30 January 2015

Why Corporations Could Get Higher Returns Than VCs

Daniel Kahneman is the only psychology professor to have won a Nobel Prize in Economics. His studies with Adam Tversky on how people value things is one of the reasons. They suggest something counter-intuitive about risk.

In one study, Kahneman ran a few scenarios with coffee mugs from a person’s alma mater. In one scenario, he gave people the mug and let them “take ownership” before offering to buy it back from them. In the other study, he let people buy the mug that was not yet in their possession. On the surface, you would think that they would value the mug the same way in both instances, but they didn’t. He had to pay, on average, $7 and some change to buy the mugs back from people. By contrast, he had to sell the mug for about $3 and change to get them to buy when they did not already own it. Kahneman’s conclusion was that people put a higher price on loss than they do gain. It is more painful to lose what you have than never get something comparable. He had to pay people twice as much to give up their mugs as they were willing to pay to buy them.

This makes sense. You might feel the pang of a relationship that fails to materialize but that is nowhere near as devastating as a divorce. Not getting the job is rarely as painful as being laid off. Loss is painful and we put a premium on avoiding the loss of valuable things.
This is one reason that Warren Buffet is worth so much. He sells insurance. People pay a premium to avoid loss. Richard Thaler discovered that people would not pay more than $200 to avoid the 1 in 1,000 chance of immediate death, which suggests they value this added probability about the same as a smart phone. But if you offer to pay someone to accept 1 in 1,000 odds of immediate death, they refuse it even for $50,000.[1]

Just to be clear on this oddly paradoxical approach to risk, here are the scenarios.

Scenario 1: You have a choice between two pills to cure what ails you. The $1 pill has a one in a 1,000 chance of killing you immediately. The premium pill eliminates this chance. How much extra will you pay for the premium pill?
Research suggests that the average person will not pay more than $200 for the premium pill.

Scenario 2: You are offered pay to be in a research study, testing the $1 pill that carries a one in a 1,000 chance of killing you immediately. How much will you demand to take this risk?
Research suggests that the average person will not do it even for $50,000. 

Oddly, this does not result from a difference in the probability of death: in both cases, it is one in 1,000. These two scenarios offer the exact same risk, the exact same chance of death. One measures how little you are willing to lose to avoid the risk and the other measures how much you have to gain to accept the risk. The pain of loss is much greater than the allure of gain. We do not feel so bad about losing out on big gains but we desperately try to avoid even small losses.

These differences in how we value risk help to explain why the derivatives, junk bond and futures markets are worth trillions. Smart investors will buy risk from people at a discount. Now that would just be interesting if it were not for something really fascinating that it suggest about how corporations could use behavioral psychology and the popularization of entrepreneurship to earn returns that venture capitalists would envy.

The prime candidates for entrepreneurial ventures are actually people in their 30s and 40s. Their startups are less likely to fail and reasonably so. They have more experience than people in their 20s and more drive than people in their 50s. They have learned about processes, products and people and typically know at least one industry reasonably well. But they have one major disadvantage in comparison to the twenty-something crowd: they have so much to lose.

Imagine a 40 year old who has been in the industry – any industry – long enough to have a potentially lucrative idea. He knows a cheaper way to make an old product or has an idea for an innovative new product or how to create a new market. He also knows that executing this idea will require capital. And leaving his job. And working at risk for at least a year – more often 3 to 7 years. It is not hard to imagine that at 40, he has been married for 10 or 12 years. His children are 9 and 7 and he has a small amount saved for their college. He is 8 years into his 30-year mortgage. He is 10 years into his job and now gets 4 weeks of vacation and is fully vested in the 401(k), which is just starting to seem sizable – but still not enough for retirement. The man has a lot to lose. Most importantly, he puts more weight on the cost of losing all that than he does on the potential gain from his entrepreneurial venture.
The twenty-five year old, by contrast, has almost nothing to lose. For this reason alone, she might be the better candidate for entrepreneurship.

If Kahneman’s studies are right, our 40 year old values what he has now vs. what he could have at a rate of about 2 to 1. If Thaler is right, he values it at a rate of at least 250 to 1. In any case, the emotional cost of losing what he already has is great. He would be sick to wake up at 47 with no 401(k), no business, no money for college for his 16 and 14 year old children, and no equity in his home. The prospect of this is more terrifying than the hope of waking up at 47 to a net worth of $5 or 10 million and the expectation of doubling that every 2 to 5 years. His preference for the second scenario is not as great as his desire to avoid the first. Loss is more sharply felt than gain.

This suggests that corporations have a great deal to make by offering entrepreneurial opportunities to their employees. Countless employees who could be great entrepreneurs shy away from the prospect because they have something to lose. What a corporation would have to offer as a percentage of returns would be less – perhaps considerably less – than what a venture capitalist or traditional banker would have to offer. A successful venture could return considerably more to the corporation than it might to the venture capitalists simply because the employee as entrepreneur would have so much less to lose than the employee who leaves his job to become an entrepreneur.

[1] Peter L. Bernstein, Capital Ideas Evolving [John L. Wiley & Sons, Hoboken, New Jersey, 2007] p. 15.

Stay tuned. This is an excerpt from an update to The Fourth Economy: Inventing Western Civilization, soon to be released with revisions. In the 20th century, we popularized knowledge work. In this generation we will popularize entrepreneurship. This is going to be big.


Anonymous said...

Don't forget about Kahneman's partner on these studies, Amos Tversky.


luisriverag said...

Really interesting angle. Seems to assume returns will be the same if a project is launched within a corporate setting or in the wild, which would be a surprise to me both in aggregate and particularly on individual cases (factor them as luck and hunger if you want)

luisriverag said...

Really interesting angle. Yet it seems to assume returns will be the same if a project is launched within a corporate setting or in the wild, which would be a surprise to me both in aggregate and particularly on individual cases (factor them as luck and hunger if you want)

Anonymous said...

2 factors that occur to this 39yo who left a Fortune100 insurance company for a start-up in the last year.

1) the non-financial cost for entrepreneurial personalities in remaining with the stable option, to the point that the steady salary / 401k / vacation is put in jeopardy by their level of frustration.

2) the capacity for some corporations to encourage entrepreneurial opportunities within their existing culture / systems / processes.

abbiestreehouse (Thomas) said...

This is off topic, so it won't hurt my feelings if you don't post it, but I watched a TED Talk today that I thought was fantastic, and it looked like the sort of thing you'd enjoy, too.

Here's the link: http://www.ted.com/talks/guy_winch_the_case_for_emotional_hygiene