument that employees most of the risk.

I hadn’t really thought about it, but it’s certainly true. Shareholders obviously suffer when a company’s stock performs poorly, but most investors diversify enough that they are insulated from suffering significantly when a firm fails. Compare that to the fate suffered by employees of companies like Enron, where many employees got burned both ways. Not only did they lose their jobs, but they also lost most of their investments because the company offered incentives for employees to invest their retirement funds in Enron stock.

If employees are the main risk bearers in any enterprise, what management practices does that dictate? And even if it is true that employees bear the risk, incentives are what really drive human behavior. Executives have many financial incentives to please shareholders, so that’s probably what they’ll continue to do.

3 Comments

  1. wow….this is the first time i noticed comments here…

    anyway, i’ve thought about this risk issue some in the past. here’s something that i’d like to add. our society for “better or worse” has chosen to socialize many risks while privatizing gains associated with those risks. certainly on the up side, this system encourages people to take certain risks in that they will likely never have to pay the full costs of failure–this encourages innovation and adventure amongst those who really normally couldn’t afford to “lose”. unfortunately, this contract has been under assault by those who can actually afford to “lose” but simply wish to exploit the system—businessmen who insist that governments and other entities back up and support their enterprises while they alone reap all the benefits (ie: lawsuit protection laws, financial subsidies, exclusive contracts, bailouts, eminent domain, decoupling of corporate/personal liability, etc.) this also extends to the concept of “corporate responsibility”. for example, global warming is a risk, the costs of which will be bourne by everyone on the planet, whereas the profit (though certainly not the entire benefit) associated with generating the warming is a gain that will be shared by the relative few. those industries will never have to pay for their denial and obstruction, and they know it. the people that run industries really have little motivation to act responsibly unless there are costs associated with their risks and failures. as long as governments continue to provide safety nets for corporate titans and absolve polluters of responsibilty for their pollution, the rest of us will continue to suffer.

  2. “Compare that to the fate suffered by employees of companies like Enron, where many employees got burned both ways. Not only did they lose their jobs, but they also lost most of their investments because the company offered incentives for employees to invest their retirement funds in Enron stock.”

    I think you overlooked one other point. Many of them have had their professional reputations irreversibly damaged. Who wants to hire an accountant with WorldCom, Enron or Arthur Anderson on their resume? Even if you had nothing to do with the scandals you’re tainted by association.

  3. Investing in your employer is risky business. I’ve heard some people say doing so increases your productivity (or whatever), that you’ll work harder to make sure your investments are healthy. But really, what real control do you have on the market price of a major company.

    My in-laws have their entire retirement fund invested in his employer, which has suffered 5 device recalls in the last 3 months. I haven’t actually looked at the stock price, but I cannot imagine this is doing anything good for them. And the company was the target of a buy-out, how do you suspect that is going.

    My (large) employer offers its stocks in the 401k portfolio; I do not buy them. Though I probably should buy some shares, they are a large and fairly healthy company. reverse-bias in action.

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