Skin in the Game

A phrase referring to direct involvement by some sort of risk en route to attaining a particular outcome or goal.

Skin in the game is a phrase that refers to being directly involved in or affected by some risk towards attaining a particular outcome or goal. 

Skin in the game

The phrase is related to symmetry, where an individual can reap the benefits in the event of a positive outcome but must simultaneously pay the price or suffer the consequence in the event of a negative result. 

Although the phrase can be applied to and has implications for aspects of people's everyday lives and careers, it is significant for gambling, business, and finance. For example, the saying was made famous by American businessman and philanthropist Warren Buffett

This phrase is commonly used to refer to business owners or executives owning shares in the company(s) they manage. That way, key shareholders work together with a shared interest in the company's success. 

Understanding skin in the game 

It is a phrase where "skin" is a metaphor for the personal or financial commitment involved, while "game" is a metaphor for actions that must be taken. 

Explanation

So, the expression is about taking risks with potential rewards and not simply letting others pay the price of one's decision or mistake. It refers to genuinely being invested in attaining a specific outcome. 

When an executive risks a part of their own money and invests in the company they work for, i.e., puts skin in the game, it shows that they have confidence in that company's share price and future. In addition, this portrays a positive image of the company to the public. 

Other potential investors and people in the outside world can see that the company's executives are confident. Moreover, they believe in the company's outlook, thus encouraging more individuals to invest.

It is thus seen as "insider ownership." Those who have their own money at stake will work with the company's best interest in mind and look to the future. Investors, therefore, see that the company will aim to ensure great returns for its investors.

Nassim Nicholas Taleb is a Lebanese-American essayist, risk analyst, and former options trader. He wrote a book on this notion, titled Skin in the Game: Hidden Asymmetries in Daily Life.

He explains why investors must carry a measurable risk when making a significant decision. If people want to get the benefits, they must also bear some of the risks and pay if their decision harms others. 

Decisions

So, as a moral and risk management rule, one should balance incentives and disincentives. For instance, if one risks losing money for their clients, they should also expose themselves to that same risk. 

Warren Buffett believes the executives of firms he invests in should also have their funds or "skin" invested in the company. Although Warren Buffett made the phrase famous, especially in its use in the financial domain, he did not coin it. 

The origin is unclear, but a money and investment specialist showed William Safire, an American journalist and columnist, that the phrase is not just applicable to financial risks. Instead, he stated the expression could also explain emotional investments.

Since it is related to the symmetry of incentives and disincentives, it is not only restricted to finance. It can also be seen in other careers and aspects of individuals' everyday lives. 

Examples

Examples

Some executives and CEOs invest their own money in their companies. For example, Elon Musk owns over 227 million shares of his company, Tesla, as mentioned in his Schedule 13G report from December 31, 2021. 

Bankers can gain benefits from speculating in securities that carry systemic risk. Sometimes, they can bail out or transfer that risk to the government or taxpayers in case of a blowup. However, they do not pay for the consequences if they do not have skin in the game. 

Pilots can earn a lot of money when they carefully yet quickly fly their planes full of passengers from one destination to another. However, if a pilot is careless on the job and fails, the aircraft will crash. The pilot will collide with the passengers, which they want to avoid. 

If a cook or baker has to eat the dish they make, they will put in more time and effort to prepare it because that would make them better off. So, they would "invest" more in cooking and ensure the food is cooked well for their health and satisfaction.

These are just a few examples of how investing one's own money and effort helps balance the incentives and disincentives. Through this, one can manage the magnitude of risks they are exposed to and reap the benefits available to them and others if successful. 

Requirements

Requirements

The Securities and Exchange Commission (SEC) is an independent agency that is part of the United States federal government. The SEC is responsible for protecting investors and promoting fairness in the markets. 

As required by the SEC, funds must reveal the amount of money that portfolio managers and executives have invested in the fund each year. 

Thus, the public can see records of portfolio managers who have invested their own money into the fund under observation. They can then use that information while weighing their interests to help them decide where to invest their money and how much to invest. 

The SEC also mandates that an organization reveal insider ownership and purchase or sell its securities. Such trades by executives and directors can significantly affect the price of a company's share. Again, this is because they influence investors' perceptions of the company. 

There are many forms that executives must file with the SEC to aid in disclosing specific fundamental values and information about shareholders and investments. 

Once compiled and released to the public, this information can influence and inform investment decisions. Potential and existing investors can evaluate the extent of insider ownership and the stakeholders' perspectives on the company's trajectory.

Limitations/Disadvantages

Limitations

Asking executives to invest their own money and have skin in the game can help boost confidence in the company's performance and prosperity, but it also comes with some limitations. 

Several banks and financial institutions manage their clients' capital and do not allow their employees to have skin in the game. This regulation reduces biases and conflicts of interest between managers and clients. 

For instance, some employees work as advisors to help investors decide where to invest. However, if those employees have their own money invested somewhere, the motive or reason behind their financial advice may be unclear. 

With the possibility of the advisor's financial gain, it becomes unclear whether their advice is indeed what would be most beneficial to the client. This is because a conflict of interest has been created. 

Preventing these employees from having skin in the game also tackles the problem of front running. This occurs when executives enter a trade and act on insider or non-public information about a sizeable upcoming transaction to gain an advantage.

There are also limitations to commingled funds, where corporate resources for clients and private funds held in a company are mixed. 

Executives and directors are expected to stay objective while making decisions and avoid conflicts of interest in investments. 

How can investors use this to Their advantage?

The idea behind this phrase as a moral and risk management rule is essential for passive and active investors. This is because passive investors have their money managed by someone else, while active investors make their own decisions about where and how much to invest.

Use for advantage

  • For passive investors:
    • Passive investors would depend on what their financial advisors invested in. They then use that information to structure their portfolio. 
    • Passive investors are not as involved in the investment process and typically only look for potential investments that may lead to long-term profits. 
  • For active investors:
    • People who invest in the long term on their own seek to invest in companies where the top executives are also some of the largest shareholders. 
    • Active investors are more involved in the process and typically monitor the prices more closely. They also look for profits in the short term. 

A CEO with skin in the game and a significant share in the company carries the same risk and potential benefits to reap as the other stock owners. So, investors believe that the CEO would try to make the best decisions for them, as shareholders, since it affects him too. 

Conclusion

  • Skin in the game is a phrase that describes when directors and executives have their own money invested in the companies they manage. This reflects confidence in the company and its future. 
  • The phrase is about symmetry, where an individual should balance the incentives and disincentives. They should have the chance to reap the potential benefits of a positive outcome and pay the penalty in the event of a negative result. 
  • It has limitations, like a conflict of interest between a company's managers and clients. 
Financial Statement Modeling Course

Everything You Need To Master Financial Statement Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Laila Al-EisawiLinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: