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Avoid Giving Incentives to Take Unlimited Risks

Mar 16, 2008
Are you feeling lucky and have only other peoples' money to lose? You should lie down until that feeling goes away, or a social disaster may follow.

Financial institutions and companies place huge bets on the future economic environment, in everything from future currency values, to commodity prices, to interest rates, to common stock indices. Because the sums involved are often enormous and the potential rewards regal, those who make decisions about these bets are often rewarded with a piece of the gain when they succeed. Even in the worst times, these jobs tend to pay extraordinarily well, so they are well worth hanging on to.

It's a win-win for the person making such bets. It's potentially a lose-lose for those they work for or on behalf.

Meanwhile, the rapid shifts in values for currencies, commodities and financial markets can often leave the enterprises that are trading in these markets exposed to enormous losses. This occurs because vast amounts of borrowed money are involved, so that a company doing such trading can lose far more money than it initially put up as its own equity capital. Taken to extremes, such losses can cripple or destroy otherwise sound, healthy businesses.

In recent years, we have seen a number of these debacles. One of the most interesting to consider for our purposes is the trading (apparently unauthorized) that has been ascribed to a single person, Nicholas Leeson, on behalf of Barings Bank, for many years one of Britain's oldest and most well regarded financial institutions.

Having experienced large losses, the trader decided to attempt to recoup the sums that had been lost by making even larger trades (reportedly beyond his authorization). Somehow, he was able to do this without being detected by the firm's management, and the result was that the subsequent losses grew larger. By the time the losses from the trader's miserable decisions were uncovered, the bank had no equity left and had to be dissolved.

Had the trader followed his firm's rules better or the firm stopped him before the losses became too large, the bank would still be functioning today and providing a nice economic contribution to its many customers and employees.

What's the lesson? The more incentive you give to people to make big bets and keep their jobs, the more you had better watch them closely. Try as hard as you might, you won't find out what they are doing. It's better to avoid providing such incentives. Make the risk and reward similar for company and individual alike.
About the Author
Donald Mitchell is an author of seven books including Adventures of an Optimist, The 2,000 Percent Squared Solution, The 2,000 Percent Solution, The 2,000 Percent Solution Workbook, The Irresistible Growth Enterprise, and The Ultimate Competitive Advantage. Read about creating breakthroughs through 2,000 percent solutions and receive tips by e-mail by registering for free at

http://www.2000percentsolution.com .
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