CHAPTER VII

RISK-BEARING AND ENTERPRISE

§1. _Profits and Earnings of Management_. The profits of a business, as they are ordinarily reckoned, whether for the purposes of income tax or of a balance sheet, comprise several elements which are fundamentally distinct. The relative importance of these various elements varies greatly from one type of business to another. The profits of a private business include, for instance, the remuneration of the work of management, which in the case of a Joint Stock Company is mostly paid for by salaries or directors' fees. It is to their profit that farmers, small shopkeepers, and the partners of a private firm look not merely for a return upon their capital, but for the reward of their own labors. "Earnings of Management," as they are usually termed (though in truth they often cover other and humbler forms of labor) are thus frequently one of the ingredients of profits.

§2. _The Payment for Risk-bearing_. There is another element of great importance about which our ordinary ideas are apt to be so vague that it will be well to devote a chapter to its examination. This is the element of payment for risk, or rather the reward of risk-bearing. Risk is inherent in all business, as it is inherent in all life. The vagaries of nature and the vagaries of man are alike responsible. The farmer may find his harvest ruined by a drought or by a deluge; the coal or the gold, for the extraction of which you have perhaps set up an extensive mining plant, may come to an end which is unexpectedly abrupt. You may put your money into roller-skating rinks and find that cinemas have become the rage with the fickle public; sometimes "the market" may decline for causes which remain obscure but with consequences which are disagreeably plain. But while risk is always present in some degree, the degree varies enormously from one industry to another. Now, it is obvious enough that in an exceptionally risky industry, where there is a considerable possibility that the capital invested will yield no return at all, the profits of those concerns which succeed are likely to exceed the rate of interest on gilt-edged securities. But what is likely to be the magnitude of this excess? Is risk-taking rewarded if there is any such excess, however small? Or will it suffice that the gains and losses should average out to a fair rate of interest over the whole industry? To enable us to think closely let us suppose for a moment that we can measure accurately what the chances are.

Suppose, then, that there were a precisely equal chance of success on the one hand and failure on the other in any enterprise, failure involving a complete loss of all the capital invested. Suppose, further, 6 per cent to be at the time a fair return on a perfectly secure investment. What would be the return which must be expected from the risky enterprise, in the event of its succeeding, before it will be undertaken? The reader may be tempted to answer, 12 per cent. But 12 per cent would not suffice. An equal chance of 12 per cent or nothing, as compared with a certainty of 6 per cent, does not mean that the risk in the former case is paid for to the tune of 6 per cent. It means that it is not paid for at all. In each case what a mathematician would call the _expectation_ is a return of 6 per cent. The odds are evenly balanced; in the long run, over a large number of cases, if the law of averages works as we assume it does, you would get just as much from the one type of investment as the other. Now, risky enterprises will not, as a rule, be undertaken on terms like these; investors and business men will not take risks with the odds precisely equal; they must have them, or believe that they have them, in their favor.

§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

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