§3. Monte Carlo and Insurance. To assert this is not to ignore the strength of the appeal which the gambling instinct makes to many, if not to most of us. The taste for gambling is, indeed, so deep and widespread that it would be foolish to leave it out of account in this connection. It is clear enough that at places like Monte Carlo people are prepared to have the odds unmistakably against them, apparently for the sheer pleasure and exhilaration of taking risks. Moreover, though for most people play at Monte Carlo represents a mere holiday indulgence, it would be unsafe to assume that what appeals to them there will not also appeal to them in their business affairs. But what exactly is the secret of the charm of Monte Carlo? It is the great attractive force of a small chance of a large gain, as compared with the deterrent force of a large chance of a small loss. People will readily pay $5 for one chance in a hundred of making no more, perhaps, than $400 or $450. And it is very likely that this holds good in the world of business. If, for example, we were to suppose that the promoters of a new enterprise were confronted with one chance in fifty of a profit of 50 per cent per annum on their capital, as against forty-nine chances of a profit of 5 per cent, this might well prove a more attractive prospect than a certain return of 6 per cent, although the strict expectation of profit would be smaller in the former case. But the risks of business enterprise are not often of this type. They conform more usually to the opposite type of a large chance of a relatively small gain, balanced by a small chance of serious loss or entire failure. Now for almost everyone the possibility of a great loss will count as a deterrent (just as the possibility of a great gain may count as an attraction) for much more than its strict actuarial value.
The truth of this proposition is demonstrated by the existence of institutions more impressive than Monte Carlo—the Insurance Companies, which play so large a part in the economic life of modern times. Every year, and upon an ever-growing scale, both private individuals and business concerns pay sums of money, which reach in the aggregate a colossal sum, as premiums to insure themselves against loss by Fire, Shipwreck, Burglary, Death, Death Duties, against every risk which Insurance Companies will cover. Now Insurance Companies are not, as we say, in business for their health. They find their business profitable, and pay good dividends to their shareholders. Moreover, they incur a considerable expenditure on offices, on clerical staff, on agents, and the like. All these payments must be defrayed out of the premiums they receive; so that it is plain that the premiums greatly exceed the expectation of the risks insured. The odds are heavily in favor of the Insurance Company—of that the stupidest person can have no shadow of doubt. Yet we continue to insure, as private individuals and as business men, and so far from being ashamed of our proceedings as a weak and nerveless folly, which somehow we are unable to resist, we blazon them forth in the strong accents of conscious pride. We preach insurance to our neighbors as the core of self-regarding duty, and, if ever we feel a twinge of uneasiness, it is lest we, too, may have omitted in some particular to practice what we preach.
The significance of this is unmistakable. Be our psychology what it may, however deep and irrepressible our taste for derring-do, however inadequate the scope which the dull routine of modern life affords for our adventurous impulses, we are most of us anxious to avoid the risk of great financial loss. We are very glad to find someone to take it off our shoulders if we can; so glad that we are prepared to pay him for the service, to pay him a sum which covers not only the actuarial equivalent of the risk, but something substantial over and above. In this we are entirely rational. Our conduct is justified by the law of the diminishing utility of money, which was noted at the end of Chapter III. It would be plainly foolish, for instance, to substitute for the certainty of an income of $2500 per annum an even chance of $5000 or nothing, since the utility to us of $5000 is not twice as great as that of $2500.
The majority of business risks are not of a kind against which it is possible to insure. Insurance companies confine themselves to risks which are mainly a matter of what we call objective rather than subjective chance, i.e. risks in respect of which knowledge of detailed facts peculiar to the individual case is of minor importance. But such knowledge is of paramount importance in the case of ordinary business risks. If, for example, a new enterprise is to be undertaken, the special knowledge and experience which its promoters possess is a vital factor in determining their estimate of the risk involved. An outsider with no special knowledge would necessarily require to estimate the risk far more highly if we were to form a rational opinion on the basis of his knowledge. So great, indeed, would be the risk to him, that we can lay it down as a sound maxim that people are extremely rash who invest their money in risky undertakings about which they know very little. This subjective aspect of business risk has a significance to which it will be necessary to revert.
But, though most business risks are not and cannot be a matter for premiums and policies, the principle, which the practice of insurance illustrates, applies none the less. In the light of their knowledge and experience, the promoters of a new undertaking must weigh up the chances of failure and success, though they will not do so by the precise methods of an actuary. They will require that any chances of serious loss should be balanced by such chances of exceptional gain, as would raise the expectation of profit well above the normal return on secure investments. The more risky the project seems the greater, generally speaking, must be the expectation of profit required to induce people to undertake it.
If we suppose business men to calculate reasonably, it follows that the average profits in any industry over a long period of years, reckoning in the losses of the concerns which disappear altogether, are likely to be higher, the more risky is the industry. Such a result will not, of course, occur in every case. Even when the calculations are reasonable, they may be entirely falsified by the event. Moreover, business men may not calculate reasonably on the information which they have. But, unless we suppose their judgment to be subject to a prevailing bias in one direction, i.e. to be unduly optimistic as a general rule, we should expect, and in any case they must expect, profits above the ordinary in a risky industry.
This conclusion is sufficiently important. Far too many people, though they admit it when it is expressly stated and dismiss it even as a tiresome commonplace, are apt to neglect it when the occasion for applying it arises. For example, the great importance to any industry of good management is generally recognized, and the consequent desirability of paying adequate salaries to the managerial staff. The importance of securing a supply of capital is very widely recognized, and the practical necessity of paying a fair rate of interest is thus, however grudgingly, conceded. But the "residuary profits," as they are called, which accrue at present to the owners of a business, are denounced in some quarters in a sweeping fashion, which seems to ignore altogether the all-pervading element of risk. People speak as though you might appropriately limit profits in every industry to some uniform percentage on the capital employed, without making it clear whether you would even be allowed to make up in good years for the losses incurred in bad. The effect of introducing any such crude device into our present industrial system could only be to paralyze enterprises of an unusually risky kind, which, so far from being pushed to an excess at present, are more probably curtailed unduly from the standpoint of what is socially desirable. Like the fixing of a low maximum price for a commodity it would cause the supply to wither up and disappear.
§4. Risk under Large-scale Organization. While this is true of the present economic system, the question is worth considering whether it represents a fundamental necessity, whether, for instance, under our world socialist commonwealth the factor of risk-bearing need play so important a part as it does in the actual business world. This question cannot be answered with a conclusive simplicity; opposing considerations present themselves, between which it is not easy to strike a balance. On the one hand, in accordance with the law of averages gains and losses tend to cancel out over a large series of transactions, when reasonable calculations have been made. Thus Insurance Companies, while they take heavy risks off the shoulders of policy-holders, incur relatively trifling risks themselves; they can predict the aggregate sums which they will be called upon to pay within a small margin of error. In the same way it might seem that every enlargement of the scale of business would make for an automatic insurance and a consequent economy of risk; and thus that if all businesses were comprised in a single financial unit, gains and losses would cancel out over so wide a range that the degree of risk remaining would be almost negligible.
This might indeed happen, if business risks were mainly of that objective kind in which the insurance companies specialize; for then we could assume that the chances of success or failure would be estimated reasonably. But, in fact, most business risks, not being of this kind, must be estimated by processes of human judgment, which are very fallible. And here we must take account of the law of averages in another aspect, with a different bearing on the argument. When an industry comprises a large number of separate concerns, and the decisions accordingly are taken by many men, acting independently of one another, the errors of calculation will tend to some extent to cancel one another out. The undue optimism of one man will be balanced by the undue pessimism of another; and, if there is no prevailing bias in either direction, the errors of judgment will not affect the results for the industry as a whole. But where the effective decisions are taken by very few men, the chances are far greater of a preponderating balance of error in one direction. The risks dependent on the factor of human judgment tend therefore to increase.
This truth can be illustrated by a phenomenon which is fairly familiar. It is recognized by intelligent persons that the risks of speculation in a particular commodity market or stock market increase more than proportionately to the scale of operations. A man who sets out as a "bull" upon a small scale can buy without sending up the price against him in the process, and, if he decides later that his judgment is mistaken, he can at any time cut his losses and sell out without much difficulty. But a "bull" on a very large scale cannot complete his purchases except at a price which has been raised in consequence of his own action, and he cannot count on being able to "unload" at or near the market price, should he decide to do so. If, accordingly, he miscalculates, he cannot save himself from serious loss as a smaller man might do by a prompt discovery of his error. His difficulties spring from the fundamental fact that the effects of his calculations are too great to be offset by those of the different, and often opposite, calculations of other men.