In 2008, I transitioned from professional practice to academia. Since then, I have been privileged to teach at several fine universities in theWashington, D.C.area. For me, the difficult economic times have had a silver lining in that they have given me so much to draw upon to illustrate course material.
Before long, though, even as I was teaching about proper risk management and illustrating it with business world examples, I began wondering why this fundamental concept wasn't getting through to my students. They had a good intellectual understanding of financial risk, but I sure wasn't seeing it manifest in their mock portfolios. Every time my students entered one of the many investing competitions, all hell would break loose. Portfolios of just one or two stocks were common. There were portfolios of just gold. Others had only one currency. The dodgiest hedge fund manager wouldn't concoct such outrageously risky portfolios. Even students who told me they're naturally very risk-averse weren't demonstrating it.
Reward being an economic good (something one wants more of) and risk being an economic bad (something one wants less of), one should reasonably expect that the latter would temper one's pursuit of the former. But rather quickly, I realized that while a proper appreciation of risk should imbue it with a deterrent quality, my students were equating risk with reward. Hence, since they wanted maximum reward, ipso facto, they should not only bear risk but even consent to more — as if it were nothing more than a tasteless side dish that came with the entrée of reward and which therefore could be discarded unconsumed.
So this past semester, I tried something different. Rather than evaluate them on any ex-post measure of reward versus risk, I wanted to see if my students' risk appetites would diminish if I placed a true disincentive before them ex-ante. It worked like a charm.
Almost all investing challenges suffer from one key shortcoming: Players have nothing to lose. The least realistic competitions are the "absolute return" contests. In evaluating contestants only on how high their stocks jump, such contests practically beg players to bet the farm. Slightly better are those that match players' returns against some benchmark, usually the S&P 500. But even these do not calibrate risk against personal tolerance. Players are still incented to shoot for the moon. My students were merely playing the game according to its logical calculus.
This time, I started by asking the class who wished to play my contest of investing against the S&P 500. All hands went up. This neither surprised nor pleased me. Then I introduced my risk calibrator: Students who wished to play must pay. I wouldn't take their money or anything else from them. Instead, I required them to wager a currency of much greater value than the few dollars most of them have. I required them to wager a number of points of their final grade. All hands went back down.
Perfect. I was getting through.
Each player had to decide how many points of their final grade they would put at risk. Bet big and beat the S&P 500 and a B student becomes an A student. But bet big and lose, and a B student becomes a C student or worse.
In the end, only a handful of the nearly 200 students attempted my crucible. I got wagers ranging from 0.5 points all the way to 100 points. (The student who risked 100 quickly saw the error of his wager.) I accepted both and everything in between, with a clustering around 2 points.
I emphasized that students who chose to accept the challenge would get a sense of the vastness of the task facing professional portfolio managers every day, where billions of dollars and entire careers are at stake. There was a deep pedagogy at work here. The financial theories bequeathed us by Nobel laureates Harry Markowitz and Bill Sharpe are foundational. But variables like sigma and beta can be too nebulous for many students. Just as in physics or chemistry, though, one experiment can clarify what thousands of words cannot.
We know that incentives matter. But I wanted to see if disincentives matter as well to my students. I now have my answer: emphatically, yes.
You're probably wondering about the results of my contest. No student won. However, I believe the experience taught them about risk far better than any additional amount of lecturing could. All of the others were shooed away by the price of admission. That's not a bad thing, either. Many people cannot in fact afford the price of admission to the capital markets. They just don't realize it. At least my students do.
Michael Justin Lee, a veteran Chartered Financial Analyst, teaches in the departments of finance at George Mason University and the University of Maryland. McGraw-Hill will release his new book, "The Chinese Way to Wealth and Prosperity," this month. His email is firstname.lastname@example.org.Copyright © 2015, Los Angeles Times