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1

Module 6

Risk/Reward, Incentives Learning objectives

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Goals of Module 6

Contrast risk/reward Tradeoffs, biases, and incentives

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Biggest takeaway

Understand relationship between risk and reward, more specifically which risks are worth taking.

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What do employers want

workers that can make the right/critical decisions.
- What skills are you developing now that will make you valuable to employers.

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Indiviudals (Risk/Reward)

Measured using expected utility, how they make decisions.
- How much reward needs to be present for one to take a risk
- Most individuals are risk averse, and will pay to avoid risk.

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Examples of Risk/Reward for individuals

How to get people to leave their jobs and work for your startup, you have to pay them more, incentives like star es in the company etc.
People pay to avoid risk= Insurance (multi-billion dollar industry)

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Organizations

Dont have natural risk aversion.
-They are risk neutral

They weigh in opportunity cost or cost of capital

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How do organizations reflect risk

The cost of capital/Opportunity cost

-Project future cash flows from investments/opportunities
Then they discount those cash flows back to present value based on cost of capital
- Cost of capital is commensurate with riskiness of firm

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Risk and reward can be viewed in

Organizations
-Yield for US/Japan

-CAPM (capital asset pricing model)
#see formula
-Only reward systemic risk (rewarded for market movements)
-Not diversifiable risk (diversifiable I investing in google, apple etc)

-Efficient frontier- everything on line ins optimal tradeoff between Risk/Reward. , higher risk reward is up rights low and low is bottom left

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How do use the "reward" amount
ex- I need a ten percent rate of return

-Cost/Benefit analysis
-Projected cash flow
-Discount back to Present Value
-Determine Optimal Choice

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Gov/Society

Measuring reward to society is difficult (reward of national parks?)
Cannot calcite risk and reward well
Many times gov is the only entity able to take on risk, regardless of reward

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Bias

SUBJECTIVE view/ probability from objective
-Many sources
- Alter the decision making
-Problem when it interferes with the way me model how people make decisions.

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Donald Rumsfeld (Sec. of Defense GW Bush)

What are biases?
They are the known unknowns. (I don't know how to do surgery)
Most biases come from unknown unknowns. (Things that we aren't aware that we don't know)
- Ex how bad hurricanes cane after Andrew

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Types of Bias***
- All effect the way we view risk

Age biases (younger people take more risks)
Cultural biases
Experience biases (people that lived through disasters ten to overestimate it's likelihood of recurrence, vis versa)
Gender bias. (Men tak emoe risks than woman)
Media biases (terrors attacks are gonna kill me)

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Incentives

How to get people to make the decisions that we want
-Mostly financial incentives
-Moral- "do the right thing"
-Natural- "Happiness, curiosity"
-Personal vs society
- Coercive- Negative reinforcement

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Incentive levels

1) Individual
2) Organizational
3) Societal

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Study of Economics is basically

Study of incentive systems

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LAW OF UNINTENDED CONSEQUENCES

Whenever you put an incentive give system in place, someone tries to get the incentive without putting in work.
- You can never perfectly predict how someone will use the incentive system

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Welfare system

Designed to allow provide single mothers with cash ignorer to support them and their children.
Unintended consequence: Single mothers pop out children for paycheck and do nothing but live off the gov.
- Continues cycle of poverty

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Poltiical Incentives

Politicians are most concerned with getting elected.
- More focus on short term plays to make everyone happy and get elected, while giving up long term benefits.
-This means discount rate

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Political Incentive, discount Rate

Raise the discount rate
Meaning that todays dollars counts more than future dollar.
-Sacrifice short term gain, rather than long term gain.