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Incentive schemes that reward successful managers with huge bonuses, without penalizing them for losing years, skew behavior towards risky investment strategies: "...appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return."

Dealbreaker's refutation is pretty unconvincing. First, I doubt that most traders have enough equity to counteract the effect described above. Second, banks being "long volatility" just means that they make more money when the market moves. That has nothing to do with the risk inherent in an investment strategy's distribution of payouts. One can have a trading strategy that capitalizes on volatility but still hedges risk effectively (I mean, it's not easy...)

My guess is that in most banks it's senior management whose equity compensation ratio is enough to make them take the long view. Therefore you'll see more blowups at poorly managed banks, or at pure-play investment vehicles.

last timestamped: 13:19:48 10-Jan-2008
in categories:Commerce/Investing





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