Diversification, Skewness and Adverse Selection

When I first read about the fascinating ‘Star Wars’ deal between Steven Spielberg and George Lucas, my reaction was that this was a simple diversification story. But then I realized that it is more complex than that; the obstacles in the form of skewness preference, adverse selection and moral hazard are strong enough to make deals like this probably quite rare.

The story itself is very simple and Business Insider tells it well. Back in 1977, George Lucas was making his ‘Star Wars’ film, and Steven Spielberg was making ‘Close Encounters of the Third Kind’. Lucas was worried that his ‘Star Wars’ film might bomb and thought that ‘Close Encounters’ would be great hit. So he made an offer to his friend Spielberg:

All right, I’ll tell you what. I’ll trade some points with you. You want to trade some points? I’ll give you 2.5% of ‘Star Wars’ if you give me 2.5% of ‘Close Encounters’.

Spielberg’s response was:

Sure, I’ll gamble with that. Great.

Both films ended up as great classics, but ‘Star Wars’ was by far the greater commercial success and Lucas ended up paying millions of dollars to Spielberg.

At the time when neither knew whether either of the films would succeed, the exchange was a simple diversification trade that made both better off. So why are such trades not routine? One reason could be that many films are made by large companies that are already well diversified.

A more important factor is information asymmetry: normally, each director would know very little of the other’s film and then trades become impossible. The Lucas-Spielberg trade was possible because they were friends. It is telling that the trade was made after Lucas had spent a few days watching Spielberg make his film. It takes a lot of due diligence to overcome the information asymmetry.

The other problem is skewness preference. Nobody buys a large number of lottery tickets to “diversify the risk”, because that diversification would also remove the skewness that makes lottery tickets worthwhile. Probably both Lucas and Spielberg thought their films had risk adjusted returns that made them attractive even without the skewness characteristic.

It is also possible that Lucas simply did an irrational trade. Lucas is described as “a nervous wreck ... [who] felt he had just made this little kids’ movie”. Perhaps, Spielberg was simply at the right time at the right place to do a one-sided trade with an emotional disturbed counterparty. Maybe, we should all be looking out for friends who are sufficiently depressed to offer us a Lucas type trade.

Posted at 1:38 pm IST on Thu, 27 Mar 2014         permanent link

Categories: behavioural finance, CAPM

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