Bonus Babies by Paul Wilmott
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PostPosted: Wed, Feb 11 2009, 2:32 pm EST    Post subject: Bonus Babies by Paul Wilmott Reply with quote

This is an interesting article illustrating how the bonus system of investment firms works again shareholders of those firms. In short, avoid owning shares of companies that hand out big bonus to their traders.

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Op-Ed Contributor

Bonus Babies

By PAUL WILMOTT
Published: February 10, 2009

“DON’T put all your eggs into one basket” is the layman’s expression encouraging diversification. This was put into mathematics in a financial context by Harry Markowitz in the 1950s, in his Modern Portfolio Theory. He showed how to construct a portfolio of financial assets so as to maximize expected return for any given level of risk. This idea has inspired much theory and practice of investing, at all levels.

Only last month my bank manager had me complete a questionnaire so he could figure out how much risk I was comfortable with, and then he gave me the computer-generated result that told me how much of my money should be in cash, how much in bonds and how much in stocks. So with your grandmother telling you what not to do with all your eggs, your bank manager giving similar advice, and Professor Markowitz, a Nobel laureate, backing this up with mathematics, you’d expect that traders in banks would have got the message. Yet as the following simple thought experiment shows, it is not quite so straightforward.

It is your first day in your first job out of business school. You are going to be a trader in an investment bank! You will be rich! You will retire by the age of 30 and spend the rest of your days doing charitable works (when not on your yacht, of course). You are shown to your desk and introduced to your fellow traders. You notice something very strange, that they are all making similar trades using similar financial instruments. That’s odd, you think, there doesn’t seem to be much diversification going on.

Never mind, you are going to put into practice everything you’ve learned in school, and that includes diversification, so your trades will be safely diversified from those of your colleagues. Now to see if that makes any sense, we’ll put some numbers to this, and imagine what could happen to your plans for buying that yacht. Does diversifying improve your chances of getting a big bonus?

Suppose that you have 100 colleagues, each trading with $10 million. Bearing in mind Einstein’s advice, we are going to keep things simple, so as to make the mathematics as transparent as possible, and assume that they are betting on a coin toss. And, crucially, they are all betting on heads on the same toss of the same unbiased coin — it doesn’t get more undiversified than that.

It’s 50-50 whether they win or lose. If the single toss comes up heads then they all win, and the bank makes 100 times $10 million, of which each trader perhaps gets a tidy $2 million bonus. That’s their down payment on a decent yacht. Everyone’s happy: traders, management, shareholders and depositors. But if it comes up tails, they lose, and the bank goes bust. But while the traders and management only have to find new jobs, the shareholders and the depositors potentially face losing their life savings.

You come along, and, thanks to your college education, you have found a much better trade than your colleagues. Let’s say that you are betting on another, independent coin — but one that is biased. This coin has a 75 percent chance of heads. And you’ve also got $10 million to invest.

Let’s look at two possibilities: first, that you do the responsible thing of betting the good odds on the biased coin, and second, that you bet on the heads on the 50-50 toss just like your colleagues. I say that the first case is “responsible” for two reasons: one because it’s a better bet than that of your colleagues and so will increase the bank’s expected return; and two because it also helps the bank diversify. That’s classic Modern Portfolio Theory, and is also common sense.
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more:

http://www.nytimes.com/2009/02/11/opinion/11wilmott.html
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