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July 2, 2012

Emmett Dulaney: Are risk and vesting correlated?

ANDERSON, Ind. — In business, as in life, the safest thing to do is often nothing. If you don’t take a chance, you can usually avoid the dangers that could befall those who do venture outside the norm and propose new businesses, new products or otherwise embrace risk in the pursuit of reward. What cannot be overlooked in the equation, though, is that risk can differ based upon how vested you are in the cost of undertaking it.

In an attempt to come up with a method of quantifying this, I devised a simple experiment conducted in two parts. In part one, 15 of the students attending the Entrepreneurship/Finance Camp this summer were each given a $5 bill for no reason whatsoever. It was then explained to them that they could keep the money and be done, or they could give the money back. If they gave the money back, they then could reach into a bag and pull out another bill to keep in place of this one. Inside the bag were two $50s, four $20s and five $10s.  In addition, they were informed, there were also 50 $1s.  

There are a number of ways of calculating the odds in this scenario. One of the several possible methods of so doing is to acknowledge that 11 of the 61 bills that can be pulled from the bag are greater than the $5 being given up to take a chance; thus, there is approximately a 20 percent chance of coming out ahead (under no circumstance is it possible to come out even). Another method is to calculate the average of the bag: $280 divided by 61 bills equals $4.59, and thus it is 41 cents less than the cost of participating. No matter what calculation you use, the numbers will change as others interact with the bag and remove a bill of one denomination or another.

Of the 15 attendees given the offer, 13 (87%) chose to take a chance, and the bag was reduced by one $50, one $20, one $10 and 10 $1s.  In other words, 10 of 13 (77%) were worse off by participating and three benefitted, with one seeing a gain of 10 times his starting capital.  As soon as that $50 bill was removed from the bag, the odds changed in favor of the house rather sharply, yet no one who said they wanted to take a chance changed their mind based on this. They still wanted to take a chance, and they did.

In the second part of the experiment — which was actually conducted much earlier with another group — a similar trial was carried out with the same denominations and rules, and the only change was that the students weren’t just given the initial $5. They first had to perform menial labor to earn the buy-in amount. Since what they were foregoing was now something they had had to first earn, the percentage in this group that chose to take the gamble in the presence of the exact same odds turned out to be almost a reciprocal (15%) of those in the other group. This gives promise for conducting a more elaborate study on a larger scale, but the initial analysis at least points to vesting and risk being correlated.

Columns from the Falls School of Business at Anderson University appear Tuesdays in The Herald Bulletin. This week’s columnist, Emmett Dulaney, teaches marketing and entrepreneurship.

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