HiioiS 
 . W3 
 
 
 
 
 
 
 • 
 
 
 
 
 
 
 
 
 
 
 
MATERIALS FOR THE STUDY 
 OF BUSINESS 
 
RISK AND RISK-BEARING 
 
THE UNIVERSITY OF CHICAGO PRESS 
 CHICAGO, ILLINOIS 
 
 THE BAKER & TAYLOR COMPANY 
 NEW YORK 
 
 THE MACMILLAN COMPANY OF CANADA, LIMITED 
 
 TORONTO 
 
 THE CAMBRIDGE UNIVERSITY PRESS 
 LONDON 
 
 THE MARUZEN-KABUSHIKI-KAISHA 
 TOKYO, OSAKA, KYOTO, FUKUOKA, SENDAI 
 
 THE COMMERCIAL PRESS, LIMITED 
 SHANGHAI 
 
Risk and Risk-Bearing 
 
 BY 
 
 CHARLES 0. HARDY 
 
 THE INSTITUTE OF ECONOMICS 
 WASHINGTON, D.C. 
 
 THE UNIVERSITY OF CHICAGO PRESS 
 CHICAGO, ILLINOIS 
 
 Boston CHVge 
 
 Tower ReL Library 
 
Copyright 1923 By 
 The University of Chicago 
 
 All Rights Reserved 
 
 Published May 1923 
 Second Impression March 1924 
 Third Impression October 1927 
 Fourth Impression December 1929 
 
 146641 
 
 Composed and Printed By 
 The University of Chicago Press 
 Chicago, Illinois, U.S.A. 
 
f 
 
 EDITOR’S PREFACE 
 
 Collegiate training for business administration is now so widely 
 attempted that the time has arrived when experiments should be 
 conducted looking toward the organization of the business curriculum 
 into a coherent whole. Training in scattered “business subjects” 
 was defensible enough in the earlier days of collegiate business training, 
 but such a method cannot be permanent. It must yield to a more 
 comprehensive organization. 
 
 There can be no doubt that many experiments will be conducted 
 looking toward this goal; they are, indeed, already under way. This 
 series, “Materials for the Study of Business,” marks one stage in such 
 an experiment in the School of Commerce and Administration of the 
 University of Chicago. 
 
 It is appropriate that the hypotheses on which this experiment is 
 being conducted be set forth. In general terms the reasoning back 
 of the experiment runs as follows: The business executive administers 
 his business under conditions imposed by his environment, both 
 physical and social. The student should accordingly have an under¬ 
 standing of the physical environment. This justifies attention to 
 the earth sciences. He should also have an understanding of the 
 social environment and must accordingly give attention to civics, law, 
 economics, social psychology, and other branches of the social sciences. 
 His knowledge of environment should not be too abstract in character. 
 It should be given practical content, and should be closely related to 
 his knowledge of the internal problems of management. This may be 
 accomplished through a range of courses dealing with business admin¬ 
 istration wherein the student may become acquainted with such mat¬ 
 ters as the measuring aids of control, the communicating aids of 
 control, organization policies and methods; the manager’s relation 
 to production, to labor, to finance, to technology, to risk-bearing, 
 to the market, to social control, etc. Business is, after all, a pecuni¬ 
 arily organized scheme of gratifying human wants, and, properly 
 understood, falls little short of being as broad, as inclusive, as life 
 itself in its motives, aspirations, and social obligations. It falls 
 little short of being as broad as all science in its technique. Training 
 
 Vll 
 
Vlll 
 
 EDITOR’S PREFACE 
 
 BASIC ELEMENTS OF THE BUSINESS CURRICULUM 
 
 Of problems of adjustment tc 
 physical environment 
 
 a) The earth sciences 
 
 b) The manager’s relationship 
 to these 
 
 Control 
 
 1. Communicating aids of control, 
 
 for example 
 
 a) English 
 
 b) Foreign language 
 
 2. Measuring aids of control, for 
 
 example 
 
 a) Mathematics 
 
 b) Statistics and accounting 
 
 3. Standards and practices of con¬ 
 
 trol 
 
 a ) Psychology 
 
 b) Organization policies and 
 methods 
 
 Of problems of technology 
 
 a) Physics through mechanics, 
 basic, and other sciences 
 as appropriate 
 
 b) The manager’s administra¬ 
 tion ol production 
 
 Of problems of finance 
 
 a) The financial organization 
 of society 
 
 b) The manager’s adminis¬ 
 tration of finance 
 
 Of problems connected with the 
 market 
 
 a) Market functions and mar¬ 
 ket structure 
 
 b) The manager’s administra¬ 
 tion of marketing (including 
 purchasing and traffic) 
 
 Of problems of risk and risk¬ 
 bearing 
 
 a) The risk aspects of modern 
 industrial society 
 
 b) The manager’s administra¬ 
 tion of risk-bearing 
 
 Of problems of personnel 
 
 a ) The position of the worker 
 in modern industrial society 
 
 b) The manager’s administra¬ 
 tion of personnel 
 
 Of problems of adjustment to 
 social environment 
 
 a) The historical background 
 
 b) The socio-economic insti¬ 
 tutional life 
 
 c) Business law and govern¬ 
 ment 
 
EDITOR’S PREFACE 
 
 IX 
 
 for the task of the business administrator must have breadth and 
 depth comparable with those of the task. 
 
 Stating the matter in another way, the modern business admin¬ 
 istrator is essentially a solver of business problems—problems of busi¬ 
 ness policy, of organization, and of operation. These problems, great 
 in number and broad in scope, divide themselves into certain type 
 groups, and in each type group there are certain classes of obstacles 
 to be overcome, as well as certain aids, or materials of solution. 
 
 If these problems are arranged (i) to show the significance of the 
 organizing and administrative, or control, activities of the modern 
 responsible manager, and (2) to indicate appropriate fields of train¬ 
 ing, the diagram on the opposite page (which disregards much over¬ 
 lapping and interacting) results. It sets forth the present hypothesis 
 of the School of Commerce and Administration concerning the basic 
 elements of the business curriculum, covering both secondary school 
 and collegiate work. 
 
 This present volume deals with the problems of risk and risk¬ 
 bearing. 
 
 L. C. Marshall 
 

 
 
 
 
 
 
 
 
 
 
 .. 
 
 
 * 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
AUTHOR’S PREFACE 
 
 This volume grows out of an effort on the part of the Faculty of 
 the School of Commerce and Administration of the University of Chi¬ 
 cago to reorganize its curriculum so as to make its courses correspond 
 to the functions performed in the process of providing present-day 
 civilized society with economic goods. In view of the extent to 
 which the book owes its existence to the need of a text to fill a gap 
 in the equipment available for carrying out such a plan, this may 
 be an appropriate place to indicate something of the nature of the 
 instruction scheme in which a course in risk and risk-bearing finds a 
 place. 
 
 In his Freshman year, a student regularly takes a sequence of 
 courses dealing with the whole field of economics and business adminis¬ 
 tration, the usual sequence being Industrial Society, Value and 
 Distribution, Business Administration. These courses are designed 
 to give him a view of the whole field with which his later studies have 
 to do, largely for the purpose of enabling him to approach the more 
 detailed courses with a better grasp of the relationship between the 
 things he is at the moment studying and the rest of the economic 
 order. The course in Industrial Society, in particular, concerns itself 
 with the interrelations of the various institutions which make up the 
 economic organization of society. 
 
 There follows during the Sophomore and Junior years a group of 
 intermediate courses which together cover the entire field in more 
 detail, each dealing with a specific social-economic function, the 
 institutions through which this function is performed, and the prob¬ 
 lems of administration which arise out of its performance. These 
 functions are six: production (in the technological sense), finance, 
 marketing, labor, risk-bearing, and social control. Courses dealing 
 with these functions, together with another group which deals with 
 the recording, facilitating, communicating, and computing aids to 
 business administration 1 make up the backbone of the curriculum, 
 and are required of all students, whereas advanced courses dealing 
 with specific problems in these fields (such as investment analysis, 
 
 * Including accounting, statistics, business communication. 
 
 xi 
 
Xll 
 
 AUTHOR’S PREFACE 
 
 foreign trade, bank management, trade unions) are required only 
 of students specializing in the given field. 
 
 Of the six functions referred to, risk-bearing is the most likely 
 to require explanation. As will be seen by an examination of the 
 Table of Contents of this volume, the course out of which it has grown 
 is made up of material much of which ha? traditionally been presented 
 in courses in the theory of distribution, money and banking, insurance, 
 investments, marketing, and speculation. To some, these elements 
 may perhaps seem incongruous, and it may even be suspected that the 
 principle of selection has been that of lumping together various odds 
 and ends crowded out of other courses. Such a procedure might 
 be justifiable. Indeed, from a practical point of view, one of the 
 direct gains from the organization of the course was that it made 
 possible the offering of what seems to the author an adequate amount 
 of work in life and fire insurance, speculation, and business forecasting 
 to meet the needs of the majority of students, without the necessity 
 of injecting into each subject for administrative reasons a sufficient 
 amount of material to fill out a conventional number of “student 
 hours” to constitute a course. 
 
 It is believed, however, that a course in “risk-bearing” has a 
 stronger justification than administrative convenience. The connect¬ 
 ing thread which runs through all the material is the influence of 
 uncertainty. Indeed, it might be clearer to designate the course as a 
 study of the influence of uncertainty on business affairs. Throughout 
 most of our academic work in business management, emphasis is 
 laid upon the importance of certainty. We are constantly reiterating 
 the fact that efficient management involves scientific investigation 
 to determine the important facts which bear upon our problems and 
 careful study to insure that our plans shall reflect the significance of 
 these facts. The author has no desire to minimize the force of this 
 teaching. Nevertheless, there are definite limits to the application of 
 scientific method in business. As is pointed out in detail in chapter 
 iii, it is the persistent element of uncertainty which makes necessary 
 the exercise of business judgment, and makes possible the reaping of 
 business profit. The principal topics of this course, business fore¬ 
 casting, investment and speculation, and insurance, serve well to 
 bring out the difference between the two fundamental bases for a 
 judgment of probability, on the one hand formulations of mathematical 
 probabilities based on careful statistical investigation, on the other 
 hand the comparison of data which are never sufficient to permit 
 
AUTHOR’S PREFACE 
 
 xm 
 
 an exact estimate of the chances of success or failure from a given 
 line of effort, yet do suffice to furnish a basis for an intelligent choice 
 of alternatives. 
 
 So widespread is the custom of including the bulk of the contents 
 of this course under the heading of “ finance, ” that a further comment 
 on the relation of finance to risk-bearing seems pertinent. It is quite 
 possible to define “finance” so broadly as to include under its sway 
 much of the domain here appropriated for “risk-bearing.” Indeed, 
 it is possible to bring almost any business problem into the “financial” 
 category, since the results of good or bad management almost invari¬ 
 ably, given time enough, take the form of financial advantage or 
 disadvantage. In the author’s judgment, however, clearness is gained 
 by restricting the application of the term “financial” to such phases 
 of business management as have to do with the acquisition of capital, 
 the control of funds, the repayment of loans, and similar questions; 
 in short, to the maintenance of an adequate supply of capital (including 
 both that borrowed on short-time instruments and that permanently 
 invested). To include in “finance,” as has been done by some 
 writers, such matters as the question whether to expand the scope of 
 one’s operations at the height of a boom, or the choice between two 
 price policies, involves an overemphasis on one set of factors which 
 must be considered in deciding such questions, and a neglect of the 
 factors of sales management, technological efficiency, and risk which 
 are more often effective in determining action than are any financial 
 considerations concerning the proposed program. 
 
 The section devoted to the business cycle illustrates the point 
 of view upon which the book is based. Traditionally this subject 
 has been assigned to the student of banking. Yet, whether we 
 approach the problem from the angle of business management, and 
 inquire what are the effects of the cycle on the administration of 
 finances, the management of labor, and the production and sales policy, 
 or whether we approach it from the angle of a student of economic 
 theory and inquire whether the causes of the cycle are found in 
 financial, market, or labor conditions, it is perfectly clear that the 
 cycle is not merely a financial phenomenon, but pervades every 
 aspect of our economic life. The common aspect of the problem 
 which the cycle imposes upon the treasurer, the personnel adminis¬ 
 trator, and the sales manager, is the element of uncertainty concerning 
 the decisions other men are making. It is in each case as a risk- 
 
XIV 
 
 AUTHOR’S PREFACE 
 
 bearer that the manager must reckon with the periodicity of the 
 phenomena with which he deals. The appropriate place for a survey 
 of the causes of the cycle and the methods of forecasting or controlling 
 it is in a course dealing with risk and risk-bearing; the appropriate 
 place for discussion of the details of adjustment of the labor, the 
 financial, and the sales policies to such forecasts, is in courses dealing 
 with those functions. 
 
 As is the case with other intermediate courses in the curriculum 
 described above, no attempt is made to cover the entire field in 
 exhaustive fashion. Rather it is intended to present simply the 
 amount of material which every professional student of business 
 can fairly be expected to include in a four year’s course, which must 
 include his general business training, his specialized training for his 
 particular line of endeavor, and whatever of literary and scientific 
 education not strictly vocational he may secure in addition. For 
 example, it is anticipated that students taking this course will elect 
 additional work in investment analysis if their major interest is in 
 finance; in insurance, if they expect to enter that field of employment; 
 in marine insurance, either separately or in connection with courses 
 in foreign trade, if they are looking to foreign commerce as a field of 
 life-work, and so on. 1 
 
 Although emphasis has been placed upon the way in which a course 
 in risk and risk-bearing dovetails into a curriculum organized upon a 
 functional basis, the attempt has been to organize the material in such 
 a way that it can be used effectively with students having a different 
 background. It is believed that the material can be presented 
 advantageously to students having no other preliminary training than 
 the customary introductory courses in economics. Colleges whose 
 offerings in economics and business are more limited in number than 
 is the case with the professional school of business may find a course 
 in risk an effective way of reducing the number of courses needed to 
 cover the fields touched upon, thereby making possible more extended 
 work in other fields. The first ten chapters may be used conveniently 
 as the introductory portion of an advanced course in investment 
 analysis. Business men will find little that is new in the discussion 
 
 1 Speculation is treated somewhat more fully than this general plan requires, 
 with a view to making advanced courses unnecessary, chiefly because of the small 
 number of students interested to take advanced courses in this f.eld and the pau¬ 
 city of material for use in such courses. 
 
AUTHOR’S PREFACE 
 
 xv 
 
 of their special fields of work, but may find value in the discussion of 
 the interrelations of the different topics presented. 
 
 My indebtedness to co-operating friends is very heavy. Dean 
 L. C. Marshall has incurred a burden of responsibility for the appear¬ 
 ance of a book dealing with this field, for its inception was due to his 
 suggestion, and his unflagging interest and faith in the project made 
 it possible for the material to be accumulated and subjected to the 
 test of the classroom in its earlier as well as its later stages of develop¬ 
 ment. He has also made innumerable suggestions of detail in connec¬ 
 tion with the form in which the material is presented. To Professor 
 F. H. Knight, my colleague in two universities, my debt is also 
 unusually great, both for access to preliminary drafts of his book, 
 Risk, Uncertainty, and Profit, during the period when my own ideas 
 on the subject were first taking definite shape, and for innumerable 
 helpful suggestions and clarifying criticisms. Professor Leverett S. 
 Lyon has collaborated in the preparation of chapter xii, and has 
 contributed much to the development of my view on many questions 
 of theory. Professor A. S. Keister and Messrs. S. P. Meech and 
 L. W. Mints have used preliminary mimeographed editions as text 
 material, and have given me the benefit of their criticisms. Professors 
 R. W. Stone and C. W. Wassam and Messrs. W. E. Atkins and H. C. 
 Simons have read portions of the manuscript, and I have profited 
 much by their suggestions. Grateful acknowledgment is made of the 
 hearty co-operation of authors and publishers in connection with my 
 requests for permission to use extended quotations. Mr. John E. Part¬ 
 ington has rendered efficient aid in the preparation of the index. 
 
 C. O. Hardy 
 
 Iowa City 
 April 14, 1923 
 

 
 
 
 
 
 
 
 
 
 : I 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
TABLE OF CONTENTS 
 
 PAGE 
 
 CHAPTER 
 
 I. Forms and Extent of Business Risk .i 
 
 Universality of Risk. Sources. Risk in Production and in 
 Marketing 
 
 II. Ways of Dealing with Risk: Elimination of the Risk . io 
 
 Methods of Dealing with Risk. Prevention Research. 
 Market Analysis. Time and Motion Study. Co-operation. 
 Specialization. Combination of Risks. Reserves. Mathe¬ 
 matics of Probability 
 
 III. Ways of Dealing with Risk: Transfer to Others; As¬ 
 sumption of Risk.32 
 
 Specialization in Risk-Bearing. The Owner-Manager. Profit. 
 
 Risk and Control. The Choice of Administrators. Business 
 Judgment 
 
 IV. Ways of Dealing with Risk: Transfer to Specialists— 
 
 Continued .56 
 
 Insurance. Hedging. Contracting Out 
 
 V. Uncertainty and the Business Cycle .63 
 
 Phases of the Cycle. Causes. Uncertainty in Producers’ 
 Calculations. Uncertainty in Buyers’ Calculations. The 
 Cycle in Production of Basic Capital. In Agricultural 
 Production 
 
 VI. Business Forecasting.. . .84 
 
 Methods. Interpretation of Prices. Index Numbers. Cor¬ 
 poration Reports. Steel and Iron. Agricultural Produc¬ 
 tion. Banking Conditions and Interest Rates. Composite 
 Barometers 
 
 VII. Risk and the Management of Capitai.116 
 
 Ways of Investing. Investment in One’s Own Business. 
 
 In Repayment of Debts. Deposits with Financial Institu¬ 
 tions. Security Investments. Personal Loans. Specula¬ 
 tion. Gambling 
 
 xvii 
 
XV111 
 
 TABLE OF CONTENTS 
 
 PAGE 
 
 VIII. The Security Markets. 128 
 
 The Market for Old Securities. The New York Stock 
 Exchange. Functions. Trading Methods. Relations of 
 Brokers with Customers. Deliveries. Information. Con¬ 
 trol of the Exchange. Classes of Members. Short Selling. 
 
 Wire Houses. Other Stock Exchanges. Trading Outside the 
 Exchanges. The Market for New Securities. Investment 
 Banks. Marketing Low Grade Securities 
 
 IX. Stock Speculation as Business Enterprise , . .157 
 
 Traders’ Technique. Market Maxims. The Technical 
 Position. Trading on the News. Manipulation. Proba¬ 
 bilities of Success. Speculation for the Long Swing 
 
 X. The Analysis of Securities. 181 
 
 The Factors in Security Analysis. Tax Exemptions. Mar¬ 
 ketability. Legality. United States Government Obliga¬ 
 tions. Foreign Government Bonds. Industrial Securities. 
 Analysis of the Industry. Financial Statements. The 
 Balance Sheet. The Income Statement. Policy and Per¬ 
 sonnel. Railway and Public Utility Securities. Diversifica¬ 
 tion ‘ 
 
 XI. Speculation in Commodities. 205 
 
 Organized and Unorganized Markets. Futures Contracts. 
 Futures Markets. Delivery. Direct Settlement. Ringing 
 Out. Transfer. Speculators’ Methods. Land Speculation 
 
 XII. Hedging , . 223 
 
 Advantages of Hedging. Degree of Protection Afforded. 
 
 A Supposititious Case. A Modification of the Assumptions. 
 Relation of Spot Prices to Futures Prices. The Normal 
 Spread. Conclusions 
 
 XIII. Life Insurance. 237 
 
 Insurance as a Hedge. The Risk Insured. Policy Contracts. 
 Company Organization. Selection of Risks. Calculation of 
 Premiums. The Net Premium. Loading. Disbursement of 
 Funds. Expenses. Methods of Settlement. Surrender 
 Values. Policy Loans. Group Insurance. Fraternal In¬ 
 surance. Life Annuities. Disability Clauses. War Risk 
 Insurance 
 
TABLE OF CONTENTS 
 
 xix 
 
 PAGE 
 
 XIV. Fire Insurance.288 
 
 The Risk Insured. Policy Contracts. The New York 
 Standard Policy. Mortgage Clause. Coinsurance. Three- 
 quarter Value and Three-quarter Loss Clauses. Use and 
 Occupancy Insurance. Company Organization Stock. 
 Mutual. Lloyd’s. Reciprocal. Rate Making. Public 
 Control 
 
 XV. Miscellaneous Property Insurance .320 
 
 Marine Insurance. Tornado. Automobile. Crop. Credit. 
 Miscellaneous Lines 
 
 XVI. Guaranty and Suretyship .327 
 
 Suretyship Compared with Insurance. Corporate Surety¬ 
 ship. Advantages. Types of Protection. Insurance of 
 Real Estate Titles. Bonded Abstracters. Title Guaranty. 
 Torrens System 
 
 XVII. Risks of Labor .336 
 
 Types of Risk Carried by Labor. Unemployment. Sources. 
 
 Cost. Ways of Dealing with Unemployment. Risk of 
 Accident and Occupational Disease. Employers’ Liability. 
 Workmen’s Compensation. Benefits. Compensation Insur¬ 
 ance 
 
 XVIII. Social Aspects of Risk-Bearing .355 
 
 Profit Taking. Social Interference with Monopoly Profits. 
 
 Dangers in Limiting Profits. A Fair Return. Profiteering. 
 
 Risk and Control. Ethics of Gambling. Ethics of In- 
 
 « 
 
 surance. Ethics of Speculation. Risk-Bearing and the 
 Social Order. Risks of Modern Industry Compared with 
 Medieval. Risk under Socialism 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER I 
 
 4 
 
 FORMS AND EXTENT OF BUSINESS RISK 
 
 Risk may be defined as uncertainty in regard to cost, loss, or 
 damage. In this definition, emphasis is on the word uncertainty. 
 Where destruction or loss of capital is certain in connection with a 
 business process, it can be charged up in advance as a cost. It is not 
 a risk. When the destruction or loss is uncertain, it may be dealt with 
 in accordance with judgments of probability, and presents a problem 
 in risk. In this chapter our task is to make a preliminary survey of 
 the forms and extent of risk involved in present-day economic life. 
 
 It is a common statement that risk is universal. As one author 
 puts it: 
 
 The owner of wealth must, if he is rational, invest it in some productive 
 enterprise, unless, under the circumstances, he decides to consume it; and, 
 wherever it is invested, there will be some risk that part of it will be lost 
 by the dishonesty of others, the deterioration in value of the property in 
 which it is embodied, or in change of value of the standard of deferred 
 payment. If he thinks to escape by hoarding it in the shape of specie, 
 robbery is to be feared, to say nothing of the opportunities of gain'which 
 are given up. If he decides to consume the wealth at once, he runs the risk of 
 coming to poverty . 1 
 
 Or, in Professor Fisher’s words: 
 
 If we take the history of the prices of stocks and bonds, we shall find it 
 chiefly to consist of a record of changing estimates of futurity, due to what 
 is called chance, rather than of a record of the foreknown approach and 
 detachment of income. Few, if any, future events are entirely free from 
 uncertainty. In fact, property, by its very definition, is simply the right to 
 the chance of future services. A mine owner takes his chances as to what 
 the mine will yield; the owner of an orange plantation in Florida takes 
 risks of winter frosts; the owner of a farm takes risks as to the effect of 
 sun and rain and other meteorological conditions, as well as risks of ravages 
 of fire, insects, and other pests. In buying an overcoat a man takes some 
 risk as to its effectiveness in excluding cold, and as to the length of time it 
 will continue to be serviceable . 2 
 
 1 John Haynes, “Risk as an Economic Factor,” Quarterly Journal of Economics , 
 IX, 410. 
 
 2 Irving Fisher, Nature of Capital and Income , pp. 265-66. 
 
2 
 
 RISK AND RISK-BEARING 
 
 Statements such as these, though strictly accurate, are, neverthe¬ 
 less, apt to give a false impression of the extent, or rather of the 
 importance, of the unknown element in human calculations. All these 
 manifold risks do exist, but most of them are of no practical conse¬ 
 quence. The only risks which need be given consideration in a 
 business decision, or for that matter in any other decision, are the 
 cases where the property interest, or other interest, at stake on the 
 outcome of a single uncertainty is large relative to the total of which 
 it is a part. For example, the risk of windows being broken by small 
 boys is a real risk for owners of expensive plate glass windows but is 
 of no practical significance to owners of an equally large amount of 
 capital in the form of many small windows. 1 Risk in any practical 
 sense is not present in all our calculations. 
 
 Uncertainties of practical importance to the business manager may 
 conveniently be classified in accordance with their origin, as follows: 
 
 1. Risks of destruction of property through the physical hazards of 
 nature: storm, flood, fire, etc. These are among the most serious 
 hazards in many lines of business, notably in live stock raising and 
 in transportation. Most of the losses caused by hail, flood, and storm 
 would be avoided if we knew in advance what conditions to expect. 
 They are part of the cost of our ignorance. To measure the total 
 cost, however, we must add to the actual losses the cost of precautions 
 taken against disasters which never occurred, and the loss of produc¬ 
 tion on account of the existence of these risks. 
 
 The magnitude of these losses reflects primarily the extremely 
 rudimentary development of our science of weather forecasting. 
 The extreme range of our ability to forecast deviations of weather 
 from its past average is less than a week, and tolerably accurate 
 forecasts can be made only twenty-four to forty-eight hours in advance. 
 Even this limited range of forecasting, however, has tremendously 
 reduced the volume of losses from weather conditions. 
 
 2. Closely related to the preceding are uncertainties in the productive 
 process. —In spite of the immense advance in applied science in the 
 past 150 years, there still remain numerous points where commitment 
 of capital is based on uncertainties. Strength of materials is one such 
 
 1 Of course in the illustration given the coincidental breaking of all the small 
 windows is a theoretical possibility, and, if it occurred, would be quite as serious 
 as the breaking of the one large one. The point is that such coincidences are so 
 extremely rare that their possibility may be disregarded entirely. The justifica¬ 
 tion for this treatment of infinitesimal risks is developed more fully in chap, ii, 
 note 1. 
 
FORMS AND EXTENT OF BUSINESS RISK 
 
 3 
 
 weak point in our applied science, particularly in the case of materials 
 which have suffered depreciation in use. The effectiveness of labor is 
 another point at which advance estimate and final result are apt to 
 vary, and variations of weather make agricultural production notori¬ 
 ously speculative. 
 
 3. Social hazards include the risks due to deviations of individual 
 conduct from what is expected , such as robbery, defalcation, and forgery, 
 and also risks due to the impossibility of predicting the behavior of 
 social groups. Strikes, riots, wars, tariff changes, tax reforms, pro¬ 
 hibitory laws illustrate the range of these risks. 
 
 4. Risks due to individual ignorance cause many losses and make 
 possible many profits .—In a sense all risks are due to ignorance, for 
 if all the conditions of any situation were known there would be no 
 risk involved in it for anyone. There is, however, a distinction worth 
 maintaining between risks due to the limitations of human knowledge 
 and risks which are due to the failure or inability of individuals to take 
 advantage of the knowledge which is accessible to themselves or to 
 those with whom they come into competition. It is risk of this 
 character which keeps down the competition to seize favorable busi¬ 
 ness openings and makes it possible for persons of superior knowledge 
 and skill to profit by their superiority. Potential competitors are 
 kept out of the field by their ignorance of its existence or its extent, 
 and many who do enter are unable to compete effectively. 
 
 5. Market risks form the most important group of all .—By market 
 risks we mean the unavoidable uncertainties due to the fact that time 
 elapses between the purchase and the sale of commodities, during 
 which time unpredictable changes often occur in the prices and other 
 market conditions surrounding the commodities dealt in. Rarely is 
 it possible to conclude both the buying and the selling part of a 
 given transaction simultaneously, so as to relieve the business man 
 of risk, and even when it can be done there is risk that he will be held 
 to one contract and be unable to enforce the other. 
 
 The extent to which the time element makes business risky has 
 been indicated by President Hadley: 
 
 Down to the present century, a large part of the speculative profits were 
 made by taking advantage of differences of price in different places—chiefly 
 in connection with foreign trade. The means of communication and trans¬ 
 port were so defective that there was often a great scarcity of an article in 
 one region and an abundance of the same article in another. The shipowners 
 who moved the article from the latter place to the former had a chance of 
 
4 
 
 RISK AND RISK-BEARING 
 
 enormous profits. But the business was also attended by great risk. 
 Transportation was far less safe, either from the elements or from human 
 violence, than it is today. There was no telegraph, no good postal service, 
 no efficient protection from pirates by sea or highway robbers by land. 
 All these causes combined to render the arrival of goods so uncertain that 
 the very wages of the seamen were made contingent upon the safe delivery 
 of the cargo, and the whole body of sailors thus became participants in the 
 speculation. 
 
 The nineteenth century has witnessed a change in these respects. 
 Improved means of communication have greatly lessened the differences in 
 price in different markets. It is no longer possible to have a glut of wheat 
 in Chicago and a scarcity in Liverpool. The modem post-office and the 
 telegraph furnish prompt information of what is going on all over the 
 world and enable merchants to know where goods are most needed. The 
 steamship and the railroad furnish a quick and safe means of placing the 
 goods where they will meet such needs as may arise. The difference of 
 price of any staple article in two large wholesale markets will not generally 
 be much greater than the cost of transportation from one to the other. 
 So moderate have the profits from this source become that the business of 
 those who try to secure them is now known as arbitrage rather than specula¬ 
 tion. Only in the trade with barbarous or half-civilized races does foreign 
 commerce retain its character as an extra-hazardous business. 
 
 The speculator of today makes his money chiefly by taking advantage 
 of differences of price between different limes rather than between different 
 markets. It is not so much the difference in the price of wheat in Chicago 
 and in Liverpool which furnishes the source of his profits, as the difference 
 between its price in Chicago this month and next month. When such 
 speculation anticipates an actual demand, it is of great service to the com¬ 
 munity. The long time which elapses between production and consump¬ 
 tion, between contracts and their fulfilment, makes it extremely important 
 to have responsible men to anticipate the wants of the market and take the 
 risks on their own shoulders. 1 
 
 It will be noted that from the standpoint of risk it makes no 
 difference whether the buying or the selling occurs first. In many 
 cases the business man contracts to deliver a certain commodity at a 
 given price, then purchases the things he needs to fulfil his contract. 
 The sale of a newspaper subscription, a building contract, the collec¬ 
 tion of university tuition, are all transactions of this character. More 
 frequent are the transactions where something is bought first with the 
 idea of selling it, or some product into which it enters, at a profit. 
 
 ‘Adapted by permission from A. T. Hadley, Economics, pp. 104-5. (G. P. 
 
 Putnam’s Sons, 1899.) 
 
FORMS AND EXTENT OF BUSINESS RISK 
 
 5 
 
 Sometimes both elements are present in the same transaction, as when 
 a tailor first buys cloth, then after taking an order for a suit, buys the 
 labor to make it up. In all transactions of either of these types, and 
 it must be repeated that practically all business is of one type or the 
 other, the longer the time involved in the fulfilment of obligations 
 entered into, or in the disposal of commodities bought, the greater 
 the risk of adverse changes, either in price or in other market condi¬ 
 tions. Declines in price of one’s product occurring after capital has 
 been sunk in plant and inventory have probably ruined more businesses 
 than any other single group of causes. Increases in cost of materials 
 and labor after contracting to sell one’s product are sometimes equally 
 disruptive. Such changes in prices may be due to decline of demand 
 arising from a change of consumers’ tastes—the collapse of the Ameri¬ 
 can Bicycle Company is a good illustration; or to appearance of a 
 more efficient method of production, as in the supplanting of hand 
 weaving by factory processes; or to the appearance of a rival com¬ 
 modity which renders a superior service, as when the tungsten filament 
 supplanted the carbon for electric lighting purposes; or to changes 
 in the general level of prices, as is illustrated by the decline of gold¬ 
 mining during recent years of advancing prices. 
 
 Of course the conditions which give rise to the chance of adverse 
 changes also bring the chance of favorable changes. When the 
 probability of such unpredictable changes, one way or the other, is 
 considerable, and business is entered into with a view to profiting by 
 a preponderance of favorable changes, the business is said to be of a 
 speculative character. If the capital invested is highly specialized, 
 the speculative element is increased because of the impossibility of 
 recovering the investment if things go wrong with it. Real estate, 
 grain, cotton, fresh fruit and vegetables, sugar, live cattle and hogs, 
 horses are dealt in largely as speculative commodities, though in 
 marketing many of these commodities it is feasible to reduce the 
 speculative element in business by “hedging.” (See chap, xii.) 
 
 In most lines of business profit does not depend upon favorable 
 changes in the market, and the owner-manager would gladly give 
 up his chance of profit from fluctuations of the market for the sake 
 of freedom from its risks. The fluctuations, like the physical hazards 
 referred to above, are a disturbing element, and though they may 
 give rise to as many gains as losses, the necessity of taking precautions 
 against them involves a cost which is a dead loss to the group as a 
 whole. In strictly speculative lines, on the other hand, the fluctua- 
 
6 
 
 RISK AND RISK-BEARING 
 
 lions are the chifef source of profit, though here also they may give 
 rise to as many losses as gains. 
 
 In relatively few cases does a highly speculative business derive 
 its character from uncertainties in the productive process. Mining 
 and oil-drilling furnish the best examples of this sort of risk. The 
 development of inventions is highly speculative, partly because of 
 market considerations and partly from uncertainties connected with 
 production. 
 
 The following comparison of the uncertainties involved in produc¬ 
 tion and in marketing brings out other reasons for the emphasis which 
 has been laid on the market as a source of risk: 
 
 In the field of production, of course, the body of knowledge is on the 
 whole better organized and more precise. The various systems of manage¬ 
 ment relate more to production than to marketing. 
 
 Though a vast field for research, marketing has had comparatively 
 little scientific study. It has not seemed particularly susceptible to scientific 
 study. It abounds in the human equation. This does not mean that much 
 ability has not been expended on this field not only in studying and inciting 
 demand but also in recording performance. Map and tack systems, quotas 
 and bonuses, selling costs and carefully prepared statistics of various kinds 
 have for a considerable period been employed by the most progressive selling 
 organizations. These internal statistics have also been accompanied by 
 external statistics affecting and reflecting market conditions. But in the 
 last analysis, the figures finally used in marketing, however obtained, are 
 based on the law of averages, frequency, or proportion; the standards set, 
 no matter how carefully and specifically adjusted, are in the last analysis 
 averages, modes, or proportions and apply en masse rather than in detail. 
 This does not mean that these data are not regarded as exceedingly valuable. 
 Nevertheless a great problem in marketing is to get down beneath the law 
 of averages and types. 
 
 Production is so much more specialized and standardized, so much 
 more precise than marketing, that it is possible, given certain facts of 
 material, dimension, and design, to set a maximum time for the performance 
 of a certain specific operation. The appliers of scientific management have, 
 furthermore, shown the possibility of determining a minimum time for this 
 operation with conditions continuing the same and of prescribing the means 
 whereby this minimum time need not be exceeded. In other words, the 
 scientific manager in production cannot only tell William Jones how long 
 he should be in machining a certain part, but can furnish him with the best 
 feeds and speeds to employ in doing the work in the time specified, and if 
 the methods and time apply in Philadelphia it is presumed that they will 
 also apply in Boston. But in marketing, no manager, no matter how able 
 
FORMS AND EXTENT OF BUSINESS RISK 
 
 7 
 
 and experienced, would attempt to tell Thomas Smith how long he should 
 be in selling a pair of shoes to William Jones, nor to give more than general 
 instructions as to the best way in which to do the selling. About the best 
 this manager has been able to do is to say that in a week, on the average 
 and according to the season, Thomas Smith should sell so many dollars’ 
 worth of shoes. In machining the part, the conditions are more stand¬ 
 ardized, the operation more specialized, the human factor is smaller and is 
 more under control. In selling the shoes, the opposite is true. In produc¬ 
 tion, the time for an operation can be measured by minutes and less; in 
 marketing, I have encountered no practical use being made of units of less 
 than one week. 
 
 This warrants the consideration for a moment of certain fundamental 
 differences between production and marketing. These differences may be 
 balanced against each other as follows. In production, men meet only as 
 members of the business—as subordinates, peers, or superiors. Neither 
 the customer nor the competitor is encountered directly. In marketing, 
 on the other hand, men are in contact not only with the other members 
 of the business, but also with the customer to serve and the comnetitor to 
 meet. In production, the problems are likely to be more those of cost— 
 material, labor, and overhead. In marketing, the attention is more focused 
 on price. Knowledge of cost is not particularly essential. The market is 
 fixing values outside of the business’ control. Emphasis is also likely to 
 be laid on quality and service. In production, the problems on the whole 
 are internal. In marketing, the problems on the whole are external. Com¬ 
 petition is on every hand. The market is to be analyzed. In production, 
 there is probably for the individual business a possibility of greater inde¬ 
 pendence of action. Marketing is probably more hedged about by the 
 customs of the trade. In other words, as said before, marketing abounds 
 in the human equation. 1 
 
 The last sentence in the preceding selection touches one of the 
 fundamental and irremovable elements of uncertainty in the business 
 man’s problem. “Business touches the human equation.” That is, 
 the decision of a business problem depends on a judgment as to what 
 certain individuals will do under given, or partially given, circum¬ 
 stances. This is always fraught with uncertainty, if for no other 
 reason because if A’s decision depends on what B will do, and B’s 
 decision on what A will do, ; t is obviously impossible for both to get 
 all the data they need. The only way in which one can arrive, even 
 in theory, at a scientific solution is through a rigid exclusion of free 
 
 1 Adapted by permission from S. O. Martin, “Scientific Study of Marketing,” 
 in Annals of the American Academy of Political and Social Science , LIX (1915), 
 78-80. 
 
8 
 
 RISK AND RISK-BEARING 
 
 choice from his interpretation of human conduct; but on such an 
 interpretation the business manager himself would have no interest 
 in the result of his analysis anyway, as his own action would be 
 determined outside his own choice. 
 
 Moreover, quite apart from the theoretical impossibility of arriv¬ 
 ing at a scientific judgment in matters of human conduct, the business 
 manager runs quickly into serious practical difficulties. Time and 
 cost set limits to the extent of his researches. No more than a general 
 in the field can he wait till all the relevant facts have been gathered, 
 nor can he afford to spend in their collection an amount greater than 
 they will add to his profits. Even these limits he cannot definitely 
 know. How much time, how much money it is worth while to spend 
 in trying to complete the data on which to base a given decision, 
 depends on facts which frequently cannot be known till the investiga¬ 
 tion is complete and the decision has been made. 
 
 In other words, the choice between two business policies or lines 
 of action is in most cases not comparable to the solution of an algebraic 
 equation, a type of problem where two trained minds may be expected 
 to arrive invariably at the same conclusion. Sometimes it is rather 
 like the translation of an inscription on a defaced monument where 
 some of the words can be deciphered with ease, some can be made 
 out with the aid of photography, and some can only be conjectured. 
 Sometimes it is like a question of ethnography, where the expense of 
 collecting data concerning an uncivilized race may make it necessary 
 to depend on the unconfirmed accounts of a few travelers. Sometimes 
 it is like the decision of a general in the field, where action must be 
 taken at once, without waiting for the much desired information to 
 arrive. 
 
 The conclusion is not, however, that since we cannot know all we 
 would like to know we cannot conduct ourselves rationally. If time 
 or cost prevents our reaching a valid final judgment, there still remain 
 several ways of meeting the situation. To these we will give atten¬ 
 tion in chapter ii. 
 
 QUESTIONS 
 
 1. “The grower, the manufacturer, and the merchant must speculate.” 
 Why? 
 
 2. Are risks greater in a changing condition of industry? in a market of 
 greater time area ? 
 
 3. Commercial speculation may concern itself either with the time area or 
 the space area of the market. Explain. 
 
FORMS AND EXTENT OF BUSINESS RISK 
 
 9 
 
 4. How does the “roundaboutness” of modern industry affect risks? 
 
 5. Explain how the presence of highly specialized capital goods in modern 
 industry accentuates risk. 
 
 6. Does expanding education have any tendency to increase risk ? 
 
 7. How has the development of improved transportation and commu¬ 
 nication affected risk ? 
 
 8. Do you gather that risks are increasing? Is there any answer to this 
 question? Suppose they are increasing; is society worse off? 
 
 9. “Business touches the human equation.” Explain. 
 
 10. Try to outline what would be involved in a complete elimination of 
 significant risk in our business life. 
 
CHAPTER II 
 
 WAYS OF DEALING WITH RISK: ELIMINATION 
 
 OF THE RISK 
 
 It is clear enough that there is no escape, present or future, from 
 the presence of uncertainty in the administration of business, and that 
 we must accordingly deal with risk. The elimination of the risk 
 requires the elimination, not of the loss or damage itself, but of the 
 uncertainty concerning its time or place or extent. Usually this 
 involves the substitution for the uncertain loss of a smaller but certain 
 loss in one form or another. This cost, for instance, may consist of 
 the price of a safety device, which may never be used or needed but 
 if it is needed, may save many times its cost—it may be an insurance 
 premium, or it may be the cost of an investigation to remove the 
 uncertainty. 
 
 Methods of dealing with risk may be analyzed into the following 
 types: 
 
 A. Elimination of risk by: 
 
 1. Prevention of the harmful events 
 
 2. Forecasting, or research to remove the uncertainty 
 
 3. Combination of risks 
 
 4. Accumulation of reserves to provide for meeting the risks 
 
 5. “Compensation,” or offsetting of risks 
 
 B. Assumption of Risk 
 
 1. By owner-managers 
 
 2. By investors and speculators 
 
 3. By laborers 
 
 C. Transfer of risks to others 
 
 1. Transfer to entrepreneurs, from 
 
 (a) Laborers, through the wage system 
 
 ( b ) Capitalists, through the interest system 
 
 2. Contracting out 
 
 3. Hedging 
 
 4. Insurance 
 
 5. Guaranty, suretyship, underwriting, etc. 
 
 10 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 II 
 
 The present chapter deals with the various methods of eliminating 
 risk. 
 
 1. The prevention of harmful events is an ancient and universal 
 method of reducing risk .—No very detailed discussion of this method 
 of dealing with risk is necessary. Umbrellas, lightning rods, fireproof 
 walls, and burglar alarms furnish everyday illustrations. Science and 
 invention are constantly improving our technique for the removal of 
 risk by prevention of harmful events, sometimes by the development 
 of new methods, oftener by what is quite as important, the reduction 
 of the cost of old methods. 
 
 2. Reduction of risk by research has greatly increased in impor¬ 
 tance .—As civilization advances the relative importance of science 
 grows. On the one hand, the mass of accumulated information and 
 experience requires more study and more specialization for its mastery; 
 on the other hand, the complexity of the problems to be handled, the 
 magnitude of the enterprises to be controlled, make such mastery 
 ever more necessary. Just as in the latter part of the Middle Ages the 
 trained lawyer gained control of the administration of justice, and a 
 little later the physician wrested physic from the barber, so in the 
 nineteenth and twentieth centuries the construction engineer sup¬ 
 plants or directs the rule-of-thumb contractor, the works engineer 
 who grew up in the plant gives way to the engineer with technical 
 training, the trained nurse ousts the “practical nurse.” The increas¬ 
 ing importance of science in business is merely one illustration of 
 its increasing importance in all human affairs. 
 
 The same factors which have brought about the development of 
 scientific method in other fields have been operative in the field of 
 business management, and here as in other fields the recognition of 
 the value of exact knowledge and intelligent planning, though recent, 
 has been very rapid. Whether the problem in hand is that of choos¬ 
 ing a location, promoting an official, canceling a purchase order, refund¬ 
 ing a bond, or writing an advertisement, the business manager has a 
 choice of the two methods of procedure—snap judgment based on 
 tradition, personal experience, haphazard information, and the cir¬ 
 cumstances of the moment, or careful judgment based on investiga¬ 
 tion of all the available data. So far as may be, he should rely upon 
 the latter. One of the principal functions of formal education for 
 business, indeed, is to indicate the value in business of modern methods 
 of scientific analysis in such varied forms as the development of com¬ 
 mercial research for the management of the market; of psychological 
 
12 
 
 RISK AND RISK-BEARING 
 
 and social investigation as a guide in the administration of personnel 
 problems; of time study, laboratory analysis, and other technical 
 methods of attack on the technical problems of production; of cost 
 accounting as a guide in directing business policies. 
 
 The following selections describe certain aspects of the trend of 
 business in recent years toward more exact scientific methods: 
 
 MARKET ANALYSIS 1 
 
 In order to determine to what particular class of customers his sales 
 campaign should be directed, a manufacturer finds it necessary to study 
 his market carefully under present conditions of keen competition. Blun¬ 
 derbuss methods are wasteful; hence they are becoming antiquated. The 
 demand for any article varies according to purchasing-power, living condi¬ 
 tions, occupations, racial characteristics, climatic conditions, and numerous 
 other influences affecting the different classes of consumers. The object of 
 market analysis is to determine which class or classes of consumers con¬ 
 stitute the potential market for the product, to ascertain where that class 
 is located, and to find out what channels of distribution are most readily 
 available for reaching them. 
 
 There are few, if any, commodities for which equal per capita sales 
 may be expected in all sections of the market, provided the market is more 
 than local in its scope. In each district there are numerous classes of 
 consumers with widely different tastes and desires, and the relative pro¬ 
 portions of these classes in different districts always vary. In New York 
 City, for example, the population of the metropolitan district in 1910 was 
 6,475,000. In the same year the population of the Cleveland metropolitan 
 district was 613,000. From these figures it cannot be assumed that the 
 New York market for any particular article is potentially ten times as 
 great as that of Cleveland. New York represents the extremes of wealth 
 and poverty. Fifth Avenue and the Lower East Side are at opposite ends 
 of the economic scale. Their wants and their purchasing power are wholly 
 unlike and each differs from the large middle-class strata. In Cleveland 
 the relative proportions of these several classes, with their numerous grada¬ 
 tions of purchasing power and of wants, are not the same as in New York. 
 The population of Cleveland, furthermore, differs in its composite parts from 
 that of Cincinnati or other cities, and these differences in the make-up of 
 the population affect potential demand. Another line of demarcation is 
 between urban and rural districts. Because of these diversities a reliable 
 estimate of potential demand can seldom be made upon a gross per capita 
 basis. 
 
 In analyzing the market for some products, conditions other than those 
 of a strictly personal nature must be taken into account. A manufacturer 
 
 1 Adapted by permission from M. T. Copeland, Business Statistics , pp. 178-83. 
 (Harvard University Press.) 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 13 
 
 of electric flat-irons, for example, in analyzing his market found that in 
 one city of 300,000 population 25,000 families were supplied with central 
 station electric current. Thus there were 25,000 possible customers in 
 that city. In another city of approximately the same size only 3,000 families 
 were supplied with electric current; hence the potential market in this 
 second city was much smaller. 
 
 For some products the market is clearly denned; in such cases the 
 market is easily analyzed by the manufacturer. The manufacturer of 
 machine tools, for example, knows that his product can be sold only to 
 machine shops and engineering works and his task is to learn all the establish¬ 
 ments existing and planned for in the territory that he wishes to cover with 
 his sales organization. A similar situation confronts other producers of 
 equipment and materials that are sold to manufacturers. Certain manu¬ 
 facturers of specialties sold to other classes of customers can encompass 
 their market in a list that does not assume excessive proportions; a manu¬ 
 facturer of surgical appliances, for example, can readily obtain and utilize 
 a practically complete list of possible customers. For the great mass of 
 goods sold at retail, however, and for general supplies sold to manufacturers, 
 the market is of a different type and potential demand is much less easily 
 estimated. 
 
 In undertaking an analysis of the market for an article which is sold 
 over a wide territory and for which a market index can be selected only 
 with difficulty, too much attention may be given to wealth statistics, which 
 are assumed to indicate incomes received by consumers. Wealth statistics, 
 as a rule, have little significance in market analysis. In the first place, 
 there are no reliable wealth statistics, and, in the second place, even if 
 such statistics were available, they would give slight clue to the probable 
 demand for any particular article. Wealth statistics are published, to be 
 sure, by the United States government, but they are rough approximations. 
 
 Wealth statistics are commonly reduced to a per capita basis, but a 
 per capita wealth figure is of little worth for any purpose, for it does not 
 show the distribution of the wealth. It makes a vast difference to manu¬ 
 facturers looking for prospective markets whether the wealth in any district 
 is fairly evenly distributed among the consumers or concentrated largely 
 in the hands of a few very rich persons; the quantity of any commodity 
 purchased by an individual consumer seldom varies in direct proportion to 
 his wealth or income^ 
 
 Finally, even if the wealth figures were available in such form that they 
 could be relied upon and the distribution of the wealth among the popula¬ 
 tion ascertained, the figures would not accurately indicate market potentiali¬ 
 ties. Not only are wealth statistics inadequate indices of incomes, but 
 different classes of people engaged in different occupations and living under 
 different conditions do not expend their incomes in the same way, even if 
 those incomes are approximately equal. 
 
14 
 
 RISK AND RISK-BEARING 
 
 Average wages are another set of statistics occasionally referred to as 
 furnishing an index of potential demand. The United States Bureau of 
 the Census publishes average wage statistics, and similar figures may be 
 obtained from other sources. An average wage, however, for all the persons 
 engaged in manufacturing in Massachusetts, for example, includes the 
 wages of numerous highly skilled workmen and also the wages of unskilled 
 men, women, and children. The average is not representative and does 
 not indicate that Massachusetts is necessarily a poorer potential market 
 for any manufacturer than some other states where the average wages may 
 be higher. 
 
 Per capita consumption figures for large groups of commodities, such 
 as clothing or foodstuffs, are finding their way into some advertising pub¬ 
 lications, as affording a guide to potential markets. The only per capita 
 consumption figures which are worthy of consideration are those for such 
 articles as coffee or sugar, where fairly accurate records of importation and 
 domestic production are maintained. The census figures for the value of 
 the product of the various manufacturing industries are too inaccurate, in 
 the form in which they are presented, to be acceptable as a basis for estimates 
 of per capita consumption, and there is too great uncertainty as to the 
 amounts added to the manufacturers’ selling prices in the course of the 
 marketing processes to warrant placing any reliance upon estimates of 
 total retail selling value or total amounts paid by consumers for these 
 products. These per capita consumption figures, moreover, are gross 
 figures including many grades and qualities, some of which are virtually 
 non-competing. Such statistics are of little aid in making a careful market 
 analysis. 
 
 Instead of attempting to use statistics for wealth, income, or per capita 
 consumption, the first task in undertaking a statistical analysis of a market 
 is properly to determine just what class or classes of consumers constitute 
 the potential market and, if there are varying degrees of demand, what 
 demand may be expected from each class. For this, personal investigation 
 or inquiry may be necessary. The next step is to ascertain the number 
 of consumers of each class in each sales district. From these two sets of 
 statistics the total potential demand for each district under normal condi¬ 
 tions can be estimated. 
 
 These figures for estimated potential demand, when compared with past 
 sales records, show in which districts the best opportunities exist for sales 
 development and serve as a basis for establishing quotas for salesmen. 
 Ordinarily the comparison of sales records with estimated potential demand 
 shows that the degree of saturation is not uniform in all markets. It is 
 usually found upon investigation that a higher percentage of potential 
 demand has been realized in some markets than in others, thus indicating 
 the direction in which expansion may most readily take place. 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 IS 
 
 Another factor to which attention may be given in analyzing a market 
 for some products is the percentage of distribution—that is, the percentage 
 of the total number of possible retail outlets in which the goods in question 
 are sold. A manufacturer of a food product sold in retail grocery stores 
 generally wishes to induce as large a number of grocers as possible in each 
 district to carry his product. If 75 per cent of the retail grocery stores are 
 selling the article, he considers that he has 75 per cent distribution, without 
 reference, of course, to the relative volume of trade of the retailers. 
 
 In establishing sales quotas, allowances must be made not only for 
 differences in degree of saturation and percentages of distribution but also 
 for differences in general business conditions. From season to season general 
 business conditions fluctuate in each district. A poor cotton crop may cut 
 down the normal demand in the cotton states while a good grain crop in 
 the same year may cause business to be exceptionally brisk in the wheat 
 district. Hence the statistical indices of business conditions in each 
 district must be taken into account in comparing salesmen’s records with 
 established quotas. 
 
 TIME AND MOTION STUDY 1 
 
 According to statements made by scientific managers, the process of 
 analysis, or time and motion study, in the larger sense, should where 
 possible begin with the determination of a site for manufacture. The 
 really scientific manager, starting out de novo, will consider all available 
 sites with reference to the time and motion expenditure, determined 
 by actual experiment, necessary in securing an adequate supply of proper 
 materials, in the going to and from the shop of the numbers of the different 
 classes of workmen needed or likely to be needed, in the shipment and 
 marketing of the product, etc. Having in mind the character of the 
 productive process, and the most efficient productive arrangements possible, 
 he will then, with regard to the greatest possible saving of waste time and 
 motion, work out with the utmost care and with reference to future expansion 
 the plans for the construction of his plant. This will involve a most careful 
 study of all the general internal arrangements and processes, the most 
 efficient methods of planning the work to be done and of routing it through 
 the shop so that there may be no delay in transmitting orders, no waste 
 carriage of materials and partly finished products, no lost time in the 
 assembly room waiting for delayed parts. With the same ends in view, 
 and in the same manner, he will also determine the most effective placement 
 of machinery, the storage of tools and materials, and the location of the 
 various elements of the office force. 
 
 The shop constructed and the machinery installed, he will apply time 
 and motion study in an endless series of experimental tests to determine 
 
 Adapted by permission from R. F. Hoxie, “Scientific Management and 
 Labor Welfare,” Journal of Political Economy, XXIV (1916), 833-43. 
 
i6 
 
 RISK AND RISK-BEARING 
 
 what possible improvements can be made in machinery and its operation, 
 and in the tools, fixtures, materials, and specific processes of "work. The 
 best feed and speed for each machine, with reference to the different grades 
 of materials, will then be established. The different jobs or processes will 
 be analyzed and re-analyzed, and their elements experimentally combined 
 and recombined, the tools and fixtures changed and rearranged, and all 
 these variations timed and retimed in an effort to discover the most efficient 
 productive combinations and methods. 
 
 This time and motion study analysis will extend, it is thus claimed, to 
 every feature and all organic relationships of the mechanical process of 
 production. But it will not stop there. It will be extended to cover the 
 managerial functions and the office work. The duties of the managers, 
 superintendents, and especially of the shop foremen will be analytically 
 studied and reorganized. The methods of storage and delivery of tools and 
 materials, the dispatching of orders from the office to the shop, the purchas¬ 
 ing of materials, the marketing of products, and all the methods of account¬ 
 ing will likewise be subjected to time and motion study, in this larger sense, 
 
 with a view to discovering the most efficient means and methods. 
 
 It will endeavor to discover by repeated analysis and experimental timing 
 the best character, combination, and arrangement of tools, materials, 
 machinery, and workmen, the most efficient and convenient lighting, heat¬ 
 ing, and seating arrangements for the workmen, the proper period for con¬ 
 tinuous operation by them, considering the element of fatigue, the rest 
 periods needed, their most efficient character, combination, and sequence 
 of motions, etc. Moreover, these particular job experiments will not be 
 confined to one man, or to a few of those who are to accomplish the task. 
 Many men will be timed with the idea of discovering, not the fastest speed 
 of the fastest man, but the normal speed which the group can continuously 
 maintain. If necessary, hundreds and perhaps thousands of time and 
 motion studies will be made to determine this before the task is set and the 
 rate established. And whenever a new or better method or combination 
 has been discovered by the time and motion analysis, which is supposed to 
 continue even after the task is set, the whole process of careful and extended 
 timing for task-setting will be repeated, and new tasks and rates established 
 reasonably conformable to the new conditions. 
 
 Finally, as an integral part of this broader time and motion study, all 
 the results secured by it will be continuously and systematically filed as a 
 permanent asset and guide to future action. Thus conceived, time and 
 motion study appears to be considered a method of analysis applicable to 
 practically every feature of the productive and distributive process, con¬ 
 sidered apart from its purely financial aspects, a process of analysis applied 
 continuously throughout the life of the establishment. And the scientific 
 management based upon it is conceived to be a perpetual attempt to dis¬ 
 cover and put into operation the new and continuously developing technical, 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 17 
 
 organic, and human arrangements, methods, and relationships constantly 
 revealed by it to be more efficient and more equitable. That this broader 
 conception of time and motion study as the essential basis of scientific 
 managements exists not as a mere dream, but as a practical ideal striven 
 for with the confident hope of realization, the writer can attest from his 
 experiences in the best class of scientific-management shops. 
 
 Although the drift in the direction of scientific method is clear, the 
 extent to which the standards of exact science can be maintained 
 varies greatly with the character of the facts to be handled. In the 
 physical sciences no solution is accepted which does not square with 
 all the known facts, and if not all the relevant facts are known, judg¬ 
 ment must be suspended till they can be secured by observation or 
 by experiment. In this realm, no truly scientific judgment rests on 
 estimates. This is less true of the biological sciences, and still less of 
 the social sciences. In psychology, philology, ethics, sociology, educa¬ 
 tion, economics, the phenomena are so complex, the objects of study 
 are so heterogeneous, and the mass of relevant data is so enormous that 
 resort must often be had to samples instead of complete data, esti¬ 
 mates frequently take the place of measurements, and evidence which 
 falls far short of meeting the standards of the exact sciences is ne¬ 
 cessarily accepted as a basis for generalization. Consequently 
 conclusions must be less final. This is true partly because of con¬ 
 siderations of time and partly because of considerations of cost. 1 
 The student of astronomy can afford to wait for years for the reappear¬ 
 ance of a comet or of a total eclipse to confirm or disprove his 
 hypothesis, the physicist can spend enough money on a single experi¬ 
 ment to make sure the conclusions are right, knowing that if the 
 measurements are exact the experiment need not be repeated, but the 
 educator, the military scientist, or the anthropologist cannot as a 
 rule test his theories completely in the laboratory. He cannot even 
 expend the funds necessary to observe the world-wide variations of 
 the phenomenon he is studying. And yet he cannot, if his science is 
 to have any practical application, defer judgment till the evolution ot 
 society has confirmed or disproved his views. Hence he must speak 
 in terms of preponderance of evidence, of typical results, of tendencies, 
 and of probable results from given lines of conduct. 
 
 1 It is perhaps worth noting that time and cost are not entirely separable 
 elements. Often they depend on one another, that is, it is possible to shorten the 
 time of an investigation if cost can be disregarded, or to avoid the cost if one can 
 wait long enough for the facts to become clear. 
 
i8 
 
 RISK AND RISK-BEARING 
 
 The same contrast appears in the attempt to apply the scientific 
 method to the solution of business problems which we have seen in 
 its application to problems of thought and of knowledge. In dealing 
 with certain types of data, highly exact measurements are possible, 
 and the results repeat themselves with accuracy. Questions of the 
 technique of machine industry are of this type, so long as comparisons 
 of prices (of cost goods and output) are excluded, and even these over 
 short periods of time are susceptible of very reliable estimation. It 
 is in this field, therefore, that scientific management has made the 
 most rapid strides. The value of accuracy and of scientific planning 
 is no longer a question; the engineer has won his place. On the 
 other hand, as was noted in chapter i, in agricultural production the 
 incalculable element of weather makes it impossible to predict results 
 with the same accuracy, and in marketing, finance, and labor admin¬ 
 istration uncertainties abound, some due merely to the undeveloped 
 state of the science of business research, others impossible to avoid. 
 
 There are very definite limits to the extent to which individual busi¬ 
 nesses find it to their advantages to eliminate risk either through research 
 or through protective devices. The determining consideration is one 
 of cost, and there are many fields in which it remains true that it is 
 cheaper to run risks than to avoid them. Cost of elimination of 
 risk, moreover, is often in the nature of a fixed charge. One night 
 watchman, for example, can keep guard over numerous buildings 
 almost as well as over one. One lighthouse warns thousands of vessels. 
 Once the research necessary to establish a new truth has been com¬ 
 pleted it costs little to impart the results to many businesses and 
 perpetuate it for future generations. But the original costs of obtain¬ 
 ing the information may involve a large investment with a high degree 
 of risk that nothing useful will be learned. The larger the volume of 
 business, the more likely is this fixed charge to be a good investment; 
 hence a strong tendency shows itself, other things being equal, for 
 risky enterprises to be carried by large-scale methods. 
 
 The same advantage may be gained by either of two other 
 methods — co-operation and specialization. 
 
 In the co-operative method the cost of research or protection is divided 
 directly among a large number of business units. This method of 
 reducing risk is well illustrated by many of the activities of govern¬ 
 ment. Weather-forecasting has reduced immensely the risks of loss 
 and damage to property on account of frost and flood. No single 
 business could afford to maintain a weather-forecasting service of the 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 19 
 
 scope of that provided by the government, yet when the cost of this 
 service is spread over all the lines of business which profit by it, it 
 makes only a trifling addition to the burden of taxation. Research 
 undertaken by the Department of Agriculture, the Department of 
 Commerce, consular bureaus, and the Geological Survey has resulted 
 in large additions to our store of exact knowledge in fields where a 
 few years ago production was prevented or made hazardous by a lack 
 of sufficient facts on which to base a valid judgment. In like manner 
 government may be shown to be our most important co-operative 
 device for eliminating risk through prevention of harmful events. The 
 maintenance of fire departments and of lighthouses and many other 
 phases of government activity are merely co-operative methods of 
 eliminating the risks of production through activities which would be 
 far too costly for single businesses, but which are very economica 
 when their cost is divided among all who benefit from them. 
 
 Other co-operative devices besides government may be used in 
 the same way. Chambers of commerce maintain bureaus of exchange 
 of credit information to lessen the risk of bad debts. In small com¬ 
 munities they often contribute to the support of night watchmen to 
 supplement the protection afforded by the city police. Trade associa¬ 
 tions reduce risk by the maintenance of research organizations. This 
 is but a beginning of a very long list. 
 
 A second characteristic modern method of spreading the cost of 
 research over a large number of business units is the development of 
 specialists who furnish the service for pay. This method is illustrated 
 by such diverse enterprises as clipping bureaus, advertising agencies, 
 investors’ service bureaus. A very recent development of this sort 
 is the specialized labor service bureau whose chief business is the 
 collection of data for trade-union use in labor disputes. 
 
 3. Elimination of risks by combination increases in importance with 
 the development of large-scale enterprise .—By combination of risks is 
 meant a grouping of similar items in such a way that we can tell more 
 about the group than we can about the items which compose it. 
 Elimination of risk by combination is the application of the so-called 
 law of large numbers. It is often the case that we have a high degree 
 of certainty about a group of data while at the same time we are in 
 complete ignorance about the particular items which make up the 
 group. Thus we may be quite sure that we can predict within 30 
 per cent the amount of rainfall which will occur in a given region in 
 the next year, while if we try to predict the precipitation for any 
 
20 
 
 RISK AND RISK-BEARING 
 
 particular week, it is more likely than not that the actual result will 
 be either less than io per cent or more than 1,000 per cent of our esti¬ 
 mate. So with death rates, marriages, enrolments in colleges, deser¬ 
 tions from the army, accidents due to fireworks, and thousands of 
 other contingencies. A single event defies prediction, but the mass 
 remains always practically the same or varies in ways which we can 
 predict. It is obvious that any device by which we can base our 
 business decisions on the average which we can predict, instead of on 
 the single event, which is uncertain, means the elimination of risk. 
 The larger the number of cases observed the less is the deviation of 
 results from those which a priori were most probable. (Cf. note i,p. 27.) 
 
 In the following selection Professor Ross elaborates a number of 
 applications of the principle of combination of risks: 
 
 The uncertainty as regards the yield of product sets up a current of 
 amalgamation that favors large-scale industry. In almost any line of pro¬ 
 duction minor fluctuations are constantly occurring in the different parts 
 of a business. As, however, these succumb to an average within the single 
 enterprise, they inspire no uncertainty and are not disturbing factors. 
 The larger the enterprise the more do the variations incident to its branch 
 of production reduce to an average and disappear, the fewer are the uncom¬ 
 prehended species of variation. For instance, to the owner of a cow the 
 loss at calving time is uncertain, while to the owner of a great herd this loss 
 appears as a regular percentage that can be computed and allowed for. 
 Even to the rancher the loss by stampede is uncertain, but to a great cattle 
 syndicate with many herds, the loss from this source can be roughly esti¬ 
 mated in advance. Again, in a small refinery the possibility of over-doing 
 a batch of oil or sugar may be a source of serious uncertainty, while in a 
 large refinery the law of the average prevails. 
 
 But with a rapid growth in the size of the business unit, the great 
 fortunes prove too few to handle the big enterprises. Hence the joint-stock 
 corporation is invoked to supply masses of capital without calling on the 
 rich man. Albeit the stimulus to corporate enterprise has been ascribed 
 to the growth of great industry, no small measure of its success has been due 
 to its fitness for uncertain undertakings. By owning stock in a dozen differ¬ 
 ent corporations and sharing in a dozen undertakings, one is exposed to 
 twelve times as many variations, but each disturbs only one-twelfth as 
 much as when one is proprietor of a single enterprise. Some of the numerous 
 variations will cancel each other, and the rest will locate their effects at the 
 margin of one’s fortune, where the subjective value of equal losses and 
 gains is nearly the same. 
 
 The corporate form, therefore, is at its best a mutual insurance scheme, 
 whereby the losses and gains due to variations are first pooled, and then 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 21 
 
 shared equitably among a large number. By thus enlarging the bearing 
 and absorbing surface, by creating solidarity through the interlacing of 
 many private interests, the difference between the variable and the uniform 
 type of production is minimized. While there is a corporate drift all over 
 the field of business, we find it most pronounced in speculative branches, 
 such as mining, boring for oil or gas, electric enterprise, building and 
 improvement undertakings, the theatre business, and the introduction of 
 new devices, machines, utensils, toys, foods, fibers, fuels, etc. 1 
 
 4. Risks may be lessened by the maintenance of reserves, i.e., the 
 withholding of resources from use to have them in readiness for a 
 contingency which may or may not appear. Even in seasons of most 
 active business, the existence of risk prevents the employment of our 
 resources to 100 per cent capacity. Some items may be utilized to 
 capacity or beyond proper capacity, but in many departments there 
 are always some reserves of capital not actively employed. Thus the 
 manager of a bank, in addition to the funds he expects to need from 
 day to day, carries in his vaults a sum of fdle money which he probably 
 will not need, but which at some time he may need very badly. The 
 grocer carries a little bigger stock than he will probably need before 
 he can secure another shipment. Financial managers refuse to pay 
 out in dividends the entire earnings of their firms, or even the full 
 amount which can apparently be spared. Manufacturers carry extra 
 stocks of raw materials and of repair parts. Such reserves are not 
 entirely due to the risk. They may be accounted for by economies 
 in manufacture or transportation of large units, but in large part they 
 are necessitated by the presence of risk. 
 
 The loss of production due to the idleness of the capital reserve 
 cannot properly be called a waste. Its maintenance is a cost —the cost 
 of uncertainty. Whether it is a social waste depends on the question 
 whether the uncertainty can be removed at a cost less than the loss 
 of production from the maintenance of the reserve. In large part, 
 the uncertainty is of course quite beyond our powers to remove, and 
 the maintenance of the reserve may be the most economical way to 
 deal with it. So long as this is true, the cost of maintaining reserves 
 is no more a “waste” than is the wear and tear on machinery or the 
 cost of raw materials used up. 
 
 Professor Pigou has pointed out the way in which the develop¬ 
 ment of a more coherent social organization has made possible a more 
 
 1 Adapted by permission from E. A. Ross, “Uncertainty as a Factor in Pro¬ 
 duction,” in Annals of the American Academy of Political and Social Science , VIII 
 (1896), 115-19. 
 
22 
 
 RISK AND RISK-BEARING 
 
 effective combination of risks and thereby rendered the maintenance 
 of reserves less necessary: 
 
 The development in the means of communication facilitates the com¬ 
 bination of uncertainties in one very simple way. It puts investors into 
 contact with a greater number of different openings than were formerly 
 available. This effect, though of great importance, is so obvious and direct 
 that no comment upon it is required. There is, however, a more subtle way 
 in which the development in the means of communication works. Dr. 
 Cassel has observed that industrial firms have, in recent times, been lessen¬ 
 ing the quantity of stock that they carry in store, waiting to be worked up 
 relatively to their total business. The improvement in this respect applies 
 all round. As regards production, “ there is, in the best-organized industries, 
 very little in the way of material lying idle between two different acts of 
 production, even if these acts have to be carried out in different factories, 
 perhaps at great distances from each other. A modern iron-works has no 
 large stock either of raw materials or of their product, yet there is a con¬ 
 tinuous stream of ore and coal entering, and of iron being turned out of it.” 
 In like manner, factories are coming to keep a smaller amount of capital 
 locked up in the form of reserve machines not ordinarily in use. The same 
 tendency is apparent in retail trading. The ratio of the average amount 
 of stock kept to the aggregate annual turn-over is smaller than it used to be. 
 
 Now, prima facie, this change of custom would seem to be of little 
 significance. After all, a reduction in the amount of finished goods held by 
 retailers, of reserve machinery held by manufacturers, and so on, does not 
 necessarily imply a reduction in the aggregate amount of these things held 
 by the whole body of industrials. On the contrary, we are naturally inclined 
 to suggest that the wholesaler and the machine-maker must increase their 
 stocks pari passu with the decrease in the stocks of their clients. As a 
 matter of fact, however, this suggestion is incorrect. The reason is that 
 the wholesaler and the machine-maker represent points at which uncertain¬ 
 ties can be combined. The development of the means of communication, 
 therefore, in so far as it directly transfers to them the task of bearing uncer¬ 
 tainty, indirectly lessens the amount of uncertainty that needs to be borne. 
 Uncertainty-bearing, in short, is rendered more efficient. 1 
 
 Another writer has shown that combination of risks operates in 
 exactly the same way to reduce the necessary social reserves of 
 unemployed labor: 
 
 The irreducible minimum of unemployment does not appear only in 
 the general percentage for all trades taken together, it is shown also by each 
 trade or group of trades taken separately. 
 
 ’ A C. Pigou, Wealth and Welfare, pp. ioo, ioi. (The Macmillan Co.) 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 2 3 
 
 It holds true not of decaying industries but of those on which the 
 development of the nation’s prosperity has been based. For each group, 
 indeed, taken as a whole, there appears to be much the same irreducible 
 minimum below which the year’s unemployment percentage never falls. 
 Depression of trade is marked by very varying maxima. In the best years 
 all the groups alike tend to have about two per cent, unemployed. An 
 excess of the supply of labour over the demand appears to be a normal 
 condition in the skilled and organized trades. 
 
 Suppose that ten centres of casual employment—say ten similar 
 wharves—each employ from 50 to 100 men on any one day, so that each 
 considered separately requires a regular staff of 50 and a “reserve” of 50 
 more. In so far as the variations of work depend upon general causes, 
 affecting all the wharves simultaneously and similarly, the busy and slack 
 times respectively will tend to coincide and the variations in the total work 
 to reproduce proportionately those of each separate wharf. In so far, 
 however, as the variations at different wharves are unconnected, they will, 
 in the total of men required at all the ten from day to day, tend to neutralise 
 one another, because a busy time at some wharves will coincide with a 
 slack time at others. Suppose that in fact the numbers employed at the 
 whole ten from day to day range from a minimum of 700 to a maximum of 
 800. These daily numbers, whatever they are, will give the numbers of 
 “regular” and “reserve” labourers who may theoretically find work at the 
 whole ten wharves taken together. They must be taken as unalterable, 
 determined solely by the necessary irregularities of trade and tide. They 
 would presumably be the actual numbers employed supposing all the ten 
 were amalgamated into a single wharf having the same mass and flow of 
 custom. But so long as the wharves remain distinct, the number of indi¬ 
 viduals who will practically be required to do the same work is affected also 
 by quite a different set of considerations. It is clear that if each separate 
 wharf forms an absolutely distinct labour market so that no man works 
 at more, than one, then, however the variations of business neutralise one 
 another, the number of individuals required to do the work will be 100 for 
 each wharf or 1,000 in all. It is clear, on the other hand, that if the whole 
 ten form a single labour market within which labour is absolutely fluid, 
 then the full number of individuals required will coincide with the maximum 
 of 800 employed on any one day. The total number of men practically 
 required to do the work without delay (and by consequence the number of 
 reserve labourers) is, in fact, increased by every barrier to free movement 
 from one wharf to another, and can be correspondingly decreased by every¬ 
 thing tending to the organisation of the whole ten into a single labour 
 market. 
 
 The greatest barrier to free movement in any area is ignorance among 
 the men as to the demand for labour in different directions; every means 
 taken to remove this ignorance enables the work of any area to be done with 
 
24 
 
 RISK AND RISK-BEARING 
 
 a smaller reserve of labour. But the general distribution of the most 
 accurate information as to the amount of work at each centre is only a 
 first step. Even if every man knows exactly how many men will be wanted 
 next day at each wharf, this will not of itself (i.e., unless each knows also 
 exactly how his fellows will act) prevent too many individuals from applying 
 at one wharf and (perhaps) too few at another. If it is desired to do the work 
 with the smallest possible reserve of labour, some means must be adopted 
 for directing the right number of specified individuals to each wharf from 
 some one centre or exchange. 
 
 The foregoing arguments may now be summarised. For the work of 
 a group of casual employers a certain theoretically determinable number of 
 men may be regarded as necessary; the number will be fixed by conditions 
 of trade which must be taken for the present as unalterable. And, in so 
 far as these trade conditions involve rapid and irregular variations of work 
 within fairly definable limits, a part of this total number will have the 
 character of an inevitable reserve of partially employed labour. But the 
 actual number of men by whom the work is done, and its relation to the 
 theoretically necessary number, will be affected also by another set of con¬ 
 siderations, quite unconnected with the total volume of work or the unalter¬ 
 able conditions of trade. In the first place, every hindrance to the perfect 
 fluidity of labour from centre to centre will swell the actual number of indi¬ 
 viduals doing the work by an amount representing the degree of friction. 
 To return to the numerical instance, the work of ten wharves, which, if 
 they had become for purposes of employment one wharf, might have been 
 done by 800 men, would with a certain degree of friction, require the services 
 of 900. In that case there would, even when the wharves, as a whole, were 
 busiest, be at least 100 men out of work. 
 
 Those men who will in practice be added to the theoretical maximum 
 for any area by friction between its separate centres, though the product of 
 disorganisation are true reserve of labour without which, given that degree 
 of disorganisation and friction, the industry could not be carried on 1 
 
 It will be noted in the foregoing argument that the problem is not 
 solved by distributing accurate information as to the amount of work. 
 What each will do is for the individual to determine. If one is to do 
 this with scientific accuracy, it is necessary for him to know what 
 every other laborer is going to do and, of course, it is equally important 
 for every r other laborer to know what the first laborer is going to do. 
 If each man’s decisions depend upon other men’s conduct it is 
 obviously impossible to eliminate a large amount of uncertainty by 
 any conceivable system of information. The only way to eliminate 
 
 1 Adapted by permission from W. H. Beveridge, Unemployment , pp. 68-81. 
 (Longmans, Green & Co., New York, 1910.) 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 25 
 
 this element of uncertainty is to establish some central agency to 
 apportion the labor in accordance with some agreed standard of 
 proper distribution. 
 
 Exactly the same analysis applies to every other form of competi¬ 
 tion. So long as we actually have competition, one large element of 
 uncertainty can never be eliminated. No matter how accurate the 
 business man’s information as to the prospects in a new field, his 
 decision to enter that field involves a large element of risk, unless he 
 knows how many other people are contemplating the same oppor¬ 
 tunity and how many of them will finally decide to enter the field. 
 Under present conditions this often is not difficult, for few may know 
 of the opportunity, but the more widespread the dissemination of 
 information, and the more general the disposal to act upon the informa¬ 
 tion relative to new opportunities, the more likely is any such oppor¬ 
 tunity to be “ overexploited.” In other words, the only way to 
 eliminate this risk is to provide some central agency through which 
 the tasks of business men may be cleared and by which their efforts 
 may be apportioned in some rational way. 
 
 Assume a given population and a given amount of labor to be 
 performed, it is obvious that the only alternatives are first, a more or 
 less random distribution of the employment, or second, complete 
 employment for some and unemployment for others, or third, a 
 rationing of labor so that each shall get part-time employment. This 
 still leaves unanswered one fundamental question: Why does the 
 volume of employment remain smaller than the available supply of 
 labor ? Why, if there are unemployed reserves of labor, does it not 
 pay someone to start new enterprises to take up this slack? For 
 apparently, it must be possible to employ the men in such a way 
 that they can be paid more than they can get doing nothing, and 
 still leave some profit to the employer . 1 
 
 The difficulty seems to be this: that entrepreneurs hesitate to 
 make investments in industries unless they have a reasonable assur¬ 
 ance of being able to get a sufficient supply of labor to keep the capital 
 busy, and the exact amount to be needed is always a matter of 
 uncertainty. Hence, with any given supply of labor, the extension 
 of industry will be likely to stop at a point where something less than 
 
 1 It should be noted that the question involved here is not the question of 
 earning even a living wage, for if there are more laborers than can be employed at 
 a living wage, it would still be profitable to employ them at one-half a living wage, 
 which is better in most men’s estimation than nothing. 
 
26 
 
 RISK AND RISK-BEARING 
 
 full-time employment for ioo per cent of the people is afforded. In 
 the case of the dock laborers, a supply of labor only sufficient to keep 
 the docks busy in a season of minimum demand would mean that the 
 docks would be undermanned at busier seasons. Docks simply will 
 not be built up to that point, or if, through error, they are so built, 
 they may be operated, but will be allowed to depreciate. Apply this 
 line of reasoning to industry at large. One of the factors with which the 
 average business man must deal is the possibility of securing labor. 
 If the labor in the vicinity is already 95 per cent employed, he is 
 much less likely to start a new enterprise than if it is only 90 per cent 
 employed. If the labor is already 99 per cent employed, no enter¬ 
 prise can start unless the income in sight is sufficient to enable it to 
 draw away its labor from industries already existing. The result of 
 starting such an enterprise may be to reduce the percentage of 
 unemployment temporarily to zero, but such a situation cannot 
 persist. The new enterprise may succeed, but its success would 
 necessitate the failure or curtailment of operations of concerns which 
 were in a weaker position and could not count on drawing their labor 
 supply away from others. There must be some reserve for contingencies. 
 Operations cannot be expanded permanently to the point where they 
 require all the available supply of labor and leave no surplus to be 
 drawn upon in case of emergency. 1 
 
 The situation in industries is similar in this respect to that which 
 exists in a military campaign. It is never possible to have all the 
 men on the firing fine at once. Quite apart from the necessity of 
 utilizing part of the forces in auxiliary functions and the constant 
 presence of a hospital reserve, a considerable proportion of the troops 
 available for active service must always be held back to provide for 
 unexpected contingencies. Only an overwhelming catastrophe or its 
 imminent prospect will call into action the total available forces. 
 
 Closely related to the method of combination to reduce risk is the method 
 of compensation, by which we mean the adjustment of business affairs 
 in such a way that losses of a given kind will be directly associated 
 with profits of another kind. This differs from combination in that 
 it does not rely upon the operation of chance to even out fluctuations 
 but seeks to match one fluctuation directly against another. Planting 
 
 'Thus, during the boom of 1919, new industries were started without any 
 source for their labor supply except labor already employed, but the resulting 
 “tightness” of the labor situation was a major factor in undermining the profits of 
 industry and shortening the boom. 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 27 
 
 a dry-weather and a wet-weather crop in the same year is an illustra¬ 
 tion. Hedging contracts (see chap, xii) combine the method of com¬ 
 pensation with the transfer of risk to specialists. 
 
 NOTE I 
 
 THE MATHEMATICS OF PROBABILITY 
 
 In connection with the elimination of risk by combination and the 
 estimation of degrees of risk, frequent reference is made to the calculation 
 of probabilities. It seems necessary, therefore, to consider somewhat in 
 detail what is involved in the discussion of probability in mathematical terms. 
 
 As is brought out more fully in chapter iii, probabilities are of three 
 classes: those in which a definite mathematical expression of probability 
 can be attained in advance of the occurrence of the uncertain event; those 
 in which such a probability cannot be known definitely in advance, but can 
 be established from the observation of regularity in the past behavior of the 
 phenomenon; and questions of judgment, in which neither a mathematical 
 nor a statistical basis of calculation exists. We are not concerned at this 
 point with the cases of judgment (which are discussed in chapter iii). 
 
 Mathematical probabilities are expressed accurately, and statistical 
 probabilities approximately, by the use of common fractions. A probability 
 of for instance, means, loosely speaking, that the event in question is 
 likely to happen once in six “trials.” More accurately this means either 
 that there are six equally probable situations, one of which constitutes the 
 event whose probability we are measuring, or else that the number of 
 equally probable cases is 6 n, n of which are classified together, any one of 
 these n constituting the event whose probability we are trying to state. 
 Thus, if in drawing cards from a full pack we estimate that our chance of 
 drawing a ten-spot is -i l 3 ", what we mean is that there are 52 equally probable 
 events, 4 of which we classify as “drawing a ten-spot,” and 48 of wjiich we 
 classify as “failing to draw a ten-spot.” All statements of probability in 
 exact mathematical terms reduce themselves to classifications of equally 
 probable events, part of which fall within and part without a given category, 
 and comparing the number of those within with those without the category. 
 
 Once this idea is understood, the mathematics of probability resolves 
 itself into a consideration of mathematical devices for simplifying the task 
 of enumerating alternatives within or without the categories in which we 
 are interested. Into the intricacies of probability mathematics we need 
 not proceed far; one or two illustrations will suffice to illustrate certain 
 principles which we need to use. 
 
 In many cases the probability of a given combination, in a series where 
 each result is one of two equally probable events, is calculated by the use 
 of the familiar binomial theorem: 
 
 (a-\-b) n = a n -\-na n l b-\-n 
 
 (: n-i)a n ~ 2 b 2 
 
 n (n — 1) (w— 2 )a n 3 b 3 
 
 + 
 
 . +b 
 
 n 
 
 2 
 
 2*3 
 
28 
 
 RISK AND RISK-BEARING 
 
 If the exponents are taken to represent the number of times that each item 
 occurs in the combination whose probability is sought, the probability will 
 be represented by the fraction whose numerator is the corresponding 
 coefficient and whose denominator is 2 raised to the nth power. For 
 instance, the chance of throwing heads seven times in succession is found 
 by taking as the numerator of the probability fraction the coefficient of 
 a 7 ; in this case unity. Taking 2 7 as the denominator, we get tTs as the 
 result. The fourth term of (a+6) 7 is 35 a 4 b 3 ; the chances of an individual 
 in seven trials throwing four heads and three tails is -AV 
 
 The reason for the relationship between the binominal theorem and the 
 calculus of probabilities will be obvious on a moment’s consideration of the 
 way in which the result given in the theorem is reached through actual 
 multiplication. In multiplying out, there is only one combination of seven 
 a’s; there are 35 combinations of four a } s and three 6’s, such as abababa; 
 aaabbba , etc. Likewise in tossing the coin there is only one way in which 
 seven heads can be tossed in succession, while there are 35 ways in which 
 seven tosses can yield four heads and three tails. In other words, there are 
 128 distinct equally probable results, 35 of which are classified together as 
 “four heads and three tails.” 
 
 The probability of a given combination in a series of events each of which 
 is one of three equally probable events, is similarly calculable by using the 
 coefficients of ( a-\-b-\rc) n to obtain the desired numerator, and 3” as the 
 denominator. 
 
 The combined probability of two independent and mutually exclusive 
 events, that is, the probability of their both happening, is the product of 
 the ratios of their separate probabilities. For instance, if the chance of a 
 certain event is \ and the chance of another is the chance of both happening 
 is I, provided that the occurrence of the one does not change the probability 
 of the other, and also provided that they cannot both happen as the result 
 of the same outside event. The chance that one or the other will happen 
 is the sum of their respective probabilities, minus the probability of both 
 happening. The chance that neither will happen is the product of the 
 separate probabilities that each will not happen. 
 
 For example, if the probability of A’s failure within 60 days is estimated 
 as one chance in 100, and the chance of B’s failure is rated as one chance in 
 200, B’s indorsement on A’s note would reduce the probability that the holder 
 of the notes may suffer a loss on account of bankruptcy to one chance in 
 20,000, provided neither A nor B was a customer of the other, or involved 
 in business relations with the other so that the failure of one would greatly 
 increase the probability of the failure of the other, and provided that their 
 businesses were so different that they could not both be overthrown by a 
 single independent cause. In practice, of course, the hazard of A’s failure 
 is never entirely independent of the hazard of B’s failure. Modern business 
 is so interdependent that the events which cause disaster to one business 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 29 
 
 are likely to cause disaster to many others. Wars, financial panics, changes 
 in taxation, new inventions, all illustrate the extent to which the hazard 
 of businesses in a single community and even throughout the civilized world 
 are interdependent. 
 
 The most important practical consequence of the theory of mathematical 
 probability is the support it gives to the empirical “law of large numbers.” 
 It has long been observed that many phenomena which display a high degree 
 of irregularity, so far as the individual items are concerned, are highly 
 regular after observation is fixed on the behavior of groups of such items. 
 Thus we may be quite sure that we can predict within 30 per cent the amount 
 of rainfall which will occur in a given region in the next year, while if we 
 try to predict the precipitation for any particular day, it is more likely 
 than not that the actual result will be either less than 10 per cent or more 
 than 1,000 per cent of our estimate. So with death rates, marriages, 
 enrolments in colleges, desertions from the army, accidents due to fireworks, 
 and thousands of other contingencies. A single event defies prediction, 
 but the mass remains always practically the same or varies in ways which 
 we can predict. 
 
 An examination of the coefficients secured by use of the binomial 
 theorem shows that so far as mathematical probabilities are concerned, the 
 law of large numbers has a sound scientific basis. For example, compare 
 the coefficients secured by raising (a-f-6) to the seventh power with those 
 secured by raising ( a-\-b ) to the eleventh power. In the first case the sum 
 of the coefficients of the first two and last two terms is 16. The sum of the 
 coefficients of the middle four terms is 112. That shows that the chance 
 of securing as many as six heads or as few as one head out of seven trials 
 is 1 1 2 6 g or If we take a similar result for the eleventh power, the sum 
 of the coefficients of the first three and last three terms is 134, while the sum 
 of the coefficients of the middle six terms is 1,914. That is, the chance of 
 getting as few as two or as many as nine heads out of eleven trials is 134 
 out of 2,048, or about one in 15. As we increase the number of terms the 
 probability of a wide divergence of the actual from the most frequent 
 result declines rapidly; hence more accurate prediction becomes possible. 
 In tossing a coin 32 times there is only one chance in 4,500 of getting 27 
 heads or 27 tails; in tossing 500 times the probability'that the number of 
 heads will be between 200 and 300 is nearly 1,000 to 1. 
 
 Calculations of mathematical probability are seldom of much importance 
 in actual business. Actuaries make extensive use of mathematical proba¬ 
 bility in determining the cost of specific clauses in insurance policies. In 
 this case the original probabilities of death or survival are not mathematical 
 probabilities. They are merely statistical frequencies, but once these 
 ratios are assumed, they may be treated as though they were mathematical 
 probabilities. For example, in computing the premium for a policy which is 
 written to be payable at the death of one or the other of two persons, the 
 
3° 
 
 RISK AND RISK-BEARING 
 
 calculation of combined probability of death within a given period is a 
 purely mathematical problem similar to those discussed above, once the 
 mortality table is adopted. The separate probabilities rest on the observa¬ 
 tion of past mortality, which it is assumed will continue. 
 
 This assumption of continued regularity is itself a corollary of the law of 
 large numbers. If we are proposing to send out 50,000 advertising letters 
 to popularize a new device, we are very much interested in knowing in 
 advance what proportion of the persons to whom these letters are sent 
 will be likely to respond. There is no a priori method of calculating the 
 probability of a given individual’s answering such a letter. Resort must be 
 had to what, in the terminology of statistics, is called the sampling process. 
 If we send out, say, ten letters and get three replies, we have some slight 
 basis for judging what is the probability of the average prospect’s answering. 
 If we send out 100 letters and get 30 replies, we have a surer basis of judg¬ 
 ment. If we send out 5,000 letters to prospects taken at random from the 
 list, we consider ourselves justified in assuming that the ratio of replies 
 received to the 5,000 letters is very close to that which will be shown by 
 sending out the entire 50,000. The basis of this assumption is exactly the 
 same as the basis for the assumption that when coins are tossed a large 
 number of times there will by an approximate equality between the number 
 of heads and number of tails shown. We do not know what the final ratio 
 of answers is to be, but we assume that whatever the ratio is for the entire 
 group, the ratio for a group of 5,000 will not diverge widely from it. The 
 high degree of success which has attended the use of this sampling method 
 in such widely divergent fields as market research, heredity, weather 
 forecasting, and the transmission of disease, makes it apparent that there is 
 some force at work establishing regularity of recurrence among many 
 phenomena where inspection of a few cases seems to indicate absolute 
 unintelligibility. 
 
 Presumably the situation here is the same as it was in the cases of pure 
 mathematical probability discussed before. That is, there is an inconceiv¬ 
 ably large number of equally probable cases, part of which fall within the 
 scope of one of our classifications and part within the other, and though we 
 cannot calculate in advance what the ratio is, it is perfectly sound scientific 
 method to infer a law from a regularity running through a large number 
 of cases and use it as a basis of prediction with regard to the rest. This 
 tendency of groups to display variations in their membership in definite 
 ways is the basis of all social science. The economist recognizes that there 
 are individuals who display no acquisitive bent, but he knows also that 
 in any large group such individuals are in a small minority, and he bases 
 his theory of value on the assumption that the controlling majority in any 
 given case will act as controlling majorities have always acted, and that the 
 abnormalities, that is, the infrequent variations, may be neglected. So 
 with the educator, the practical politician, and the penologist; each recog- 
 
WAYS OF DEALING WITH RISK: ELIMINATION 
 
 31 
 
 nizcs that he is dealing with individuals whose behavior is in large measure 
 unpredictable, and makes no pretense of being able to offer generalizations 
 or prescribed rules of discipline which will work well in each individual 
 case, but he does claim to be able to develop, from experience and study, a 
 program which will achieve predictable results in a large and fairly definite 
 percentage of cases. 
 
 QUESTIONS 
 
 1. Illustrate risk being reduced (1) by increasing our knowledge of the 
 future; (2) by employing safeguards; (3) by insurance; (4) by specu¬ 
 lative contracts; (5) by social control. 
 
 2. Is it possible by foresight and calculation to reduce or to avoid some of 
 the risks of industry ? All of the risks of industry ? 
 
 3. Does integration reduce risk? 
 
 4. Is the collection of statistics by trade journals a co-operative or a 
 specialized method of reducing risk ? 
 
 5. Why should not the government undertake research in manufacture on 
 the same scale as in agriculture ? 
 
 6. “A strong tendency shows itself for risky enterprises to be carried on 
 by large scale methods.” Why? Cite illustrations. Can you cite 
 illustrations of the opposite character ? 
 
 7. Should a large insurance company be able to give better rates than a 
 small one? 
 
 8. How does incorporation aid in lessening risk? Does the feature of 
 limited liability reduce risk or merely transfer it ? 
 
 9. Specifically, what inconveniences would business men suffer if the 
 reserve of unemployed labor were eliminated ? 
 
CHAPTER III 
 
 WAYS OF DEALING WITH RISK: TRANSFER 
 TO OTHERS; ASSUMPTION OF RISK 
 
 The methods outlined in the preceding chapter are not adequate to 
 remove nearly all of the uncertainties of production, and consequently 
 it is necessary for someone to bear the risks which are not so removed. 
 It is not necessary, however, that the brunt of this risk-bearing should 
 be borne by the individuals upon whom it falls in the first instance. 
 Here, as elsewhere, in modern business the principle of specialization 
 has been found useful, and much of the complexity of our industrial 
 and commercial system is the result of attempts to relocate the burden 
 of risk. Usually the transfer is combined with some other method 
 of risk reduction. Frequently, for example, specialization in risk¬ 
 bearing is associated with the reduction of risk through combination, 
 as is the case in most insurance. The fire insurance company, for 
 instance, by insuring a large number of houses in scattered localities, 
 changes the small risk of a ioo per cent loss into the practical certainty 
 of a small loss; hence the transfer of the risk is a social gain. Some¬ 
 times a transfer results in risk reduction through more successful 
 forecasting on the part of the specialist. For example, an investment 
 bank is able to assume the risks connected with floating new bond 
 issues better than can many borrowing corporations in part, because 
 of its special expertness in judging market conditions, hence assumes 
 the risk by underwriting the issues, i.e., guaranteeing their success . 1 
 Sometimes transfer is associated with prevention, as when a company 
 insuring steam boilers provides an inspection service designed to pre¬ 
 vent explosions, or a life insurance company contributes to the support 
 of a public nurse. Occasionally the transfer results merely in a 
 transfer of the risk to someone better able, or more willing, to bear 
 it, as is the case in most speculative contracts. 
 
 For purposes of discussion it is convenient to divide the subject 
 of risk reduction through transfer into three principal topics: The 
 specialization of business men as a class in carrying the risks of ordinary 
 
 1 There is also some combination of risk involved in this transfer, and sometimes 
 some prevention , if the underwriter undertakes the active management of the 
 selling. 
 
 32 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 33 
 
 business, which forms the subject-matter of the remainder of this 
 chapter; the specialization of investors in carrying various kinds and 
 degrees of risk, discussed in chapters vii to xi, and the organization 
 of special agencies for shifting special types of risk, which are dealt 
 with in chapters iv and xii to xvii. 
 
 The typical organization of modern business involves specialization 
 in risk-bearing . The ordinary relationship between employer and 
 employee, between borrower and lender, may not appear, at first 
 glance, to illustrate the transfer of risk, but a moment’s reflection will 
 show that that is exactly what its purpose is. When a business is 
 organized, the owner of the business, his creditors, and his employees 
 enter into a co-operative scheme for carrying on production, each 
 specializing in furnishing certain services. The labor group furnish 
 their time, skill, and energy. The capitalist-lender furnishes the use 
 of his capital. The owner furnishes part of the capital and part of 
 the time and skill, and assumes the responsibility for determining 
 the fundamental policies of the business. The risk is divided between 
 them. The laborer assumes most of the risks of physical harm, which 
 arise in the processes of production, though the modern tendency is 
 to transfer the financial hazard of accidents in large part to the 
 employer. The laborer also assumes the risk that if the enterprise 
 is unsuccessful, or if it develops in such a way that his services are no 
 longer needed, he will find himself left without employment. The 
 capitalist-lender subjects his investments to the hazard of complete 
 loss if the business proves so unsuccessful that the entire capital 
 invested in the business is sunk so that the loans cannot be repaid. 
 
 The owner-manager assumes the risk of failure just so far as his 
 resources are sufficient to cover that risk. He is the primary risk 
 bearer; if financial loss falls on the others, it is chiefly because he evades 
 or is unable to meet, his responsibility. In meeting this responsi¬ 
 bility, the owner-manager has a large measure of freedom of choice 
 of methods. As was pointed out in chapter ii, he finds it advantageous 
 to undertake research in order to reduce the range of uncertainty 
 with which he has to deal. He may transfer a part of his burden to 
 specialists. Certain risks, however, he must assume, and others he 
 is likely to assume. 
 
 It will be noted that the form in which the risk of business falls 
 upon the owner-manager is essentially different from the way in 
 which the risk falls upon the other members of the co-operating 
 organization. So long as the system functions in the way it is intended 
 
34 
 
 RISK AND RISK-BEARING 
 
 to function, the product of any industry is divided by withdrawing 
 first the shares of the laborers and the outside lenders, which are 
 fixed in advance by agreement, and leaving the remainder for the 
 owner-manager. The laborer who puts his time into a given pro¬ 
 ductive process is guaranteed a certain wage and is entitled to that 
 wage whether the enterprise succeeds or not. Likewise the capitalist 
 who lends his money to the business is entitled to his interest, whether 
 the enterprise succeeds or not. In theory not only the capital 
 invested by the owner but any other resources which he may have 
 must be exhausted before the loss, in case of failure, can properly 
 be assessed upon the co-operating capitalists and wageworkers. 
 The risk which falls upon the latter groups, therefore, is relatively 
 remote, and losses fall upon them only in case the owner-manager, 
 who is responsible for carrying the risks of the business, is unable to 
 meet his responsibility. 1 The return of the owner-manager, on the 
 other hand, is subject to the entire risk of the business. This is true 
 in the nature of the case not only of those businesses where there is 
 real risk of failure, but also in cases where success is practically assured, 
 for it is almost never true that the exact amount of the total income 
 of the business is known in advance, and whatever uncertainty exists 
 is concentrated upon the share of the owner-manager. As a result 
 the share of the owner-manager has a much wider proportionate range 
 of fluctuation than does the income of the business as a whole. If, 
 for instance, the gross income of a business varies from $800 to $1,200, 
 and the interest and wage bills absorb $600, the income of the owner- 
 manager will fluctuate from $200 to $600. A variability of 50 per 
 cent in the income of the enterprise results in a variability of 200 
 per cent in the owner’s share. 
 
 This is the characteristic which distinguishes profit, on the one 
 hand, from wages and interest, on the other. Profit is known only 
 as the results of the undertaking become evident, and fluctuates with 
 every factor which changes those results, while wages and interest, 
 whether paid to outsiders or “imputed” to the owner’s own labor 
 and capital, are determined in some way in advance. It follows, of 
 course, that in a given case the profit may turn out to be a minus 
 quantity. If the return of the enterprise falls short of the interest 
 and wages agreed upon, the difference is called a “loss” instead of a 
 profit. 
 
 1 The necessary qualifications of this statement, with reference to corporations 
 and limited partnerships and other cases of limited liability, are discussed below, 
 chap, xviii. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 35 
 
 Whether business enterprise , as a whole, yields an average profit 
 or an average loss is an open question. The traditional economic 
 view is that both profit and loss tend to disappear. Under free 
 competition, capital and labor tend to flow into the most profitable 
 openings that are available and to move out of the unprofitable. 
 Given time enough and knowledge enough, any opportunity wherein 
 the return remains much above the market value of the resources 
 which it utilizes will draw to itself such a volume of capital and labor 
 that the return to capital in it will be lowered to, or below, the normal 
 rate by the ordinary effect of competition, and in any enterprises 
 where the return is below normal, capital will flow out until the reduced 
 volume of production brings the return up to normal. This process 
 is never complete, because new inequalities are constantly appearing 
 as old inequalities are being flattened out. The process is like the 
 processes by which the surface of the sea seeks its level. No one 
 ever saw the sea level, yet at every moment the crests of the waves 
 are being flattened and the troughs filled through the ceaseless opera¬ 
 tion of the force of gravity. In like manner the crests of profits and 
 the troughs of loss are being flattened out by the force of competition. 
 The concept of the normal return is used just as is the concept of the 
 sea level as a base line from which to measure deviations, not as a 
 description of the condition existing at any moment. The hope of 
 profit is the inducement to incur a risk, and the result of the attempt 
 to secure profit is to destroy the opportunity to do so. Hence, 
 profit consists of a series of temporary returns, not a continuous flow 
 of income. 
 
 This analysis holds good, however, only so far as the uncertainty 
 which makes profit possible actually does disappear. As Cliffe Leslie 
 pointed out many years ago, the operation of such a tendency is 
 contingent upon the assumption that the conditions of profit and loss 
 become known, an assumption to which exceptions are innumerable: 
 
 The full knowledge and foreknowledge lately claimed for political 
 economy in modern commercial society can exist only at an opposite state 
 of development, at which human business and conduct are determined, 
 not by individual choice, or the pursuit of wealth, or commercial principles, 
 but by immemorial ancestral custom. All that relates to the occupations 
 and movements of a nomad tribe in Central Asia is known and foreknown 
 by all its members. At the more advanced states of early agricultural 
 society the power of prediction continues. Dynasties rise and fall, con¬ 
 querors come and go, empires are shattered above the head of the village 
 community; yet it survives unchanged. 
 
36 
 
 RISK AND RISK-BEARING 
 
 But just in proportion as the stationary passes into the progressive 
 condition, as industry and commerce are developed, does the social economy 
 become complex, diversified, changeful, uncertain, unpredictable, and hard 
 to know, even in its existing phase, at any given time. In the primitive 
 village community the prices of commodities and the gains of producers 
 are not only known, but foreknown, because they are customary prices. 
 But when a market grows upon the border, when dealings with strangers 
 are unrestricted by the tie of kinship or community, or by usage, the prices 
 at which things are bought and sold can no longer be known beforehand, 
 and are not even necessarily known to everyone afterwards. Production 
 can no longer be exactly adjusted to consumption, supply to demand, both 
 the number and the means of customers from without being unknown. 
 And as industrial development proceeds; as labour is subdivided, and 
 occupations multiply, and the methods of production improve; as commerce 
 enlarges its borders and changes its paths, the unknown more and more 
 takes the place of the known. The desire of wealth, or of its representative 
 — money—instead of enabling the economist to foretell values and prices, 
 destroys the power of prediction that formerly existed, because it is the 
 mainspring of industrial and commercial activity and progress, of infinite 
 variety and incessant alteration in the structure and operations of the 
 economic world. 
 
 Just as from the strength of the impulses to marriage, together with 
 observations of their consequences, you may predict that, other circum¬ 
 stances remaining the same, nearly the same number of young men in busi¬ 
 ness will marry this year as last; so from the strength in this country' of 
 pecuniary interest, and the course of conduct it has been found for centuries 
 to lead to, you may predict that, if business does not greatly fall off, about 
 the same number of young men will go into it this year as last. But you 
 can no more predict from their love of money what prices and profits the 
 young men will get in their business than from their love of fair women 
 what fortune they will get with their wives. And you might as well assume 
 that, allowing for difference of age, looks, and family, and other attractions, 
 the fortunes the wives bring will be equal, as that, allowing, according to 
 the orthodox formula, for differences in the nature of their employment, 
 they will make equal rates of profit on their capital. Here the real main 
 postulate of the deductive economist comes in. They cannot, he says, 
 make a higher rate of profit in one business than in another, because other 
 people will not allow that if they know it, but will cut in at once. And he 
 assumes that they do know it. He assumes that the choice of occupations 
 and investments, and the movements cf labour and capital, are determined 
 by knowledge so accurate that the result is the same percentage of profit 
 on capital all round, and a scale of comparative prices in proportion to the 
 quantity and quality of the labour and sacrifices required to produce 
 commodities, or their comparative cost of production. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 37 
 
 Even in a modern village the innkeeper, publican or shopkeeper, who 
 is making a small fortune, does not invite competition by telling his neigh¬ 
 bours of his profits; and the man who is not doing well does not alarm his 
 creditors by exposing the state of his affairs. If you take a whole country 
 like England, it becomes a matter of accident, situation, and personal 
 history and connexion, what a man knows about the state of any particular 
 business. 
 
 In both home trade and international trade the migration of labour 
 and capital has some effect on wages and profits, and the comparative cost 
 of producing different commodities some effect on their comparative value 
 and price; but, in both cases the effect is uncertain, irregular, and incalcu¬ 
 lable. In neither case is there an equalization of either wages or profits. 
 If a particular business is known or believed to be flourishing, capital 
 flows into it; but it also flows into businesses that are, in reality, very 
 unprosperous. One has only to keep one’s eyes open in the streets of 
 London to see, year after year, shops fail, disappear, and reappear with 
 another name over the window, though the locality evidently does not 
 support them. Save in so far as the prosperity of their own. business 
 depends on that of others, the people in one trade know little or nothing 
 of the condition of other trades, or no more than the newspapers tell them. 
 
 In truth, the choice of employment runs in a very narrow groove. 
 There is, no doubt, a tendency of trades to localize themselves, like cotton 
 manufacture in Lancashire, in the places with the best natural aptitudes for 
 them. But in the degree and manner in which this localization takes place 
 it is largely the result of want of information, and want of originality and 
 enterprise, and is far from effecting the best distribution of industry. Men 
 follow each other, like sheep, in flocks, though the sheep are not wise in 
 inferring that wherever there is enough good grass for a few, there must 
 be plenty for the whole flock that goes after them. 1 
 
 So much may be said for the doctrine that profits tend to dis¬ 
 appear. Other students believe that there is a tendency to a perma¬ 
 nent positive return, not received by all business men but received by 
 the average business man, and constituting the reward of the owner- 
 manager group as a whole for the service of risk-bearing. Their 
 reasons for this belief may be stated as follows: Of two opportunities, 
 if one offers a certain return of 6 per cent, while the other may yield 
 anywhere from nothing to 12 per cent, the former is the more attrac¬ 
 tive. Other things being equal, people prefer to put their capital into 
 enterprises which offer the certainty of a given return rather than 
 into those which offer a probability of the same return but no certainty. 
 
 1 Adapted from Thomas E. C. Leslie, “The Known and the Unknown in the 
 Economic World,” Fortnightly Review , XXXI (1879), pp. 934-49. 
 
38 
 
 RISK AND RISK-BEARING 
 
 Hence, doubtful enterprises do not attract capital in sufficiently 
 large quantity to bring the return in them down to the same average 
 level as in safe enterprises, but only down to the level where the 
 most probable difference is sufficient to overcome the disinclination 
 to incur risk. Profit is therefore a permanent and necessary part of 
 the social dividend and is accounted for as the only incentive to render 
 the service of “uncertainty bearing,” which is as essential a service 
 as that of saving capital or doing work. 
 
 This reasoning is probably correct, at least for certain types of 
 risk, but it is by no means conclusive. It is clear that the hope of 
 profit is the incentive leading men to put their capital at risk rather 
 than to put it in safe investments, but it does not necessarily follow 
 that speculative enterprises as a whole must necessarily return a 
 profit to their owners. It is only necessary that there be a sufficient 
 number of successful enterprises to keep the hope of profit alive. 
 Some men, indeed, are so conservative and cautious that they must 
 have, not only the possibility, but a high probability of a return 
 before subjecting their capital to unnecessary risk, but the necessity 
 of society’s paying profit to business men does not rest upon the 
 cautiousness of the most cautious or even the average man. All 
 that is necessary is that for enterprises with a given degree of risk 
 there shall be a sufficient prospective profit to attract thither the 
 capital of those individuals who are least concerned about risk (or 
 those for whom the risk is least), in sufficient numbers to exploit 
 the opportunity. And it is by no means certain that for business 
 enterprises as a whole this necessitates a positive level of profit. 
 Certainly there are many enterprises in which society is served by 
 uncompensated risk-bearers. Prospecting for gold is generally 
 believed to be a case in point, and developing new inventions is 
 probably another. 
 
 Many men are disposed to underrate risk where their own interests 
 are involved, and society reaps the benefit of their error. Adam 
 Smith’s observations on this point are as sound today as they were 
 in 17761 1 
 
 That the chance of gain is naturally over-valued, we may learn from 
 the universal success of lotteries. The world neither ever saw, nor ever 
 will see, a perfectly fair lottery; or one in which the whole gain compensated 
 the whole loss; because the undertaker could make nothing by it. In the 
 
 1 For a qualification, however, cf. chap, vii 
 
WAYS OF DEALING WITH RISK. TRANSFER 
 
 39 
 
 state lotteries the tickets are really not worth the price which is paid by 
 the original subscribers, and yet commonly sell in the market for twenty, 
 thirty, and sometimes forty per cent advance. The vain hope of gaining 
 some of the great prizes is the sole cause of this demand. The soberest 
 people scarce look upon it as a folly to pay a small sum for the chance of 
 gainihg ten or twenty thousand pounds; though they know that even that 
 small sum is perhaps twenty or thirty per cent more than the chance is 
 worth. In a lottery in which no prize exceeded twenty pounds, though in 
 other respects it approached much nearer to a perfectly fair one than the 
 common state lotteries, there would not be the same demand for tickets. 
 In order to have a better chance for some of the great prizes, some people 
 purchase several tickets, and others, small share in a still greater number. 
 There is not, however, a more certain proposition in mathematics than that 
 the more tickets you adventure upon, the more likely you are to be a loser. 
 Adventure upon all the tickets in the lottery, and you lose for certain; 
 and the greater the number of your tickets the nearer you approach this 
 certainty. 
 
 The contempt of risk and the presumptuous hope of success are in no 
 period of life more active than at the age at which young people choose 
 their professions. How little the fear of misfortune is then capable of 
 balancing the hope of good luck appears still more evidently in the readiness 
 of the common people to enlist as soldiers, or to go to sea, than in the 
 eagerness of those of better fashion to enter into what are called the liberal 
 professions. 
 
 In all the different employments of stock, the ordinary rate of profit varies 
 more or less wfith the certainty or uncertainty of the returns. These are 
 in general less uncertain in the inland than in foreign trade, and in some 
 branches of foreign trade than in others; in the trade to North America, for 
 example, than in that to Jamaica. The ordinary rate of profit always rises 
 more or less with the risk. It does not, however, seem to rise in proportion 
 to it, or so as to compensate it completely. Bankruptcies are most frequent 
 in the most hazardous trades. The most hazardous of all trades, that of a 
 smuggler, though when the adventure succeeds it is likewise the most 
 profitable, is the infallible road to bankruptcy. The presumptuous hope 
 of success seems to act here as upon all other occasions, and to entice so 
 many adventurers into those hazardous trades, that their competition 
 reduces their profit below what is sufficient to compensate the risk. To 
 compensate it completely, the common returns ought, over and above 
 the ordinary profits of stock, not only to make up for all occasional losses, 
 but to afford a surplus profit to the adventurers of the same nature with 
 the profit of insurers. But if the common returns were sufficient for all this, 
 bankruptcies would not be more frequent in these than in other trades. 1 
 
 1 Smith, Wealth of Nations, Book I, chap. x. 
 
40 
 
 RISK AND RISK-BEARING 
 
 The common statement that profit is the “reward” of risk¬ 
 bearing means simply that the hope of profit is the inducement which 
 leads men to incur the risk of a loss, not that the profit actually 
 attained in a given case bears a predictable relation to the amount of 
 risk actually undergone in that case. Obviously there is no conscious 
 purpose on anybody’s part to “reward” the risk-taker. 
 
 The only way in which risk enables an individual to secure a 
 profit is by its tendency to keep others out of the field. What we 
 have to deal with is a constant shifting of capital from one field to 
 another in the effort to secure the maximum return for individual 
 owners. The greater the number of capitalists who strive to enter 
 a given field, the less the prospect of profit from investment in that 
 field, and the less the risk the greater that number is likely to be. 
 Almost any other force which limits the amount of capital available 
 for investment in a particular line may give rise to profit in the same 
 way. The only reason economists have fixed upon risk as the source 
 of profit is its frequency, for if a given line of endeavor offers with 
 certainty more than the market rate of interest and wages to those 
 who engage in it, the other deterrents are rarely effective. If, for 
 instance, we had numerous cases of high profits in certain lines caused 
 by social disapproval of the enterprises, we should have to develop 
 courses in odium and odium-bearing to complete our survey of the 
 quest of profits. Such cases are not unknown , 1 but aside from monop¬ 
 oly they are so few, comparatively speaking, that there is no material 
 error in assuming that absolutely certain opportunities for getting 
 more than a normal return without monopoly simply do not exist. 
 
 This does not mean, however, that the uncertainty to be effective 
 must be present in everyone’s mind, least of all in the mind of the 
 profit-seeker . 2 Profits are made most successfully by those who 
 know first and reap an advantage from the uncertainty in other 
 men’s minds. As Hadley puts it: 
 
 Many of the writers who treat of the relation between business risk 
 and business profit make the mistake of assuming that profits are an amount 
 
 1 Money-lending in the Middle Ages and the “white slave traffic” in modern 
 times are illustrations. 
 
 1 In this respect the relation between uncertainty and profit is similar to that 
 between other elements of distribution and the services which they “reward.” 
 For instance, wages may be regarded as an incentive to overcome laziness, but this 
 does not mean they will be withheld from those who prefer work to leisure. They 
 reward those who relieve the rest of society from overcoming its laziness. Again 
 interest as the “reward of abstinence” is the due of those whose saving involves no 
 conscious abstinence at all, as long as some saving involves the exercise of abstinence. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 41 
 
 paid to the individual capitalist to cover his risk of loss. Far from it. 
 They are paid to capitalists as a class for protecting the public against its 
 risk of loss. They are charges which the capitalists make, not for insuring 
 themselves, but for insuring society against the losses incident to industrial 
 experiment and industrial progress. 1 
 
 Or in the words of a German economist of a generation ago: 
 
 The entrepreneur must always to a certain extent carry risk, the risk 
 of both a technical and an economic failure of production. But the signifi¬ 
 cance of the risk depends on the individual. To walk on a tight rope over 
 an abyss is obviously a frightfully risky thing for an ordinary mortal, but 
 for a trained acrobat walking on the rope may involve no special risk at 
 all. So it is with the entrepreneur. A business man versed in the technique 
 of industry and commerce knows the art of keeping his balance and under¬ 
 stands how to take business risks with success; it does not appear to him 
 a perilous thing to establish and carry on a business, while a novice shrinks 
 from the risk. 2 
 
 To state the point more precisely, the significance of risk as a 
 source of profit depends in each case on its effectiveness as a deterrent 
 to competitive efforts to exploit the given opportunity, and its effec¬ 
 tiveness depends on the degree of uncertainty inherent in the situation, 
 the number of people to whom the probability of success appears 
 great, their attitude toward the taking of risk, and the amount of 
 capital they control. If the “supply of entrepreneur ability” is large 
 either because the uncertainty in many people’s calculations is small 
 or because a reckless attitude prevails, risky enterprises will be 
 developed and the percentage of failures will be high. Whether the 
 average level of profit is high or low, whether indeed it exists at all 
 as a positive quantity, seems to be a question of local circumstances 
 about which no general statement of value can be made . 3 
 
 1 Economics , pp. 288-89. 
 
 2 Kleinwachter , Das Einkommen und seine Verteilung , p. 287. (Leipzig, 1896.) 
 
 3 Cannan suggests that both very risky and very safe enterprises yield less 
 than an average return because of their undue attraction for people of abnormally 
 high, or abnormally low, caution. (Palgrave, Dictionary of Political Economy, 
 article on “Profit.*’) This conclusion seems to be verified by tentative results of 
 studies of returns of stocks and bonds made under the author’s direction, but this 
 evidence is not yet complete enough to warrant a positive statement. 
 
 The statistical evidence from income studies is inadequate. King found 
 ('Wealth and Income of the People of the United States, p. 168) that owners of business 
 made a somewhat higher return than hired laborers ($899 as compared with $507, 
 in 1910), but this difference, after allowance is made for interest on invested capital, 
 may be no greater than the average difference in wage-earning capacity of the two 
 
42 
 
 RISK AND RISK-BEARING 
 
 Where monopoly exists it is possible to sell goods at a price yielding 
 a profit, sometimes an enormous profit above the cost incurred, 
 without apparent risk. In these cases the conditions which give rise 
 to monopoly—such as patent rights, terrorism, limitation of natural 
 resources—operate to protect the investor from competition just as 
 in the cases we have been considering risk operates to protect him. 
 Whatever causes operate to check the flow of investment into a 
 given industry may give rise to an opportunity for profit in it; the 
 cause of the monopoly operates just as risk does, but more effectively . * 1 
 
 The securing of monopolies is an extremely profitable business for 
 the few who succeed in it. —It does not seem, however, to be more 
 free from risk than any other business. The development and 
 early financing of inventions is notoriously speculative. Obtaining 
 franchises to establish public services may not involve much risk for a 
 few whose connections enable them to do it most successfully, but 
 their success is clearly conditioned on the degree of ignorance or 
 uncertainty on the part of the public from whom they get the privilege, 
 or of rival investors who might otherwise bid for it. 
 
 Most sources of profit involve either monopoly or risk. —By superior 
 wit and by strength of will it may be possible to buy the essentials 
 of production at a price below the market, while selling at prices 
 based on the full market costs, thus making extraordinary profits. 
 Smuggling goods and then selling in a market where prices depend 
 on competition of duty paid goods; “moonshining” whiskey and 
 
 groups. Professor Knight has summarized the evidence and the opinions of lead¬ 
 ing economists (Risk, Uncertainty, and Profit, pp. 364-66). He concludes that 
 profit as a whole is negative. For a fuller summary of the scanty evidence, 
 cf. Porte, Entrepreneurs et Profits industriels, pp 182-215. 
 
 1 It should be noted that in strict logic the return which accrues to the owner 
 of a monopoly, after the value of his opportunity has been definitely established, is 
 really a part of his interest, not his profit. Once the amount is known w r hich can 
 be gotten out of, for instance, a patent, the patent itself has a value which capitalizes 
 that return, and the return becomes interest on that capitalized value. The 
 profit, which comprises the whole capitalized value of the patent, minus the cost 
 of obtaining and developing it, arose at the time the value attached itself to the 
 patent, that is, at the time uncertainty passed into certainty. (Indeed it accrued 
 in part before that, for as soon as it becomes highly probable that the patent will 
 have value, it acquires a value which discounts that probability.) So with other 
 cases—the return from a monopoly of certain quality of land is, after all, only the 
 rent of that land, no different in character from any other rent. Profit arises when 
 the income producing power of the land is increased by the formation of the monop¬ 
 oly, not when the higher rent is collected afterward. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 43 
 
 selling in a market where the tax is a main element in the market 
 price, are examples. “ Outbargaining ” labor or shrewdness in securing 
 capital on favorable terms works out likewise. There does not seem, 
 however, to be any necessity for erecting these gains into a distinct 
 distributive share or regarding them as exceptional. The question 
 is always, not “What is the specific source of profit?” but “Why 
 does not the competition of other managers destroy the profit in 
 exploiting that source?” The cases cited all seem to resolve them¬ 
 selves into cases where competition is reduced on account of risk—as 
 in the smuggling industry, or into special aptitude for bargaining, 
 which must be recognized in determining the wages of the bargainer, 
 or into some form of monopoly. Frequently, for example, a local 
 group of laborers may be exploited because only one opportunity 
 for employment is accessible to them; the opportunity to profit by 
 such a situation is a simple case of monopoly of location. 
 
 Risk and control are closely associated. —In the preceding discussion 
 the effect of risk on profit and on business organization has been dis¬ 
 cussed on the assumption that the two functions of carrying risk and 
 appropriating profit are associated with the exercise of control. The 
 combination of these three elements is the root of the present system 
 of industry, and is commonly referred to as the right of private prop¬ 
 erty. Some of the social results of this combination and some of the 
 ways in which the traditional relationship of its elements are being 
 modified are discussed in chapter xviii; our present interest is to note 
 that the dominant figure in present-day industrial and commercial 
 organization, the business man, owner-manager, or entrepreneur, as 
 he is variously designated, owes his position to the supposed advan¬ 
 tages of vesting control in those who are financially able and are 
 willing to assume the risks of industry and the responsibilities of 
 control for the sake of an opportunity to reap a more or less uncertain 
 reward in the form of profit. We must now consider some of the quali¬ 
 fications for successful entrepreneurship. 
 
 Certain mental attitudes and characteristics are necessary for adminis¬ 
 tration and operate more or less crudely to select the individuals on 
 whom responsibilities of business shall fall. Without attempting an 
 exhaustive survey, attention may be directed to four of the qualifica¬ 
 tions which seem to be most directly significant in the selection of 
 business managers. The first is business judgment , the second is 
 willingness to incur risky the third is open-mindedness , the fourth is 
 decision. 
 
44 
 
 RISK AND RISK-BEARING 
 
 All these qualities have to do with one’s attitude toward uncer¬ 
 tainty. By judgment we mean here simply the ability to weigh the 
 known elements in a situation and determine the most probable situa¬ 
 tion with respect to the unknown. Willingness to incur risk involves 
 several characteristics. A large element in it is confidence in one’s 
 own judgment. This is something quite distinct from the ability to 
 form a correct judgment. As Professor Knight says: 
 
 .... There is diversity in conduct in situations involving uncertainty 
 due to differences in the amount of confidence which individuals feel in their 
 judgments when formed in their powers of execution; this degree of con¬ 
 fidence is in large measure independent of the “true value” of the judgments 
 
 and powers themselves.It is a familiar fact that some individuals 
 
 want to be sure and will hardly “take chances” at all, while others like to 
 work on original hypotheses and seem to prefer rather than shun uncer¬ 
 tainty. It is common to see people act on assumptions in ways which their 
 own opinions of the value of the assumption does not warrant; there is a 
 disposition to “trust in one’s luck.” 1 
 
 Next to business judgment this quality of confidence in and willing¬ 
 ness to act on one’s best judgment where certainty is absent seems to 
 be the most decisive factor in determining whether one shall be among 
 those who occupy positions of responsibility—indeed, so far as the 
 choice of managers is concerned this factor of willingness to accept 
 responsibility is perhaps more important than the ability to form 
 correct judgments, though less important in determining the manager’s 
 success. The other two qualifications for dealing effectively with 
 risk, decision and open-mindedness, may seem at first to be incon¬ 
 sistent with one another, but they are not. By open-mindedness we 
 mean the ability and willingness to change our decision or opinion 
 as soon as the appearance of new evidence makes it appear that our 
 former position was wrong; by decision the ability and will to stick 
 to a judgment once formed until such reason for change has actually 
 appeared. Efficiency in business management, as in most responsible 
 tasks, requires that one steer a middle course between two extremes. 
 On the one hand, we have the vacillator, the wobbly-minded man 
 who, having chosen one line of policy on a doubtful issue, cannot 
 forget the alternative and is constantly reopening the issue and debat¬ 
 ing the question over without any new evidence on which to decide. 
 At the other extreme we have the “bullhead,” the man who, having 
 chosen an alternative, sticks to it with obstinacy, refusing to be 
 
 1 F. H. Knight, Risk, Uncertainty, and. Profit, p. 242. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 45 
 
 influenced by new evidence which may make the grounds of his 
 original choice no longer valid. There are none so blind as those who 
 will not see. 
 
 Of these qualities only the first, business judgment , needs more 
 extended discussion. As indicated above, judgment means the ability 
 to form a valuable conclusion in a case where the evkience does not 
 suffice to establish certainty. But not all cases of uncertainty call for 
 the exercise of judgment. The determining factor is not the presence 
 of uncertainty but the character of the uncertainty, that is, the exact¬ 
 ness with which the degree of probability is known. 
 
 Estimates of probability fall roughly into three classes. 1 There 
 are, first, a few cases where a quite definite mathematical estimate of 
 probability can be reached, as, for instance, that a result will be of one 
 character seven times out of a hundred, of another character ninety- 
 three times. Many gambling transactions are of this sort, but 
 illustrations are rare in ordinary business. The Goodyear Company, 
 in 1921, issued a series of 8 per cent bonds, one-fortieth of which, 
 drawn by lot, are to be paid at $120 per $100 bond every six months 
 for twenty years. It is clear that the probability of an investor’s 
 securing a 20 per cent bonus for the use of his money for six months, 
 twelve months^ or any other definite period can be figured math¬ 
 ematically, and Che speculative value of this chance can be computed 
 with corresponding precision. No “judgment” enters into this 
 calculation. 
 
 A second and larger class of cases affords what may be called a 
 statistical basis for action. These are cases where no uniformity 
 of results could be predicted from the nature of the case, but study 
 of past results shows that uniformities have appeared with such 
 persistency that we assume they will continue to appear. This is the 
 justification of most business research, as distinguished from techno¬ 
 logical research. The merits of specific selling devices, specific 
 methods of wage payment or organization of the labor force, or specific 
 types of financial instrument cannot be judged even approximately 
 by a single case; but by collecting, organizing, and studying a mass 
 of representative cases results of great accuracy can be obtained. 
 Here again if the evidence is sufficient to establish the degree of risk 
 accurately, as it is, for instance, in many life insurance calculations, 
 no exercise of judgment is involved in the estimate of probability. 
 
 1 Cf. Knight, op. cit., pp. 214-16, 224-26. 
 
40 
 
 RISK AND RISK-BEARING 
 
 Cases of uncertainty where neither the mathematical nor the 
 statistical basis of determining probability is available call for the 
 exercise of what we call “judgment.” 
 
 These are cases where the events to be feared are so rare, or the 
 difficulty of forming homogeneous classes among them as a basis for 
 statistical generalization is so great, that there is no adequate basis 
 of experience for judging whether they will take place, or what is 
 the probability of their taking place. Thus, while the probability 
 that a given individual chosen at random is a thief might be tested 
 statistically, the probability that a certain known individual is a thief 
 is often quite unattainable. His early training, his beliefs and habits, 
 his family responsibilities, his age, and a hundred other things have 
 to be weighed, and there are not enough people who are alike in all 
 these ways to afford a basis for a statistical study. The judgment of 
 a good student of human nature on the question, nevertheless, has a 
 greater value than that of a poor student, though either may be wrong 
 and either may be right. 
 
 The method by which these cases are handled, in the author’s 
 opinion, is in essence a very crude application of the statistical method. 1 
 That is merely another way of saying that our judgments, if if ey have 
 any value at all, are based invariably on some sort of experience with 
 similar cases, either our own experience or that of others. The cases 
 from which we judge may be too few to lend themselves to statistical 
 tabulation, or too widely different for comparison, but if we use them 
 at all it must be through a crude, perhaps unconscious, application of 
 what is essentially the same process as is employed in the statistical 
 method. The difference between good judgment and bad judgment 
 resolves itself into (i) a difference in the amount of data made available 
 by personal experience or by education, (2) the ability to classify that 
 experience so that only the relevant items enter into the judgment, 
 and (3) the ability to give proper relative weight to the items which 
 make it up. 
 
 Of these the last is the most difficult. The tendency is (1) to 
 overvalue one’s own experience in contrast to that of others, (2) to 
 overvalue the evidence which points to a conclusion coincident with 
 our own desires or interests, and (3) to overvalue the recent experience 
 contrasted with that which is less fresh in our minds. To overcome 
 these tendencies is to gain immensely in skill at forming judgments. 
 And no one should feel chagrin if, having taken into consideration all 
 
 * See Note 1, at end of chapter ii. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 47 
 
 the available data and applied his most careful judgment, the event 
 proves him to have been in the wrong. No excellence of judgment can 
 eliminate the sphere of uncertainty; it can only tell us what is most 
 probable. If the improbable happens, the judgment of the reckless 
 plunger who foretold it is not thereby vindicated nor that of the 
 careful student discredited. Only average results over a period of time 
 can furnish a test of skill. Herodotus states the point aptly thus: 
 
 There is nothing more profitable for a man than to take good counsel 
 with himself; for even if the event turns out contrary to one’s hope, still 
 one’s decision was right, even though fortune has made it of no effect: 
 whereas if a man acts contrary to good counsel, although by luck he gets 
 what he had no right to expect, his decision was not any the less foolish. 1 
 
 A more detailed survey of what is implied in the formation of a 
 business judgment is given by a psychologist in the following terms: 
 
 The conception that business acumen is an indefinable, intangible some¬ 
 thing, outside the realm of educability, is widely held. Nevertheless, 
 psychologists have long insisted that intellectual insight and ability, whether 
 in business or in anything else, are the products of perfectly definite causes, 
 in part hereditary, but in part acquired, and hence, presumably, susceptible 
 in some degree to discipline. Educators have long prescribed practical 
 methods for training reasoning ability in school. There would seem, there¬ 
 fore, to be no good reason why schools of business administration should 
 not definitely avow as one primary aim the cultivation of ability to make 
 sound business judgments, even granting that it may require actual business 
 experience to develop that ability to its maximum degree. 
 
 Business judgment differs from judgment in other fields only in the 
 materials with which it is concerned—business problems and business facts— 
 and in certain minor details consequent upon the peculiar nature of those 
 materials. In its psychological mechanisms it is not fundamentally unlike 
 scientific method, or legal reasoning, or reflective thinking in any other 
 field; although the frequent short-circuiting or condensing of the process, 
 made possible through long practice and through familiarity with a definite 
 field, into what has sometimes been called “practical judgment,” often 
 obscures some of the component factors. Judgment, or reasoning, or 
 reflective thinking (whmh terms, for our purposes, we may regard as synony¬ 
 mous) may be described as essentially a complicated kind of behavior 
 by means of which the individual adjusts himself to new problems pre¬ 
 sented by an ever changing physical and social environment; problems 
 which the ready-made adjustment mechanisms of instinct, habit, and 
 memory are incapable of solving. Reasoning is made possible by the reor¬ 
 ganization and re-utilization of the element of previous experience in new 
 
 1 Quoted in Keynes, A Treatise on Probability , p. 307. 
 
48 
 
 RISK AND RISK-BEARING 
 
 forms. It is no unique operation; it involves the same mechanisms of 
 associative recall and discrimination as the simpler operations of percep¬ 
 tion, habit, and memory, although on a somewhat more elaborate scale, 
 and is ordinarily marked by greater hesitancy and conscious purposiveness. 
 The mental content in which these mechanisms find embodiment varies with 
 the nature of the materials and the habits of the individual thinker. It may 
 take the form of vocal or silent speech symbols, mental imagery of various 
 sorts (visual, auditory, or motor, verbal, or concrete), or incipient—or 
 even overt—gestures, impulses, and attitudes, although the modern psy¬ 
 chologist is inclined to regard their precise character as of less significance 
 than the use made of them. 
 
 Reasoning activities vary widely, of course, in scope and complexity. 
 An “act of business judgment” may denote anything from an instantaneous 
 sizing-up of and acting on a relatively simple situation, to the involved 
 investigations and prolonged deliberation leading up to a momentous bus¬ 
 iness decision or the adoption of far-reaching business policies. Sometimes 
 the basic data of the judgment are definite and complete; sometimes so 
 obscure that a judgment is almost a leap in the dark, and even the shrewd 
 executive cannot put his finger on the specific factors which determine his 
 decision. But in all such acts we find, explicit or implicit, common factors 
 and operations. Seldom is it possible to trace these as temporally distinct 
 and successive stages, so varied are the modes in which they may be sub¬ 
 ordinated, merged, reversed, and repeated. Nevertheless, we may con¬ 
 veniently take as a point of departure for our search for ways of training 
 judgment five stages or elements, corresponding in the main to those “steps” 
 which Dewey 1 has made familiar to students of education. 
 
 1. A felt difficulty 
 
 2. Its location and definition 
 
 3. Suggestion of possible solutions 
 
 4. Their elaboration and evaluation 
 
 5. Belief, decision, action 
 
 Let us examine these factors in greater detail, to ascertain what sugges¬ 
 tions they may afford for our problem of training. 
 
 1. A felt difficulty .—The indispensable precondition of all thinking is 
 something to think about, a problem too complex or too novel to yield to 
 such simpler and less burdensome methods of attack as instincts, habit, or 
 memory. It may be either an intellectual or a practical difficulty, present 
 or anticipated. Such a predicament serves as the stimulus for thinking, 
 and determines the direction thought shall take. “Use your head! Think 
 about it!” is the most futile—yet by no means the most infrequent—advice 
 a teacher ever gives a stupid pupil who can see no problem about which to 
 think—other than the eminently practical problem of getting the teacher 
 
 1 John Dewey, IIow We Think , chap vi. (Boston, 1910.) 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 49 
 
 to “lay off him.” Recognition of this fact has led to the increasing vogue 
 of the “project-method” or “problem-method” or “case-method” of 
 organizing educational procedure. 
 
 The business man’s problem may perhaps assume the form of an emer¬ 
 gency demanding action, but no action suggesting itself; or a suggestion 
 of doubtful merit may come to mind; or two or more possible courses of 
 action may suggest themselves, necessitating deliberation and choice. If, 
 as often happens, the problem makes its first appearance in very definite 
 form, the second and perhaps the third of the stages enumerated may be 
 omitted—or rather, condensed into the first, in the way previously men¬ 
 tioned. The task then becomes one of weighing and evaluating these 
 suggestions. But sometimes the situation is so involved in character that 
 its key is not apparent, and the second step mentioned, that of defining the 
 problem and locating the difficulty, becomes the immediate task. 
 
 2. Defining the problem .—This is essentially a matter of analyzing the 
 situation into its factors, significant and non-significant. Thus, a slump in 
 sales in a given territory may conceivably be due to any of a considerable 
 number of factors, and a large part of the task of relieving this particular 
 difficulty consists in analyzing the situation into its factors, geographical, 
 financial, personal, social, political, etc., and determining which are signifi¬ 
 cant and to what extent. Only then can one look for an adequate solution 
 to suggest itself. The problem may, on analysis, define itself as essentially 
 a problem of (a) putting in more efficient salesmen; ( b ) meeting prices or 
 terms of a local competitor; (c) improving transportation or delivery condi¬ 
 tions; ( d ) counteracting harmful propaganda; (e) making connections with 
 new dealers; (f) stimulating present dealers to greater efforts—or something 
 else. One or another of these, in turn, may call for still further definition. 
 
 It will be evident that only one who has a thorough familiarity with 
 the subject-matter to which the problem relates can tell at a glance which 
 factors are significant and which are not. We cannot insist too strongly 
 that no efficient thinking about any problem can be done without a knowledge 
 of the facts in the case. Contrary to a notion that is still altogether too 
 popular, reasoning is no empty, formal, logical gymnastic, in which one can 
 exercise himself into expertness without regard to the peculiar nature of the 
 materials involved. No matter how good a thinker a man may be in his 
 own field, he can never carry over ioo per cent thinking efficiency to a field 
 in which he is not at home. True, his previous training in thinking may be 
 of assistance to him in acquiring familiarity with a new body of material, 
 in mastering the strange viewpoints, terms, principles, and technique; but 
 only actual mastery of the raw materials can make possible good judgment 
 about any sort of problem. We see daily illustrations of foolish and incom¬ 
 petent judgments uttered by men who are experts in their own lines, but 
 whose opinions, when they venture into territory filled with unfamiliar 
 facts, principles, and technique, are not only valueless but indeed socially 
 
5o 
 
 RISK AND RISK-BEARING 
 
 injurious, simply because their susceptible readers fail to make this funda¬ 
 mental distinction. 
 
 During this analytic stage a sifting process has been going on. A host 
 of irrelevant details, offering no promise of help, have quietly dropped out 
 of sight. Simultaneously, certain others have proved suggestive, pointing 
 out hopeful lines of inquiry, and rising to positions of central importance in 
 dominating thought and determining the direction it shall take. So we 
 reach the third stage, that of suggestions of solutions. 
 
 3. Suggestion of solutions .—Suggestion or association is a fundamental 
 psychological principle, basic in all habit and memory. We recall a thing 
 only when an associate, sensory or ideational, is at hand to suggest it; in 
 the absence of such stimulus we are helpless. We can, however, actively 
 aid the recall process by assembling before us all available stimuli, in the 
 hope that one or another will have retained a sufficiently strong connection 
 to suggest the thing we are seeking. Now an analysis of any problem does 
 just this: it brings out and impresses on us certain vitally significant facts 
 to which we must look to suggest the way out. These serve to set limits 
 to the range of “trials and accidental successes” which play so central a 
 role in all problem-solving, whether on motor or ideational levels. If we 
 have had previous experiences of the particular type to which our problem 
 belongs, such associations will naturally have been established, and sugges¬ 
 tion will occur actively. 
 
 Here again is evident the vital necessity of a background of knowledge. 
 The business man confronted with a problem of a sort entirely foreign to 
 his previous experience feels helpless, because absence of associations gives 
 him no clue to the way out. Mistakes of judgment are often directly trace¬ 
 able to inadequate knowledge and consequent insufficiency of possible 
 suggestions, or to inadequate appreciation of the implications of such 
 suggestions as do arise. Probably the most common of all logical fallacies 
 is overhasty generalization. A single experience, or a striking occurrence, 
 is elevated to the dignity of a general truth and applied indiscriminately to 
 all sorts of situations, usually with disastrous results. Business men fail, 
 more often from incapacity than for any other reason, and incapacity usually 
 means ignorance of things one should know about his own business. On 
 the other hand, the leader in the financial and industrial world is not infre¬ 
 quently a man of remarkably wide information concerning matters psy¬ 
 chological, social, political, geographical, historical, and scientific, which to 
 his smaller-minded contemporary seem irrelevant and useless. Neverthe¬ 
 less, it is just this rich background that suggests to him the probable effects 
 upon general business conditions, and hence upon his own affairs, of influ¬ 
 ences apparently remote, and yet real, and thus enables him to prepare for 
 future contingencies. Those business men who were hit hardest by the 
 post-war depression were, in many cases, those who a few years before knew 
 only that the way to greater profits was by buying larger stocks on rising 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 51 
 
 markets, but who did not have that larger knowledge of social and economic 
 conditions, past and present, which would have warned them of what must 
 inevitably follow. 
 
 Let us recall once more that familiarity and practice make for short 
 cuts in this associative process, so that as soon as the problem appears, a 
 course of action may suggest itself, even though we do not stop to trace 
 the path—or perhaps not even be able to do so if we try—which logically 
 leads from the one to the other. The series, “A-B-C-D-E,” built up in 
 the past, becomes condensed and short-circuited into the direct association, 
 “A-E.” This facility in practical judgment is a priceless asset to the 
 executive; such judgments constitute a large part of his everyday thinking. 
 But behind his quick and certain judgments, which evoke our admiration, 
 we may be sure there lies a history of years of faithful, often tedious, accumu¬ 
 lation of intellectual capital and rigid discipline in its use. 
 
 Akin to these practical judgments are those uncritical and unanalyzed 
 impulses which we call “hunches” or “intuitions,” and which play a 
 disproportionately large part in some people’s decisions. Such judgments 
 differ from the kind we have been describing not in their essential elements 
 but simply in the greater obscurity of the specific factors, both in the objec¬ 
 tive situation and in the individual’s personal history, which stimulate 
 the suggestions and determine the decision, and hence in the relatively 
 greater part played by feeling and impulse. Sometimes, it is true, a man’s 
 feelings and impulses have been unwittingly trained by long experience, so 
 that his “hunches” are better than mere lucky guesses, even though he 
 be incapable of making the self-analysis that would bring their historical 
 origins to light. But let us not overlook the fact of our proneness to remem¬ 
 ber and overstress our fortunate guesses, and to forget our mistakes, and 
 so to develop a superstitious reverence for our “intuitions.” In spite of 
 their occasional inevitability, it is unsafe to form the habit of substituting 
 such impulses for critical judgments, if we can possibly find any basis for 
 critical judgments. 
 
 If the operations thus far described—discriminative analysis of the 
 problem, and associative suggestion of solutions—have sufficed to over¬ 
 come all inhibitions to action and induce that attitude of readiness to act 
 which we call belief, decision and action follow automatically. If not, we 
 proceed to seek for further evidence of the relative practicability of our 
 hypotheses. This constitutes the fourth stage of our schema—the elabora¬ 
 tion and evaluation of the suggestions; and this is what distinguishes critical 
 reasoning and sound judgment from uncritical opinion, impulse, or fancy. 
 
 4. Elaboration and evaluation of solutions. —By elaboration is meant the 
 consideration of such consequences, positive or negative, agreeable or 
 disagreeable, as may be expected to follow from this or that course of action. 
 This again involves associative suggestion, and efficiency in doing it 
 depends directly on whether or not the individual has sufficient acquaintance 
 
52 
 
 RISK AND RISK-BEARING 
 
 with the facts in question to know what their consequences may reasonably 
 be expected to be. Some of this knowledge comes from study or reading; 
 some of it comes from first-hand or second-hand experiences with people 
 and things. To a large extent, the implications which one who makes 
 business judgments must consider are social, involving an understanding 
 of how people act, individually or collectively. When we consider extending 
 credit to a man we want to know about his past career, his present habits, 
 his future purposes, in order to be able co predict the probable outcome of 
 our venture. When we consider investing, or enlarging our business, we 
 are anxious to know how “conditions” will be in a year or two years or five 
 years, which means simply that we want to know what the mass of buyers, 
 sellers, investors, and workers are likely to be doing, testing-out of the hypo¬ 
 thetical conclusion is called for. We may test hypotheses in various ways. 
 We may try out our plan experimentally on a limited scale to ascertain 
 whether it will work as we expect. Or we may try it out on the “reflective 
 level” by testing it against other accepted general principles, or with the 
 testimony of competent authorities, books or persons, on similar or related 
 problems; or w T e may submit our data, methods, and conclusions to com¬ 
 petent critics to discover possible omissions or errors. One of the marks 
 of the wise business man is his judicious choice of counselors. 
 
 5. Action— After the problem has been defined, suggestions for its 
 solution reached, elaborated, and evaluated, one of two things happens. 
 If the process has been unsuccessful, it is repeated and new analyses and 
 solutions attempted. If it has been successful and the attitude of belief 
 has been induced, the final stage, that of action , takes place. The con- 
 summatory act need not, of course, follow immediately. The direct out¬ 
 come of a reasoned business decision may be a more or less explicitly 
 formulated program for future action. If the decision covers a whole class 
 of anticipated situations, we call it the formulation of a policy. The realiza¬ 
 tion of these conditions then automatically brings the act which 
 consummates the process; the crucial point was reached and passed when 
 the act of decision was accomplished. What has been said about the ever- 
 imminent dangers of hasty generalization, of undue susceptibility to emo¬ 
 tional bias, of the urge of impulse and prejudice, of post-rationalization of 
 motives, and like enemies of logical thinking, means simply that a critical 
 attitude is no less essential for sound business judgment than for sound 
 scientific judgment. 
 
 To develop good business judgment, then, is not a hopeless undertaking. 
 Indeed, assuming reasonably good quality of brain stuff, good judgment is 
 acquired by a student in no other way than through training—that is, through 
 practice in discovering problems to think about, in getting, reflecting on, 
 and working over the indispensable capital of knowledge, in analyzing 
 problems and sifting facts, in organizing data and keeping them organized 
 to facilitate suggestions, in guarding against too hasty generalizations or 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 53 
 
 emotional bias, in maintaining an attitude of suspended judgment, in criti¬ 
 cally verifying hypothetical conclusions. And to train him in doing these 
 things is a primary function of the school of business. 1 
 
 NOTE I 
 
 UNMEASURABLE RISK AND THE NATURE OE JUDGMENT 
 
 The contrary view to that expressed in the text, page 46, is held by 
 Professor Knight, and is made central in much of his treatment of the theory 
 of risk. In his view, cases where there is no statistical or mathematical 
 basis for determining the degree of probability are the only cases of true 
 uncertainty, and the decisions in which they figure are not based on any¬ 
 thing comparable to the statistical method at all. The only way of dealing 
 with these risks is to assume them, acting on the hypothesis which is 
 estimated to be most plausible. The making of such an estimate he seems 
 to regard as a purely reflex act of consciousness, concerning which nothing 
 really significant can be said: 
 
 The mental operations by which ordinary practical decisions are made are 
 very obscure, and it is a matter for surprise that neither logicians nor psychologists 
 have shown much interest in them. Perhaps (the writer is inclined to this view) 
 it is because there is really very little to say about the subject. Prophecy seems to 
 be a good deal like memory itself, on which it is based. When we wish to think 
 of some man’s name, or recall a quotation which has slipped our memory, we go 
 to work to do it, and the desired idea comes to mind, often when we are thinking 
 about something else, or else it does not come, but in either case there is very little 
 that we can tell about the operation, very little “technique.” So when we try 
 to decide what to expect in a certain situation, and how to behave ourselves accord¬ 
 ingly, we are likely to do a lot of irrelevant mental rambling and the first thing we 
 know we find that we have made up our minds, that our course of action is settled. 
 There seems very little meaning in what has gone on in our minds, and certainly little 
 kinship with the formal processes of logic which the scientist uses in an investiga¬ 
 tion. We contrast the two processes by recognizing that the former is not reasoned 
 knowledge, but “judgment,” “common-sense,” or “intuition.” There is doubtless 
 some analysis of a crude type involved, but in the main it seems that we “infer” 
 largely from our experience of the past as a whole, somewhat in the same way 
 that we deal with intrinsically simple (unanalyzable) problems like estimating 
 distances, weights, or other physical magnitudes when measuring instruments are 
 not at hand. 
 
 We know that estimates or judgments are “liable” to err. Sometimes a 
 rough determination of the magnitude of this “liability” is possible, but more 
 generally it is not. In general, any determination of the value of an estimate must 
 
 1 Adapted by permission from Forrest A. Kingsbury, “Business Judgment and 
 the Business Curriculum,” Journal of Political Economy (June, 1922), pp. 375-88. 
 It may be noted that the term “judgment” is used in this selection in a slightly 
 broader sense than that in which the author has used it above, to include cases 
 where absolute certainty is finally attainable. 
 
54 
 
 RISK AND RISK-BEARING 
 
 be secured by the tabulation of instances of accuracy and inaccuracy of similar 
 estimates, thus reducing it to a probability of the statistical type. 
 
 The theoretical difference between the probability connected with a mere 
 estimate and that involved in statistical calculations such as those used in life 
 insurance, is clearly discernible. Take as an illustration any typical business 
 decision. A manufacturer is considering the advisability of making a large com¬ 
 mitment in increasing the capacity of his works. He “figures” more or less on the 
 proposition, taking account as well as possible of the various factors more or less 
 susceptible of measurement, but the final result is an “estimate” of the probable 
 outcome of any proposed course of action. What is the “probability” of error 
 (strictly, of any assigned degree of error) in the judgment ? It is manifestly mean¬ 
 ingless to speak of either calculating such a probability a priori or of determining 
 it empirically by studying a large number of instances. 
 
 Yet it is true, and the fact can hardly be over-emphasized, that a judgment of 
 probability is actually made in such cases. The business man himself not merely 
 forms the best estimate he can of the outcome of his actions, but he is likely also 
 to estimate the probability that his estimate is correct. The degree of “certainty” 
 or of confidence felt in the conclusion after it is reached cannot be ignored, for it is 
 of the greatest practical significance. The action which follows upon an opinion 
 depends as much upon the amount of confidence in that opinion as it does upon the 
 favorableness of the opinion itself. The ultimate logic, or psychology, of these 
 deliberations is obscure. We must simply fall back upon a “capacity” in the 
 intelligent animal to form a more or less correct judgment about things, an intuitive 
 sense of values. We are so built that what seems to us reasonable is likely to be 
 confirmed by experience, or we could not live in the world at all. 1 
 
 The issue here raised is fundamental. The view of the nature of busi¬ 
 ness judgment just quoted is in harmony with Professor Knight’s view of 
 the nature of these cases of unmeasurable uncertainty. If the uncertainty 
 we cannot measure is of a totally different character from that which we 
 can reduce to a mathematical ratio by statistical surveys, if there is indeed 
 no objective basis for an opinion of probability, it must be conceded that 
 the only way we can deal with it is by a pure creative act of intelligence, 
 “an intuitive sense of values” (or, more accurately, a recognition of truths 
 yet to be born). 
 
 In the view of the present writer, however, such a hypothesis, while 
 hardly capable of disproof, ought not to be accepted until other alterna¬ 
 tives have been found untenable. Reliance on an intuitive sense of values, 
 as a means of prediction of occurrences outside our own spiritual experience, 
 is practically indistinguishable from sheer blind guesswork, dependence on 
 which is indeed psychologically thinkable but, we hope, not our final 
 and only resource in dealing with problems of uncertainty. 
 
 Rather it appears probable that the cases of “statistical probability” 
 and the cases of “true uncertainty” are essentially alike, differing only in 
 the amount of information we happen to have at hand to deal with them, 
 
 1 Knight, op. cil. y pp. 211, 225-57. 
 
WAYS OF DEALING WITH RISK: TRANSFER 
 
 55 
 
 the length of time necessary to accumulate a line of cases big enough to 
 establish a statistical frequency, or the fineness of the classification we are 
 using. All applications of the law of averages rest on a grouping of things, 
 unlike in many respects, into classes, on the basis of certain similarities; 
 if cases nearly alike are infrequent, we must do our grouping on the basis 
 of less homogenous classes. If the classification is crude, or if the cases 
 are not numerous, the statistical method loses its accuracy. But these 
 cases certainly shade off into Professor Knight’s “true uncertainties” by 
 imperceptible degrees, the margin of error getting larger as the evidence 
 grows more scanty. 
 
 There are, indeed questions concerning which no evidence whatever 
 exists, but it does not appear probable that the human mind is equipped 
 in any way to grapple with them. And if any basis for judgment does 
 exist there seems to be no way to exercise it except to throw our cases into 
 crudely formulated “like cases,” and form an opinion on the basis of the 
 preponderance of the evidence. That the process is largely automatic 
 and unconscious is of course obvious. 
 
 The view that the so-called “true uncertainties” are cases which would 
 show statistical regularity, if a sufficient number of like cases were available 
 for comparison, is confirmed by the fact noted by Professor Knight 1 that 
 the totally unpredictable cases do show some tendency toward regularity 
 when grouped with other similarly unpredictable data. 
 
 QUESTIONS 
 
 1. The ultimate effect of improvements in business methods is usually to 
 lower prices to consumers, yet society depends on the self-interest of 
 business men, through profits, to secure the adoption of improvements. 
 Is this rational? 
 
 2. Profit is sometimes stated to be a compensation for the “irksomeness” of 
 riskbearing. Discuss. 
 
 3. Can you cite cases where profit is collected without either monopoly 
 conditions or significant risk, a) temporarily? b) permanently? 
 
 4. Outline (a) the qualities which enable one best to become a business 
 manager; ( b ) those which fit one best to succeed as a business manager. 
 
 5. What do you mean by “accepting responsibility?” Would the expres¬ 
 sion mean anything in the absence of uncertainty concerning the out¬ 
 come of one’s decision ? 
 
 1 Op. cit., p. 239. 
 
 I 
 
CHAPTER IV 
 
 WAYS OF DEALING WITH RISK: TRANSFER 
 TO SPECIALISTS —Continued 
 
 Besides the general system of organization which results in a 
 transfer of risk from capitalists and laborers to business enterprisers, 
 specialization has produced numerous types of organization to which 
 it is possible to transfer certain of the risks of business. Indeed, 
 specializing in risk-bearing is one of the most striking phases of our 
 modern differentiation of functions and functionaries. The most con¬ 
 spicuous illustration is of course the insurance company, but there are 
 a great many others. Corporate suretyship, guaranty of real-estate 
 titles, guaranteed collection services, and the hedging facilities offered 
 by produce exchanges are illustrations. 
 
 The assumption of risks for others looks at first like an extremely 
 hazardous way of building an income. It is not necessarily, however, 
 more risky than other forms of business enterprise, for the risk-bearer 
 is usually better able to carry the risk than is the one from whom it 
 is removed. This superiority may be due to superior knowledge of 
 the situation, as when a title-guaranty company investigates a real- 
 estate title, satisfies itself that there is no real risk, and then guarantees 
 the validity of the title. The owner of the property gets rid of the 
 risk by transfer, the guaranty company assumes it, but reduces it to 
 a minimum by research. 
 
 In a second class of cases the risk is transferred to a specialist 
 who is able to reduce it by prevention. This is illustrated when an 
 investment bank guarantees the sale of a bond issue, knowing that 
 its own indorsement will assure the success of the flotation, or 
 when a steam-boiler insurance company issues a policy to protect the 
 owner of a plant and then furnishes an elaborate and efficient inspec¬ 
 tion service to reduce the hazard of loss. In a third class of cases the 
 reduction of risk arises from the fact that the specialist who assumes 
 the specific risk combines it with a great number of others and so 
 reduces the amount of uncertainty, and hence the amount of risk 
 through operation of the law of large numbers. This is the basic 
 principle of most forms of insurance. 
 
 56 
 
WAYS OF DEALING WITH RISK: SPECIALISTS 
 
 57 
 
 For all these forms of enterprise the chief hazard is not the hazard 
 insured against, but the risk of failing to get sufficient business to 
 furnish a working basis for the law of large numbers, or to repay the 
 costs of organization. 
 
 It should be noted, however, that in all these cases the substitu¬ 
 tion of certainty for uncertainty effects a saving of indirect losses 
 resulting from the event insured against, even though the direct losses 
 are not reduced in number. Fire insurance affords a convenient 
 illustration. Suppose that in the space of five years on an average 
 i per cent of buildings of a certain type are burned and that the cost 
 of selling insurance, keeping track of the business, investigating 
 claims, etc., together with the profits of the insurance company, 
 brings the cost of insurance on such buildings up to 2 per cent. Sup¬ 
 pose A insures and B refuses to do so. It is evident that in the long 
 run A will pay out twice as much for insurance premiums as B will 
 lose by fires. But if B has only one or two buildings, the “long run” 
 necessary to make him fairly sure of this saving will be a great deal 
 longer than his lifetime. Instead of saving the difference between the 
 amount of the premiums and the average or normal loss, he gambles 
 for the saving of a larger amount. If he is lucky enough to have 
 no serious fires, he saves the whole premium. If his building is 
 destroyed, he probably will never five long enough to save the amount 
 lost out of his insurance premiums. Moreover, if he has his whole 
 capital sunk in one building he has no chance to save any of the loss 
 in this way until he has accumulated enough to put up another 
 building. If the building is used for business purposes, moreover, 
 its destruction is likely to mean not only the loss of the value of the 
 building, but also the loss of business, good will of customers, etc. 
 Part of this loss is unavoidable, but an insurance policy which enables 
 one to rebuild quickly or to pay off debts which have been secured by 
 the building may enable him to save a large part of this indirect loss. 
 
 One of the most important risks wdth which we have to deal is that 
 which arises from the uncertainty of the length of human life. This 
 takes two forms—the risk that one may live so long as to use up the 
 funds which he has provided to support himself in old age and the 
 risk that he may die before the end of his normal working life. Each 
 contingency needs to be provided against. 
 
 The first is taken care of in large part by the method of reserves, 
 the individual setting aside a part of his earnings as a provision for 
 old age, a larger part in many cases than would be necessary if the 
 

 RISK AND RISK-BEARING 
 
 length of life were known. The life annuity is a special device for 
 taking care of this risk. This is a contract whereby an insurance 
 company or other corporation agrees for a fixed sum to pay a given 
 individual a stipulated income so long as he lives. For one who will 
 live only an average period, the contract is not ordinarily an attractive 
 investment, but it relieves him of the risk of using up all his savings 
 and coming to want because of an unexpectedly long life. The pure 
 endowment is another contract which insures against a risk arising 
 from the length of life. It is similar to an annuity except that the 
 person taking out the contract pays his money in annual instalments 
 for a term of years, and at the end of that time receives a lump sum. 
 If he dies within the stipulated time, nothing is paid by the company. 
 Such contracts have been used in Europe by parents to provide for 
 the expense of higher education of their children, or to provide dowries 
 for daughters. Endowment-life policies combine pure insurance and 
 pure endowment in one contract. 
 
 The second type of risk connected with human life is the risk of 
 death before one’s normal working life is completed, with consequent 
 loss of earnings. The way which this risk is shifted to insurance 
 companies will serve as an illustration of what we mean by the elimina¬ 
 tion of risk through specialization and combination. For the indi¬ 
 vidual, there is nothing more uncertain than the duration of his life. 
 For the insurance company, on the other hand, the insurance contract 
 involves very little risk. Which of the insured will die no man knows; 
 how many will die, ii the number of insured is large, can be predicted 
 with great accuracy. Hence the company can profitably sell the 
 insurance at a price at which it is a good bargain for the insured. 
 
 Outside the fields of fire and life insurance, the most important 
 branch of the insurance business is marine insurance. Newer types 
 which are gaining rapidly in popularity are burglary, plate glass, 
 automobile, and credit insurance. In all these cases, the principle is 
 the same. If a business has a large enough number of risks and if the 
 risks are independent of one another, it is likely to be cheaper not to 
 insure, for unless the insurance company receives a great deal more in 
 premiums than it pays out for losses it cannot continue to do business. 
 A railroad company need not insure its station buildings, and a large 
 business owning many buildings with plate-glass windows need not 
 insure them against breakage. The amount paid out in premiums 
 will be greater than the amount needed to replace the damage. In 
 
WAYS OF DEALING WITH RISK: SPECIALISTS 
 
 59 
 
 the same way, a large number of small risks of different kinds may be 
 allowed to offset one another. Wherever such a distribution of risk 
 cannot be secured, however, assuming that the expense loading and 
 profits of insurance companies are not excessive, all insurable risks 
 should be insured against, for the insurance company, having a wider 
 distribution of risk, can definitely count on a smaller variation in the 
 number of losses than can any one individual, and hence can get along 
 with smaller reserves withdrawn from active business use to guard 
 against the impairment of working capital. 
 
 The field covered by insurance companies, however, is much 
 narrower than the field of risk involved in carrying on business. 
 For a risk to be well adapted to insurance and elimination by combina¬ 
 tion, tw r o conditions are necessary. There must be available for 
 insurance coverage a large number of independent risks, and the 
 probability of the occurrence of the event insured against must be 
 known with fair accuracy. If the first condition is absent the insur¬ 
 ance is speculative; if the second is absent it is impossible to determine 
 a fair rate, as the combination of risks does not afford knowledge 
 as to the total losses to be anticipated. Insurance under either of these 
 conditions involves simply a transfer of risk from one individual to 
 another, without reduction, and is speculative in character. To meet 
 the need for insurance or for protection against various types of loss 
 where no statistics are available from which to calculate the expected 
 loss, or where no proper distribution of risk can be obtained, the Lloyd’s 
 type of speculative insurance has been developed. In this type of 
 contract, a large group of private insurers enter into a contract by 
 which they agree to recompense the insured for his loss dividing the 
 cost between themselves. For example, people in Washington owning 
 property along the line of march of the inaugural procession sometimes 
 insure themselves against loss from bad weather on the fourth of March 
 through the London Lloyd’s. The insurers in this case may secure a 
 distribution of risk, in spite of the fact that if they have a loss on one 
 policy they will have a loss on every policy of this type. This is done 
 by diversifying the contracts. If the individual insurer writes many 
 policies and none are large, he secures a combination of risks which 
 protects him against excessive loss. But there is a large speculative 
 element involved in the fixing of the premium rates. Protection 
 against drought is of this character. So long as such policies are 
 written to cover a bona fide risk and not for speculation, they are as 
 
6o 
 
 RISK AND RISK-BEARING 
 
 useful as any other type of insurance, but the device obviously lends 
 itself admirably to gambling and is often used for that purpose . 1 
 In the earlier days of life insurance, it was permissible for anyone to 
 take out insurance on the life of anyone else, and policies practically 
 of the Lloyd’s type, on the lives of public men were often taken out 
 purely for gambling purposes. 
 
 Very similar to the speculative type of insurance is the practice 
 of hedging. This is the practice of making two contracts at about 
 the same time of an opposite, though corresponding, nature—the one 
 in the trade market and the other in the speculative market . 2 The 
 same possibility of using a contract either for the purpose of hedging 
 a legitimate risk or for the purpose of creating a gambling risk which 
 we say in the Lloyd’s contracts arises in connection with these “future 
 contracts” on the produce exchanges. When a grain merchant sells 
 a future contract to hedge against a fall in prices while he is marketing 
 his purchases of cash grain, or a flour-miller buys a future contract 
 to protect himself against loss while he is manufacturing flour which 
 he has agreed to deliver, they are securing protection against a definite 
 risk in much the same way that one secures protection against unknown 
 hazard through Lloyd’s policy, but in both cases the only way that the 
 insuring or hedging individual gets rid of his risk is by transferring 
 it to someone else who assumes it as a speculation. The whole 
 machinery of the produce exchange finds its justification in the facilities 
 which it affords for carrying on certain types of business with a mini¬ 
 mum risk and consequently at a minimum cost. There is no question 
 that it is sound business policy to make use of the hedging market 
 wherever a hedging contract can be secured on reasonable terms, but 
 the existence of a hedging market presupposes the existence of a 
 group of speculators who are taking the risk off the business man’s 
 shoulders, and there has as yet been found no way to keep these 
 contracts from being bought and sold in a purely gambling spirit. 
 
 Another way of transferring risk is what is known as “contracting 
 out,” a method similar to hedging, but not involving the use of a 
 speculative futures market. Contracting out may be explained 
 briefly as follows: 
 
 The work of the organized exchanges has certain sensational elements, 
 and volumes have been written upon these exchanges where sentences have 
 
 1 For fuller discussion cf. chap. xiv. 
 
 2 S. S. Huebner, “The Functions of Produce Exchanges,” Annals of the Ameri¬ 
 can Academy of Political and Social Science , XXXVIII (1911), 392. For fuller 
 discussion, cf. chap. xii. 
 
WAYS OF DEALING WITH RISK: SPECIALISTS 
 
 61 
 
 not been written upon the vastly greater volume of speculative contracts 
 entered into outside the limits of the organized exchange. These speculative 
 contracts are so well known that a simple illustration will suffice. I decide 
 to build a house. A contractor assumes the task. He then proceeds to 
 make sub-contracts with the purveyors of lumber, bricks, and other mate¬ 
 rials to the effect that these materials shall be delivered to him at a certain 
 future time and at a certain price. The main contractor has thus con¬ 
 tracted himself out of risk with reference to price changes in these materials. 
 
 Our contractor has thus been relieved of much of his risk. 
 
 The foregoing illustration is typical. A man agrees to do a certain 
 thing. He then contracts himself out of certain phases of the risk involved. 
 True, the burden is merely transferred to someone else, but presumably 
 this someone else is a specialist, and therein is the social defense. 1 
 
 In the building industry and in some lines of manufacturing, it 
 is practicable to pass on in this way the risk of price changes in nearly 
 all the important cost items except labor; this latter risk the manager 
 must ordinarily himself assume if he contracts in advance to sell his 
 product at a given price. During the war, however, it was not 
 uncommon for building contractors to rid themselves of this risk by 
 stipulations that the contract price should be readjusted in case 
 changes in wage rates should occur before the completion of the 
 job. 
 
 In many lines of commercial and manufacturing enterprise, risks 
 can be passed on by coupling advance sales with advance purchases; 
 in other lines, the risks must be assumed but can be kept at a minimum 
 by keeping inventories and advance orders low. Quick turnovers 
 give relatively little chance for profit or loss from price changes. 
 
 It is usually the case, however, that at some point in the chain 
 of successive buyers and sellers the possibility of contracting out or 
 coupling purchases and sales disappears. Someone must assume 
 the risks; the fact that the one who assumes them is a specialist 
 means that he has superior facilities for judging the situation, if a 
 basis for judgment exists, but it also means, as a rule, that he does not 
 secure a good distribution of risks. 
 
 QUESTIONS 
 
 1. Does insurance reduce risks or does it transfer risks from the individual 
 to society ? 
 
 2. Should a state carry insurance on its buildings? 
 
 1 Adapted by permission from L. C. Marshall, Industrial Society, pp. 501-2. 
 
62 
 
 RISK AND RISK-BEARING 
 
 3. B, a dealer, has 500 automobiles in stock. Should he insure them? 
 
 4. Give some examples of cases when it is cheaper to run risks than to 
 avoid them. 
 
 5. Should the amount of the insurance carried on buildings depend on 
 their cost or on present cost of replacing them ? 
 
 6. C is supported by the income from his wife’s property and does not 
 work. Should his life be insured? Should his wife’s life be insured 
 in his favor ? 
 

 u 
 
 CHAPTER V 
 
 UNCERTAINTY AND THE BUSINESS CYCLE 
 
 One direct result of the presence of uncertainty in economic 
 affairs is of such general interest and is so fundamental to an under¬ 
 standing of the working of a competitive business organization as to 
 require more careful study than we have found it necessary to give 
 to most aspects of the risk problem. This is the tendency of produc¬ 
 tion in certain lines to exhibit a fairly regular alternation of excessive 
 activity and stagnation. Maladjustment of production and consump¬ 
 tion we should expect to find as a result of the presence of uncertainty 
 in the calculations of producers, but the presence of a rhythm of over¬ 
 production and underproduction as a result of this uncertainty requires 
 special explanation. 
 
 In the following pages will be presented, first, a description of the 
 phases of the business cycle as they have typically shown themselves 
 in recent years, and second, a discussion of the causes of the phenomena 
 described, with particular reference to the extent to which the cause 
 is found in the existence of business risk. 
 
 The stages of the typical business cycle are generally considered 
 to be four: depression, improvement, prosperity, liquidation. 
 Although it is sometimes impossible to state accurately the time 
 at which one of these stages merges into the following one, the classi¬ 
 fication is convenient and we shall utilize it in describing the 
 phenomena of the cycle. Let us start our description with a period 
 of depression, such as existed in the United States in 1894, in 1908, 
 and in 1921. 
 
 Depression is characterized by low production , low prices , and low 
 profits .—The most conspicuous fact about the whole industrial and 
 commercial organization, as it appears at such a time, is its amazing 
 inefficiency. It is like a well-oiled machine stuck on a “dead center.” 
 Mills stand idle, mines are closed, freight cars are empty, and fleets 
 rot at the wharves. The falling off in the volume of physical produc¬ 
 tion runs in some industries to 50 or 60 per cent, while many individual 
 firms completely suspend operations. Different lines of business are 
 very differently affected, however. At the one extreme, among the 
 major industries, stands agriculture, in which the volume of production 
 
 63 
 
04 
 
 RISK AND RISK-BEARING 
 
 is usually not reduced at all. Individual farm products have their 
 own cycle of overproduction and underproduction, but these rarely 
 correspond to the cycle of general business. 1 Bakeries, ice plants, 
 distributors of fresh milk, and other producers of perishables expe¬ 
 rience a very slight falling off in their volume of business. On the other 
 hand, dealers in canned foods and preserved meats, flour-millers, and 
 most producers of staple non-perishable goods experience a drastic 
 reduction in the demand for their products. Bituminous coal pro¬ 
 duction is curtailed much more than anthracite. Production of pig 
 iron, copper, zinc, and other industrial metals is greatly reduced. The 
 building industry is likely to be greatly curtailed in its operations in 
 the early stages of a depression, but residence and public construction 
 pick up rapidly, encouraged by the lower costs of materials and labor 
 which characterize such a period. Trade, as a rule, is reduced less 
 than manufacture and retail trade less than wholesale. Prices are 
 low; prices of raw materials lower than those of half-finished products, 
 and those of finished goods relatively the highest. 
 
 The volume of unemployment reaches its maximum, as a rule, 
 about the middle of a depression, though generally the decline in 
 wages lags considerably behind the decline in the volume of business 
 and does not proceed as far. The efficiency of labor is high for three 
 reasons: first, because the cutting down of industrial forces has taken 
 the form of a weeding out of the least efficient; second, because the 
 fear of unemployment is a great stimulus to the efficiency of those 
 who remain upon the pay-roll; and third, because many laborers who 
 are on the border line between two grades of skill get into the more 
 skilled class in periods of business activity and drop back into the 
 less-skilled class when business is dull, thereby increasing the average 
 efficiency of both groups. Strikes are not numerous, though some 
 of the most destructive have occurred at just such periods. 
 
 The decrease in the volume of trade and manufacture is reflected 
 in the reports of business done by the banks. Bank statements indi¬ 
 cate a position of great strength, loans and deposits being low and 
 reserve ratios high, but the strength is not as great as it appears, for 
 the proportion of uncollectible paper held is at a maximum. 
 
 Profits in most lines of business are decreased more than is gross 
 income. Commercial failures are numerous, especially in the earlier 
 part of the depression. Interest rates are low. 
 
 1 For illustrations see Warren, Farm Management, pp. 83-90, quoted below, 
 pp. 76-78. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 65 
 
 Recovery may be either gradual or sudden .—The transition from 
 depression to prosperity is typically very gradual, at least in the earlier 
 stages of improvement, but occasionally it is startlingly sudden. 
 When the latter condition prevails, the recovery will invariably be 
 found to have been started by some exceptional circumstance, such 
 as the combination of good crops in this country with short crops 
 abroad which stimulated business in 1879, or the rush of war orders 
 which banished depression early in 1915. If no such favorable inci¬ 
 dent occurs, the depression itself gradually engenders conditions 
 which make for recovery, but the recovery in these cases is slow and 
 does not affect the whole business world at the same time. Some 
 industries are gaining ground while others are still going backward, 
 so that it is impossible to recognize the turning point until it has been 
 passed. 
 
 Increase of production usually starts at points where it has been 
 curtailed most sharply on account of excessive stocks which have been 
 carried over from the preceding period -of prosperity. Production 
 has been curtailed below even the low rate of consumption which pre¬ 
 vails during the depression, and as a result the excess is worked off. 
 Then new stocks of goods must be produced to satisfy the demand. 
 Changes in fashion and the appearance of new kinds of consumption 
 goods also sooner or later stimulate increase of production. Most 
 important of all, in several cases, has been the revival of building and 
 of railway and public utility construction. Investments of this 
 character are made with a view to the distant future, hence the 
 immediate prospect of dull business may be offset by the relative 
 cheapness of materials and labor, whereas producers of goods for early 
 consumption must be governed more by the outlook for markets in 
 the near future than by considerations of economy in the costs of 
 production. 
 
 Once the increase in business activity gets under way it is likely 
 to radiate with increasing rapidity. If building industry expands, 
 brick, cement, and lumber interests feel the effects at once; steel, 
 copper, and transportation, a little later. Each of these passes its 
 growing prosperity to others. Later still, retail buying shows some 
 effect of the increased volume of employment. No single enterprise 
 is self-sufficient; each is influenced by the fortunes of its customers 
 and of those from whom it buys. 
 
 The effects of the increase of production on the labor market and 
 the money market are obvious. Unemployment decreases, and wages 
 
66 
 
 RISK AND RISK-BEARING 
 
 rise, at first more rapidly than the cost of living, then as prosperity 
 develops tend to lag behind until the eve of a crisis, when they begin 
 again to run ahead. Bank loans increase, but interest rates are slow 
 to follow other prices upw r ard. Banking is one of the businesses 
 where an increase in customers’ demand, coming in slack times, can 
 be taken care of with the least additional expense, hence competition 
 prevents any material advance in rates until the revival has run a 
 long way. 
 
 An increase in business activity does not necessarily carry with it 
 an immediate advance in most prices. The raw material markets 
 are very sensitive because they are as a rule “buyers’ markets.” 
 There is very little organization in them to restrict production and 
 control prices, consequently prices go very low during depression, and 
 the resumption of competitive buying quickly puts them up. The 
 case of most manufactured goods is different. Their prices have 
 usually been maintained during the dull period to some extent by 
 curtailment of output, and manufacturers come into the revival period 
 with idle plant capacity, which makes it possible for them to handle 
 the increased volume of business with less than proportionate increase 
 in expenditures. Hence competition is apt to be keen until the 
 expansion of business has proceeded to the point where existing plants 
 are booked ahead to capacity, and prices show relatively little tend¬ 
 ency to advance. The advances in prices of raw materials and wages 
 go far to offset the decrease in overhead costs which results from greater 
 volume of business, so that the early stages of recovery do not bring 
 large profits to manufacturers, except where monopoly conditions are 
 present. 
 
 After a time, however, in one industry after another the expansion 
 of demand reaches the stage where manufacturers decide that it will 
 pay to raise prices even at the risk of losing some orders, and when 
 this process starts it is likely to gain momentum. An increase of 
 prices at one point means an increase of costs at another, and coming 
 in conjunction with an increase in orders and inquiries, it encourages 
 price increases where it does not make them imperative. 
 
 At first, higher prices check demand, for buyers, both middlemen 
 and consumers, are thinking in terms of a falling or stationary price 
 level, and they resent and resist advances. But when increases 
 become numerous enough to create an expectation of further 
 increases, they begin stimulating, instead of retarding, purchases. 
 Present purchases and contracts for future purchases are made in 
 
UNCERTAINTY AND THE BUSINESS CYCLE 67 
 
 anticipation of further advances, and speculators, middlemen, and 
 consumers begin to accumulate larger stocks. 
 
 Prosperity tends to develop into excessive activity , which in turn 
 causes a reaction . No sharp line can be drawn between the periods 
 known as those of recovery and of prosperity, but it is possible to draw 
 a fairly clear distinction between a wholesome type of prosperity and 
 the overexpansion which often appears as a result of prosperity and 
 brings it to a close. For prosperity never passes into crisis without an 
 intermediate period of false good times when the industrial machine, 
 though apparently running at high speed, is really failing to maintain 
 its efficiency as an organization for the satisfaction of human needs, 
 and is sowing seeds of disaster for those who are directing its course. 
 
 If there were some way by which the progress of the “boom” 
 could be checked at the point where production reaches the largest 
 volume that existing resources make practicable, the real welfare of 
 the nation would be greatly enhanced. When all the available labor 
 is employed, when our capital resources have been adjusted to keep 
 that labor force employed, and when the production of luxuries has 
 expanded to provide for a standard of living corresponding to the 
 enlarged income of society, the real improvement has reached its 
 limit. No further expansion can put more buying power into one 
 person’s pocket except by taking out of another’s. 
 
 But unfortunately there is no force operating to check the boom 
 at this time, and there are forces operating to drive it further. Of 
 these, the most important is the anticipation of a further rise in prices. 
 The higher prices go, and the longer the time during which they have 
 been advancing, the greater becomes the number of people who feel 
 sure that the next change will be another advance, and this conviction 
 gives rise to an epoch of speculative buying. The housewife buys a 
 dozen cans of food where ordinarily she would buy three, the retailer 
 loads his shelves, and the manufacturer lays in an extra stock of raw 
 materials. Speculators withdraw stocks of goods from the market. 
 
 The effect of these withdrawals of goods from consumption is to 
 create temporarily the same situation which would appear permanently 
 if a large part of our current production of wealth were withdrawn 
 and sunk in the sea. The consumable product shrinks relatively to 
 the amount of social energy expended in a production, and hence 
 the cost of living outruns the advance in individual incomes. It 
 must do so. Individuals may succeed in obtaining such rapid 
 advances of wages or profits as will offset for them the advance in 
 
68 
 
 RISK AND RISK-BEARING 
 
 living costs, but the group, as a whole, cannot do so if a large part of 
 its current product is being withdrawn from use in anticipation of 
 an increase in its price. 
 
 At the same time, the current product itself is being reduced by 
 the operation of forces inherent in the nature of prosperity. The 
 pressure of competition brings with it an accumulation of wastes. 
 Equipment is kept in operation which might better, as a long-run 
 policy, be sent to the repair-shop or the junk heap. Managers 
 harassed by customers demanding prompt deliveries neglect details of 
 economy. Imperfect goods are shipped to customers on the theory 
 that time is more important than quality, and customers accept 
 inferior goods rather than risk getting none at all. The efficiency of 
 labor declines, and labor absenteeism increases. Strikes multiply, 
 and insubordination manifests itself. At the same time, interest 
 rates rise, and if the expansion of business is very marked, transporta¬ 
 tion facilities prove inadequate. 
 
 All these difficulties accentuate the difficulty of making individual 
 incomes and expenditures balance. The boom is no longer adding to 
 the real welfare of the nation. It is subtracting from the total pro¬ 
 duced at the same time that it is inducing individuals to store up part 
 of the product for future consumption, usually for consumption at a 
 time when it will be less acutely needed than it is at the time it goes 
 into hiding. 
 
 The transition from prosperity to depression is the shortest stage of 
 the cycle, but has attracted more attention than has any other stage, 
 on account of the spectacular character which it often displays and 
 the disastrous consequences which it entails. According to the 
 severity of its symptoms, this stage is variously denominated a period 
 of retrogression, of liquidation, of crisis, or of panic. The outstanding 
 characteristics of the period are pessimism, conservatism, and caution. 
 Instead of reaching out for larger worlds to conquer, the captains of 
 industry seek to guard their frontiers. 
 
 In brief, liquidation consists of two processes: first, the liquida¬ 
 tion of stocks of goods and securities, by selling them or using them 
 up without buying or producing an equal quantity to replace them; 
 and second, the liquidation of credit, by collecting notes and accounts 
 without extending credits in equal amount to replace them. If the 
 process were carried through to completion, all business men at the 
 end of the period would have their net working capital in cash, with 
 no inventories or accounts; banks would have no loans outstanding; 
 
UNCERTAINTY AND THE BUSINESS CYCLE 69 
 
 and all stocks and bonds would be in the hands of permanent 
 investors. 
 
 Of course, in practice nothing remotely approaching this actually 
 happens. Individuals liquidate their holdings of raw materials, 
 finished goods, and securities, but only by transferring them to others 
 who are under less pressure. The total of bank loans is but slightly 
 reduced in the most drastic period of liquidation. What occurs is a 
 season of testing by which the stronger firms gain at the expense of the 
 weaker. One bank may turn its loans into cash, but only on condi¬ 
 tion that other banks stand ready to rediscount them or to loan the 
 funds to those who are pressed for payment; one speculator may 
 liquidate his holdings of stocks or of goods on condition that others 
 can secure the funds to take the load off his shoulders. 
 
 In a period of expansion, such as was described above, the culmina¬ 
 tion of prosperity and the beginning of a downward trend may take the 
 form of pressure for liquidation in either the commodity, the security, 
 or the short-time credit market. In 1907, for instance, it was pressure 
 for credit beyond the capacity of banks to supply it which precipitated 
 the effort to liquidate by dumping goods on the market and slackening 
 production; in 1920 it was the overexpanded stocks of certain com¬ 
 modities, notably silk and sugar, which led to the demand for liquida¬ 
 tion of loans; in 1903 the center of strain was in the security market. 
 In either case, the liquidation movement when once started gains 
 momentum of itself. 
 
 In the commodity markets, a relatively small amount of forced 
 selling, which may be brought about either by apprehension concern¬ 
 ing the market for the goods so sold or on account of tension at some 
 other point, exerts a depressing influence on prices and creates an 
 apprehension of further selling. Holders who are under no real 
 pressure market their goods as soon as they become apprehensive, 
 make advance sales to profit by the prospective decline, or curtail 
 purchases and use up the stocks they have on hand. This depresses 
 prices further, and the fall of prices creates financial embarrassment, 
 for goods are a basis of credit, and on a falling market curtailment 
 of credit is imperative. The financial embarrassments necessitate 
 further distressed selling, and so the downward spiral proceeds. 
 
 To avoid complete demoralization, there must be provided some 
 organization to check the violence of liquidation and maintain prices. 
 This organization can be most effectively furnished by the banks, 
 particularly if, as in this country in 1920 and in England at earlier 
 
70 
 
 RISK AND RISK-BEARING 
 
 times of crisis, they are well enough organized to resist the temptation 
 to try to force liquidation ahead of one another. Credit extensions 
 are arranged, and funds are provided to withhold sufficient goods from 
 the market to hold prices up as far as seems feasible. If the banks are 
 unable to do this, if each strives to protect itself by selling its securities, 
 withdrawing its balances from other institutions, and pressing its 
 debtors for settlement, crisis passes into panic. But if organization 
 is successful in averting the peril, the period is characterized by 
 “orderly liquidation.” Prices of raw materials decline; production is 
 curtailed in order to apply receipts to payment of pressing obligations 
 and also to avoid losses from further price declines; the weakest 
 firms pass into bankruptcy, and the next weakest submit to “voluntary 
 reorganization” which transfers control to their principal creditors; 
 but there is no panic and no sudden collapse of the market for basic 
 commodities. 
 
 A similar process of liquidation takes place in the stock market, 
 where indeed it usually begins some months earlier than in the com¬ 
 modity market. Even more than is the case in the market for raw 
 materials and manufactured products, the stock market is financed on 
 borrowed funds. Hence it is subject to exactly the same sort of 
 pressure which we have described in connection with the commodity 
 markets. A decline in prices, however caused, precipitates distressed 
 selling by borrowers to protect their loans; this depresses prices 
 further; buying is deterred and speculative selling encouraged by the 
 decline, and this still further weakens the security pledged for loans. 
 The process is more rapid than in other markets, because the propor¬ 
 tion of credit is higher and because lenders on stock-market collateral 
 do not feel, as a rule, the same obligation to try to protect their 
 debtors as do trade creditors and banks loaning to business men on 
 the security of inventories and accounts. Here also, as in the com¬ 
 modity market, the situation has been saved again and again by the 
 intervention of the stronger banks. By buying in large blocks, by 
 extending credit to finance buying by others, and by mutual agreement 
 to refrain from forcing liquidation by holders of large blocks of stock, 
 panic is prevented. 
 
 Such are the major features of the liquidation process; other 
 features of the period of retrogression need scant notice only. Rail¬ 
 road gross earnings remain large at first, because commitments already 
 entered into are carried out, and because the liquidation process itself 
 gives rise to a considerable volume of trade. Later they decline 
 
7i 
 
 UNCERTAINTY AND THE BUSINESS CYCLE 
 
 4 
 
 violently and persistently. Total bank transactions decrease; bus¬ 
 iness failures increase to from three to six times their former number, 
 and dividend payments are curtailed in many instances. Strikes 
 continue numerous; wages decline slowly; unemployment increases; 
 and the cost of living declines slightly. 
 
 The liquidation period in the nature of the case cannot continue 
 long. When it has run its course, however, production does not at 
 once resume its previous trend. Partly on account of the existence 
 of excess stocks accumulated during the period of rising prices; partly 
 on account of the loss of general confidence in the solvency of debtors; 
 partly on account of the fear of further declines in prices; partly 
 because of a curtailment of consumer demand on account of unemploy¬ 
 ment and business losses, a period of dulness is nearly sure to follow. 
 This is the stage with which our description began, and with this stage 
 it may close. We must now turn our attention to the underlying 
 causes of the phenomenon, and particularly to the way in which it 
 illustrates the disturbing influence of uncertainty in a society organized 
 on the assumption that individual business managers may be expected 
 to find and follow the lines of policy which in the long run are most 
 profitable to themselves and to the society of which they are a part. 
 
 It is not our purpose to review the numerous theories which have 
 been advanced to account for the rhythm of business, theories ranging 
 from the dominance of the profit incentive to the form of the banking 
 system, from the fluctuation of the rainfall to the exploitation of labor. 1 
 Superficially there appears to be a wide disagreement among students 
 of economic theory as to the basic causes of the phenomena of the 
 cycle, but most of the differences resolve themselves into differences 
 of emphasis upon factors which are in no way incompatible with one 
 another. Fundamentally, all the theories which seem worthy of 
 extended consideration are variations of two points of view. 2 One 
 group emphasizes the tendency for the supply of certain types of 
 goods to get out of adjustment with the demand for them. The 
 realization of an undersupply, for instance, causes a burst of produc¬ 
 tion which continues till an excess of supply becomes evident, and 
 this situation in turn causes a slackening of activity which continues 
 
 1 Leading theories are summarized in Mitchell, Business Cycles , pp. 3-19, and 
 in Hansen, Cycles of Prosperity and Depression in the United States , Great Britain 
 and Germany , pp. 81-96. 
 
 2 In this classification the author has followed in part the analysis in Hansen, 
 op. cit. 
 
72 
 
 RISK AND RISK-BEARING 
 
 till the surplus is changed into a deficit. The other group finds the 
 basic cause of the cycle in the financial structure of society, including 
 under that term: money, credit, prices, and the profit motive. 1 
 
 In the judgment of the writer, the ultimate causes of the cyclical 
 movement of business are found in the factors discussed by the writers 
 of the first group. The arguments they have presented however have 
 not been thoroughly convincing because each writer has discussed the 
 operation of the same tendency in the case of a different group of 
 phenomena, leaving the impression that in the behavior of that partic¬ 
 ular group is to be found the entire explanation of the cycle instead 
 of merely an illustration of the way in which a general tendency works 
 in a wider field. 
 
 The common element which runs through all the theories of this 
 group is the emphasis on the element of uncertainty , chiefly uncertainty 
 on the part of producers and middlemen concerning the conditions 
 that will prevail in the market when they are ready to dispose of their 
 goods. 
 
 This uncertainty characterizes all modern industry, in contrast 
 to earlier forms of economic organization, for two principal reasons, 
 namely, the length of time involved in the capitalistic process, and the 
 durability of most finished goods, which permits alternate accumula¬ 
 tion and liquidation of stocks and thereby increases the difficulty of 
 predicting the demand at any given time. It was noted in chapter i 
 that the uncertainty arising from the length of time involved in pro¬ 
 duction and from the dependence of producers on markets causes 
 irregularity and consequent risk; the way in which it results in a 
 rhythm may be explained as follows: 
 
 In any specialized economic organization, there must be some way 
 of directing the specialists in order that each commodity and each 
 service may be produced in the proper proportion to the others, 
 proper, that is, in the sense that social energy is devoted to the pro¬ 
 duction of any commodity only up to the point where additional 
 units of it are less useful (by some scheme of measurement), at least 
 are less desired by those whose desires are most effective, than addi¬ 
 tional units of some other product to which the same productive 
 energy might be applied instead. In our own organization, the 
 principal devices for securing a balanced output are prices and advance 
 
 1 Typical of the first group are the theories of Hull, Robertson, J. M. Clark 
 Warren, and England. The second point of view is represented by Mitchell, 
 Veblen, Fisher, and Hansen. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 73 
 
 orders. A falling off of orders or a lowering of market quotations 
 gives warning to the manager that the rate of production should be 
 slackened, and vice versa, an increase of orders or a rise in prices is a 
 call from society for an increase of output. The price index is avail¬ 
 able to producers in nearly all lines, while advance orders are avail¬ 
 able to relatively few. 
 
 While this system works fairly well in most respects it has one 
 serious defect. Prices and orders give information concerning the 
 prospective state of demand compared with the known facts of present 
 and future supply, but they give no clue to the changes in supply 
 which they are themselves likely to cause. What a business man 
 needs to know in order to plan production scientifically is not merely 
 how many units of his product would be bought at a given price, but 
 also how many other producers are reaching the same conclusion that 
 he is reaching, from the same facts, and are making plans similar 
 to his own. If the element of time in production could be eliminated, 
 the price system would effect a smooth adjustment of supply to human 
 need, so far as need can be expressed through offers of purchasing 
 power, but time brings an ineradicable element of risk. For each 
 producer needs to know precisely what it is impossible for all to know, 
 namely, how many other producers are about to take advantage of 
 the same demand that he individually is trying to take advantage of. 
 If A’s plans depend on B’s plans and B’s plans depend on A’s plans, 
 there is no escape from uncertainty except through an agreement of 
 the rivals, or through the intervention of an outside control—in either 
 case, monopoly. 
 
 One result of this situation is a tendency to alternations of over- 
 and underproduction. Let us assume that at a given time there is 
 evidence of demand in a given line sufficient to justify an increase in 
 the rate of production. The first managers who adapt their plans to 
 this situation are probably rewarded by increased profits. Under 
 competition, however, the tendency is for an increasing number of 
 persons to try to take advantage of the situation, each more or less 
 in ignorance of the other’s plans, and no force intervenes to check the 
 continued increase of production till it reflects itself in declining orders 
 and falling prices. By that time, however, investments have been 
 made, contracts let, and operations started which will result in fur¬ 
 ther augmentation of the supply. Time is required to check this 
 increase in the volume of production, and during this time production 
 outruns consumption unless consumption is stimulated by unprofitably 
 
7t 
 
 RISK AND RISK-BEARING 
 
 low prices. Moreover, just as was the case on the upswing, the indica¬ 
 tions that production is being overdone result in curtailment of opera¬ 
 tions by independent producers in ignorance of each other’s intentions, 
 and this tendency continues till output is decreased to a rate below 
 that which is economically justified. 
 
 A second cause of the cycle, very similar to the first but quite 
 independent of it, is the effect of uncertainty on the decisions of 
 speculative buyers with regard to the accumulation and decrease of 
 stocks. Throughout the industrial order, a large part of the transfer¬ 
 able wealth, including raw materials, half-finished products, and goods 
 ready for consumption, is in the hands of individuals who can, to a 
 greater or less extent, adjust the size of their holdings to changing 
 conditions, and who do as a matter of fact adjust them chiefly in 
 accordance with their judgment of the probable course of prices. The 
 most conspicuous illustration is the case of the simon-pure speculator, 
 who stands ready to buy anything at any price if he thinks it will go 
 higher, and to throw everything on the market if he believes the price 
 is destined to reach lower levels. But it is not merely the speculator 
 who behaves in this fashion. The manufacturer adjusts his purchases 
 of raw materials and the extent to which he produces for stock to his 
 judgment of the trend of prices; the middleman enlarges his holdings 
 when he believes the next price change will be upward, and even the 
 housewife buys fifty pounds of sugar instead of ten, if she believes 
 that the price is a bargain, a bargain, that is, compared with the 
 price that is likely to be charged her for the next order. 
 
 This would be of no consequence, so far as the cyclical tendency 
 is concerned, if all these judgments of the trend of price were formed 
 independently, for some would overbuy when others were underbuying. 
 The net result would be a fairly steady rate of buying if the number 
 of buyers was large, or an unpredictable irregularity if the number was 
 small. But the judgments are not formed independently. They are 
 all formed, in large part, on the basis of the same evidence, and of that 
 evidence the most influential part is the trend of prices in the recent 
 past. Whatever prices have been doing is accepted by a great many 
 as the most likely thing for them to continue to do, so that the higher 
 they go the more the tendency to speculative buying, and the lower 
 they go the more the tendency to use up stocks and buy from hand 
 to mouth. 1 
 
 1 Cf. Selden, “Trade Cycles and the Instinct of Anticipation,” Quarterly 
 Journal of Economics , XVI, 293-310. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 75 
 
 The effect of this tendency to mass movements of buying and 
 selling is greatly to accentuate the effect of the producers’ uncertainty 
 concerning one another’s plans, to which reference was made in an 
 earlier section of this chapter. For an increase in middlemen’s stocks 
 gives the producers twice a false index of the amount of production 
 which is economically justifiable. When the increase in buying takes 
 place it swells the volume of orders and creates a false appearance of 
 expansion in the market, and whenever the excess stock is utilized it 
 again gives a false indication, this time of contraction in the market. 
 
 The two tendencies, it will be noted, are of fundamentally similar 
 character. Producers cannot know the future conditions of supply 
 accurately if they operate in ignorance of each other’s actions; hence 
 the tendency is for all to act on much the same information and for 
 their action to overshoot its intended effect alternately in opposite 
 directions. Middlemen, speculators, consumers, likewise operate to 
 a large extent in ignorance of one another’s intentions and are likewise 
 apt to act simultaneously on the same information, giving rise to 
 alternations of abnormally large and abnormally small demand and 
 increasing the extent of the uncertainty in the minds of producers. 
 
 In the following selections, two writers give illustrations of the 
 working of the tendency to rhythm in widely different fields of 
 production. 
 
 THE CYCLE IN PRODUCTION OF BASIC CAPITAL GOODS 
 
 Let us suppose that for any reason the exchange value of the products 
 of any trade has risen. There will then be an inducement to increased 
 investment in that trade. But the new instruments ordered will not be 
 immediately ready for use: meanwhile the high level of price will continue, 
 and since each producer (in a competitive regime) is ignorant of the prepara¬ 
 tions which are being made by his rivals to meet the high level of prices, 
 the total amount of new instruments prepared will be so great that the 
 
 price of the product eventually falls below its old level.The first 
 
 drop in prices will occur as soon as the first batch of new instruments is 
 brought into use: the longer therefore this period of gestation, the longer 
 will the period of high prices continue, the greater will be the over¬ 
 investment, and the more severe the subsequent depression. 
 
 For instance, the price of coal tends to reach both its maxima and 
 minima later than that of pig-iron. While there are other causes for this, 
 part of the explanation seems to lie in the longer period of gestation necessary 
 in the coal trade. According to Mr. Hull it takes “practically a year” in 
 America to build a new blast furnace. From an English ironmaster I 
 gather the impression that in this country some fifteen months would be 
 
76 
 
 RISK AND RISK-BEARING 
 
 required. But a coal mine which is begun to be sunk now will not be in 
 working order for several years. 1 
 
 THE CYCLE IN AGRICULTURAL PRODUCTION 
 
 Man is so constituted that he is too likely to think that present condi¬ 
 tions are to continue. If we have a wet year or two, we think that it will 
 always be wet; if good prices, these are to remain forever. In the case of 
 prices, it is the very feeling of certainty that present conditions are to 
 continue that makes it impossible for them to do so. One of the most 
 important gifts for man to cultivate is his ability to forecast the future. 
 This ability is one of the most valuable business assets. 
 
 The usual guide that is followed in determining what crops and animals 
 to produce is the profits of the last year or two, but since prices may be 
 temporarily high or low, longer periods should be considered. Many 
 factors are involved. The yields in the community may be good in a year 
 of poor crops, or the community may have poor crops in a year of general 
 overproduction and low prices. Add to these uncertainties the fact that 
 the weather has nearly as much to do with the total crop as the acreage, 
 and it is no wonder that the farmer finds it difficult to tell what acreage to 
 plant. With the annual crops, the acreage is kept fairly close to the coun¬ 
 try’s needs. The longer the time required to grow a product, the worse 
 the periods of over- and underproduction become. A shortage of an annual 
 crop may be made up in a year, but it takes ten to twenty years to adjust 
 the area of apples and fifty to a hundred years to grow a lumber crop to 
 supply a shortage in lumber. 
 
 Apples in the Northeastern States are a good crop with which to illus¬ 
 trate this point. If the supply of apples is short, prices will be high. If 
 this condition continues for a few years, planting will be encouraged, but 
 the trees planted will have no effect on the next year’s crop. Prices may go 
 still higher and so stimulate more planting. This condition may continue 
 for twenty years, after which comes the deluge of apples, with more trees 
 coming on every year. This is what happened during the past generation. 
 Apples paid well from 1854 to 1864. From 1864 to 1874 prices were very 
 high. They continued fairly good till 1878. They then dropped and 
 continued to drop till 1896, when thousands of bushels were not picked. 
 Since 1896, prices have been rising, and for the last few years they are again 
 so high that people are becoming wild about them. 
 
 Nearly all the bearing apple orchards in New York were planted between 
 1855 and 1878; planting then practically stopped. It has been much over¬ 
 done. In the early nineties some orchards were cut down. 
 
 In one township in Monroe County, New York, which is in the center 
 of the apple belt, 57 per cent of the apple trees were planted from 1859 to 
 
 1 D. II. Robertson, A Study of Industrial Production , pp. 13-14. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 77 
 
 1878; only 11 per cent were planted from 1879 to 1903; while 21 per cent 
 were planted from 1904 to 1908. 
 
 From the figures thus far available, it appears that the periods of over- 
 and underproduction of apples last about twenty to twenty-five years, as 
 it takes this time to get enough trees raised to bearing age to cause overpro¬ 
 duction, and about another equal period of little planting before prices rise 
 high enough to stimulate another planting wave. It would appear to 
 be the part of wisdom for a farmer to start planting or buying orchards 
 about the middle of the low-price period when everyone is discouraged, 
 and to stop planting at the time when prices are so high that everyone is 
 planting. Some farmers do follow this practice. The farmer who planted 
 in the eighties has already been rewarded. 
 
 Hogs usually rise in price for two to three years and then drop for two 
 to three years. A very abnormal corn crop shifts the hog curve. Since 
 1866 the curve has been very regular until 1901, when the very short corn 
 crop checked hog production, so that the drop in hog prices did not come 
 until two years later. It takes about two to three years of low prices to 
 check hog production and get rid of the extra pigs that are coming on, and 
 about two to three years to get production started and the pigs raised to 
 marketable age so as to again cause overproduction. If a farmer in the 
 corn-belt changes his production on account of prices, it would appear to 
 be good policy to raise a considerable number of pigs in the second or third 
 year of low prices, and to be cautious about the number raised in the second 
 and third years of high prices. When the majority are disgusted with the 
 business is a good time to buy; when the majority are declaring that prices 
 will never again be low is a good time to sell. 
 
 Prices of horses show the same cycle, but it takes a long time to grow 
 enough colts to overstock the market, apparently eight to ten years. Those 
 who were first to start raising colts after the ruinous prices of 1896 made a 
 good profit. When the price of horses drops very low, it would appear to 
 be the part of wisdom to sell all the old horses and buy young ones that will 
 still be living when prices rise. 1 
 
 It will be noted that the fundamental reasons given by Warren 
 for the fluctuation of the price of farm products is the same as that 
 given by Robertson for the fluctuation of volume of the production of 
 coal. In each case, the essential thing is the point to which reference 
 was made above—the impossibility of eliminating the uncertainty 
 which arises under conditions of competition, from one competitor’s 
 ignorance of what other competitors are going to do. As Warren 
 notes, “It would appear to be good policy to raise a considerable 
 number of pigs in the second or third year of low prices” and “ to start 
 
 1 G. F. Warren, Farm Management, pp. 83-90. Copyrighted, The Macmillan 
 Company. Reprinted by permission. 
 
78 
 
 RISK AND RISK-BEARING 
 
 planting or buying orchards when everyone is discouraged.” This is 
 very good advice for the individual farmer, but it does not solve the 
 social difficulty, for if everybody starts planting when everybody is 
 discouraged, it is evident that nobody is really discouraged, and the 
 result of a universally efficient attempt to concentrate production in 
 the second or third year of low prices would be to insure a still further 
 descent of prices. For the present it does not appear likely that such 
 advice will be so universally accepted as to make its acceptance 
 disastrous, but it is easy to see that the efficiency of such instruction 
 depends on its own inefficiency. The problem is very much like that 
 of spreading the Christmas trade. To induce people to do their 
 Christmas shopping early is to confer a mutual benefit on the shoppers, 
 the clerks, and the retailers, but if a prophet should arise to preach 
 the gospel of early shopping with such fervor that everybody tried to 
 do his Christmas shopping in the first week of November, the results 
 would be disastrous. The prophet’s social value depends on the 
 limitations of his own prophetic efficiency. 
 
 In the case of the agricultural operations discussed by Warren, 
 the cycle is a special cycle in the individual industry. In any line of 
 competitive production where there is a large time element involved 
 in the adjustment of the rate of production, this cyclical tendency 
 shows itself. With regard to a large class of commodities, however, 
 the conditions of production in one field have a direct bearing on the 
 prosperity of producers in another field, so that the tendency is for 
 the ups and downs of many of our most important branches of produc¬ 
 tion to run together, giving rise to the phenomenon known as the busi¬ 
 ness cycle. Transportation, manufacture of steel and copper, and of 
 building materials, the production of luxuries for laborers’ consump¬ 
 tion, the fuel industries, all are bound up very closely with one another. 
 Financial institutions, such as banks, brokerage houses, and insurance 
 companies find their prosperity directly dependent upon the activity 
 of business in other important lines. In fact, outside the field of 
 agriculture, a superficial examination of the facts leads to the con¬ 
 clusion that prosperity and depression are phenomena characteristic 
 of the entire business community rather than of individual trades. 
 And even in agriculture, some influence of the business cycle is clearly 
 to be seen, though it is often overshadowed by the influence of other 
 conditions. There are however numerous industries which are almost 
 immune from the cyclical tendency. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 79 
 
 The following selection furnishes a more detailed analysis of the 
 operation of the tendency to rhythm in the errors made both by 
 producers of basic goods and by middlemen in the accumulation and 
 liquidation of stocks: 
 
 Every producer of things to be sold to producers has two demands to 
 meet. He must maintain the industrial equipment already in use and the 
 stocks of materials and goods on their way to the final consumer, and he 
 must also furnish any new equipment that is wanted for new construction, 
 enlargements, or betterments, and any increase in the stocks of materials 
 and unsold goods. Both these demands come ultimately from the consumer, 
 but they follow different laws. The demand for maintenance and replace¬ 
 ment of existing capital varies wdth the amount of the demand for finished 
 products, while the demand for new construction or enlargement of stocks 
 depends upon whether or not the sales of the finished product are growing. 
 Normally, over a long period of years, there is a certain demand for new 
 construction on which producers can rely, and hence the demand for new 
 construction is a normal part of any demand schedule for this kind of goods. 
 But it does not come regularly. 
 
 The demand for a certain product, let us say, begins to increase steadily, 
 each year seeing an increment equal to io per cent of the original demand. 
 At the end of five years the increase stops and the demand remains station¬ 
 ary. If the productive equipment has kept pace with the need, it is now 
 enlarged by 50 per cent and calls for 50 per cent more expenditure for 
 maintenance and replacements. Meanwhile there has been an added de¬ 
 mand for new construction equal in five years to half the entire original equip¬ 
 ment. If renewals are at the rate of 5 per cent a year, the first effect of an 
 increase in demand at the rate of 10 per cent in a year is to treble the de¬ 
 mand for the means of production, since a demand for new construction has 
 arisen twice as large as the previous demand for maintenance. 
 
 What happens at the end of the five years when the demand stops 
 growing ? By this time the requirements for maintenance are 50 per cent 
 greater than they were while new construction has been going on at a rate 
 equal to twice the original maintenance account. The total output has 
 grown to three and one-half times its former volume. But the demand for 
 new construction now ceases abruptly. This means that if the producers 
 engaged in construction work had enough capacity to meet the demand 
 of the fifth year the sixth year would see them running with four-sevenths 
 of their capacity idle. 
 
 Thus the law of demand for intermediate products states that the 
 demand depends not only on the demand for the final product, but on the 
 manner in which that demand is fluctuating. Making all due allowances 
 for mitigating factors in translating the illustration back into real life, it is 
 
8o 
 
 RISK AND RISK-BEARING 
 
 still difficult to see how the building and machine-making industries can 
 possibly avoid the disagreeable experience of outgrowing themselves in 
 time of prosperity. For demand can never be expected to grow at an 
 absolutely steady rate, and the slightest fluctuation seems destined to put 
 the producer of capital goods in a situation comparable to that of a passenger 
 forcibly carried by his station. 
 
 This principle may be illustrated by a town which grows rapidly up to 
 the size at which its industrial advantages are fully utilized and beyond 
 which its normal production can expand but slowly. When the point of 
 transition is reached from rapid to slow expansion, the town may find 
 that it has outgrown itself by the number of people engaged in the extra 
 construction work involved in the process of growing. Houses to take them 
 in, stores to feed and clothe them, trucks to haul the materials they work 
 with, offices, etc., all will be demanded, and thus a boom may be created 
 which is none the less temporary for being based on tangible economic needs. 
 
 The chief reasons for keeping a stock are, first, to give the customer a 
 wide selection of goods which he can actually inspect and, secondly, to give 
 assurance of being able to fill large orders without delay. What is the 
 effect of expanding demand on the amount of stock needed to fulfil these 
 functions? Obviously, the larger the orders, the greater the danger of 
 being sold out, unless the stock is increased in a corresponding proportion, 
 or something not too far short of it. The increase in demand would not 
 seem to make it necessary to keep any wider range of goods in stock. But 
 if we are thinking, not of what is necessary, but of what is profitable, we 
 have a different situation. Some goods which were just below the line of 
 toleration will become profitable to handle on the basis of the increased 
 rate at which they can be sold, and the natural result is the carrying of a 
 greater variety of goods as well as the more goods of each kind. 
 
 If the dealer is in doubt whether or not to keep a certain line in stock 
 at all, a brisk state of demand will be likely to decide him to keep it. 
 
 One other fact which may make merchants more willing to invest in 
 considerable stocks is that a time of growing demand for some one com¬ 
 modity, or a time of general increase in activity, are both times of rising 
 prices for the intermediate products called for in the business affected. 
 This makes these commodities a profitable investment so long as credit can 
 be had on easy terms with which to enlarge one’s holdings. 
 
 Taking all these things into consideration, one is justified in conclud¬ 
 ing that an increase in demand naturally tends toward an increased invest¬ 
 ment in dealers’ stocks, which is, if anything, more than in proportion to 
 the increase in sales, unless limited by: (i) difficulty in getting added credit 
 to carry the extra “working capital,” (2) an extremely sharp rise in supply 
 prices, (3) the fear that the prosperity is temporary, or (4) the inability of 
 manufacturers to make deliveries. 
 
UNCERTAINTY AND THE BUSINESS CYCLE 
 
 81 
 
 So far we have considered only one big division of the process. If we 
 imagine the effect of all this on those industries which produce the tools 
 and machinery used in the construction industry itself, we have a further 
 possibility of multiplying the effects of a change in demand. In fact, the 
 possibilities multiply with every step backward, for every industry which 
 produces the means of production for some other industry has its own 
 demand for its own tools and machinery to be filled. These possibilities 
 of intensification are soon mitigated, however, by the fact that as we get 
 farther and farther back we reach industries which produce machinery and 
 tools for a large number of other industries at once, so that they register the 
 effect of the average of a great many changes in a great many particular 
 lines of production. Thus we finally reach the steel industry, which pro¬ 
 duces the chief of all the raw materials used in making capital goods. This 
 industry is so large that a change in the demand for any comparatively 
 unimportant product, however much it may be intensified in the way we 
 have just studied, has no appreciable effect on the great mass of steel pro¬ 
 duction of the country. Only the largest industries buy enough steel to 
 have a decided effect on the demand for this basic material. Railroading, 
 which itself is to a very large extent engaged in the production of inter¬ 
 mediate products, furnishes the steel industry with an outlet for its products 
 which is so large as to be quite decisive and at the same time so fluctuating 
 as to be a constant barometer of prosperity or of depression. And the steel 
 industry itself is an equally important barometer, reporting in intensified 
 form all general movements which originate with businesses closer to the 
 final sale of the product. 
 
 In summary, the main principles contended for are as follows: 
 
 1. The demand for enlarging the means of production (including stocks 
 of finished goods on the way to the consumer) varies, not with the volume 
 of the demand for the finished product, but rather with the acceleration of 
 that demand, allowance being made for the fact that the equipment cannot 
 be adjusted as rapidly as demand changes, and so may be unusually scarce 
 or redundant to start with in any given period. The demand for equip¬ 
 ment may decrease as a result of this law even though the demand for the 
 finished product is still growing. 
 
 2. The total demand for producers’ goods tends to vary more sharply 
 than the demand for finished products, the intensification being in propor¬ 
 tion to the average life of the goods in question. 
 
 3. The maximum and minimum points in the demand for producers’ 
 goods tend to precede the maximum and minimum points in the demand 
 for the finished products, the effect being that the change may appear to 
 precede its own cause. 1 
 
 1 Adapted by permission from J. M. Clark, “Business Acceleration and the 
 Law of Demand,” Journal of Political Economy, XXV (March, 1917), 217-35. 
 
82 
 
 RISK AND RISK-BEARING 
 
 
 The principles explained in the preceding pages seem to be the 
 basic causes of the business cycle; basic in the sense that they are 
 adequate to account for a cycle without the presence of other factors, 
 such as a particular monetary, credit, or profit-making system, to 
 co-operate with them. On the other hand, given a cycle of production 
 caused by the operation of the factor of uncertainty in the way just 
 outlined, fluctuations in the level of profits, in the rates of interest, 
 and in the stock of money must inevitably follow, and must in turn 
 profoundly modify the problem of managing production. As was 
 indicated in the earlier portions of this chapter, credit operates to 
 exaggerate the violence of liquidation, or to check it, according as the 
 principal creditors are well or ill organized. High prices, lagging 
 wages, and lagging interest rates increase the level of profits and stimu¬ 
 late further increases in productive activity. But it is easy to exag¬ 
 gerate the influence of profit margins. Business men are willing to 
 operate on a narrow margin of profit if the margin is sure, or reasonably 
 probable, and an increased volume of orders, whether due to specula¬ 
 tive accumulation or to pressure of actual consumers’ demand, even 
 when the level of costs and prices is such as to make profits narrow 
 and uncertain, operates to stimulate a quick expansion of output. 
 Profit margins seem to result from, rather than to cause, the major 
 changes in business activity. 
 
 We may summarize the conclusions of this chapter as follows: 
 The cycle is not merely a phenomenon of finance. The conditions of 
 uncertainty under which production is carried on at the present time 
 tend to create a rhythm of over- and underproduction in the case of 
 many important industries. The fluctuation is more violent in the 
 case of producers’ goods, because the cycle itself creates fluctuations 
 in the demand for them which accentuate the fluctuations due to the 
 alternate over- and underestimates of probable supply. The character 
 of the cycle varies widely from one industry to another. Its character 
 is influenced chiefly by the following considerations: 
 
 1. The length of time required to adjust the rate of production to 
 the state of demand. When production requires little antecedent 
 preparation the cyclical tendency is at a minimum. 
 
 2. The extent to which production is governed by factors outside the 
 control of managers. 
 
 3. The number of independent producers. In general, the larger 
 the number of competing producers, the greater the difficulty in getting 
 
UNCERTAINTY AND THE BUSINESS CYCLE 83 
 
 information which will prevent the maladjustments which result in a 
 cycle. 
 
 4. The extent to which it is possible to store up the product for future 
 needs . The more readily the product is accumulated, the greater the 
 tendency to variation in the demand. 
 
 5. The extent to which the particular line of production is independent 
 of other lines in its activity . 
 
 QUESTIONS 
 
 1. Describe the conditions prevailing in a typical period of prosperity; of 
 depression. 
 
 2. Analyze the current business situation with a view to determining (a) 
 what is the present phase of the cycle; ( b ) to what extent the present 
 situation corresponds to that described as typical of this stage. 
 
 3. What is meant by liquidation of credits? liquidation of inventories? 
 Are the two processes sufficiently similar to justify our calling them by 
 the same name ? 
 
 4. Is liquidation of one of these two types (question 3) likely to cause 
 liquidation of the other type ? Is the process more likely to proceed in 
 one direction than in the other ? 
 
 5. In heating a house by the use of an oil burner controlled by a 
 thermostat, alternations of overheating and underheating occur, which 
 are more marked if a hot-water heating system is used than with a hot-air 
 system. Show how this difference illustrates a tendency operative in 
 causing greater cyclical fluctuations in some types of business activity 
 than in others. 
 
 6. How do the following factors determine the extent to which a given line 
 of business is affected by the cyclical tendency ? (a) the extent to which 
 production is governed by factors outside the control of managers; (b) 
 the extent to which the particular line is independent of other lines ? 
 
 7. Which class of commodities have the more violent fluctuations in price, 
 perishables or durable commodities? (Consider, first, fluctuations in 
 price connected with tbe business cycle, and second, fluctuations due to 
 maladjustments in the industry itself, due to non-cyclical causes.) 
 
CHAPTER VI 
 
 BUSINESS FORECASTING 
 
 Broadly interpreted, the term “business forecasting” might 
 include practically the whole range of activities which aim at the 
 elimination of business risk by the reduction of uncertainty. As 
 was indicated in chapter iii, the range of methods used in business 
 research is so great, and the problems are so much a part of the tech¬ 
 nique of individual lines of business, that it is not practicable in a 
 general work of this character to examine them in detail. One phase 
 of the development of business research, however, touches so wide 
 a range of enterprises and promises to be of so great importance for 
 business in general that it may properly be given fairly detailed con¬ 
 sideration. This is the technique of forecasting the coming and going 
 of prosperity and depression, which is generally referred to as “busi¬ 
 ness forecasting” in the narrower and more specific use of the term. 
 The present chapter deals with forecasting in this narrower sense. 
 
 During the last ten years there has been a great increase of interest 
 in the problem of predicting the course of the business cycle, partly 
 because the changes in business activity and in the level of prices have 
 been of unusual magnitude and suddenness, and partly because the 
 advance of economic science has made it possible to speak with more 
 confidence concerning the main outlines of a technique of forecasting. 
 The pioneers in the development of business forecasting were the com¬ 
 mercial business service agencies, particularly the Babson Statistical 
 Service and the Brookmire Economic Service. Within the past ten 
 years, the problem has been attacked vigorously by academic students, 
 notably by Professor Wesley C. Mitchell in his study of Business 
 Cycles , more recently through detailed statistical studies by Professor 
 Warren M. Persons and by the staff of the Harvard Economic Service. 
 Commercial barometers, moreover, have multiplied, and financial and 
 business periodicals have come to devote much space to analyses of 
 the trend of business activity. 
 
 Complete analysis of the causes which are making for change in the 
 business situation would be by far the most satisfactory method of fore¬ 
 casting if it were practicable. —Such an analysis, however, is wholly 
 impossible. By this is meant not merely that a mathematically com- 
 
 84 
 
BUSINESS FORECASTING 
 
 85 
 
 plete and exhaustive survey of all the facts necessary to such an analy¬ 
 sis is impossible, but that even such an approximation as will serve 
 the practical needs of business involves difficulties so great that at 
 no time will the conclusions of competent students arrived at inde¬ 
 pendently in this way be unlikely to be in substantial disagreement. 
 Such an analysis would require a survey of the extent of existing stocks 
 of goods held by producers, by middlemen, and by consumers, of the 
 rates at which production and consumption were adding to, or sub¬ 
 tracting from, these stocks, and of the ideas men held as to the desira¬ 
 bility of increasing or decreasing these stocks or changing these 
 rates of consumption and production. It would require also a more 
 accurate knowledge than anyone can hope to attain of the future 
 course of politics and of legislation, of the future of the weather and 
 the consequent yield of leading crops, of the elasticity of consumers’ 
 demand, of the tendency of fashions and changes in tastes, and of 
 other factors so numerous and so elusive as to defy accumulation 
 and comparison of the necessary data. 
 
 A limited number of items may serve as an acceptable index of the 
 general situation. —The overwhelming difficulties in the way of col¬ 
 lecting the data necessary for a complete analysis of the business 
 outlook at any given time may be overcome to a large extent by using 
 the device known to statisticians as sampling. A limited number of 
 items are chosen for careful study, and the remaining evidence is 
 ignored on the theory that if the items chosen for study are really 
 representative and are fairly numerous, no serious error is likely to 
 result from treating the sample as though it were the whole body of 
 evidence. This sample may be selected in either of two ways. The 
 attempt may be made to pick out the most important causes of busi¬ 
 ness changes, such as changes in crops, contraction and expansion 
 of available supplies of credit, and taxation, keep close watch of them, 
 and ignore the rest. Or, the course of past cycles may be studied to 
 determine what statistical data have most faithfully reflected or pre¬ 
 dicted the course of prosperity and depression in the past, and a num¬ 
 ber of these items may be followed, the assumption being that the 
 regularities which have shown themselves in the past may be expected 
 to continue in the future, and that the use of a considerable number of 
 indices will protect the observer against the danger of being misled 
 by an accidental irregularity in the behavior of the items under con¬ 
 sideration. 
 
 Thus in the attempt to develop a technique for forecasting the 
 course of the business cycle, two methods have suggested themselves, 
 
86 
 
 RISK AND RISK-BEARING 
 
 each of which is advocated in preference to the other by a consider¬ 
 able number of students of business. These methods may be desig¬ 
 nated as the method of economic analysis and the method of statistical 
 comparisons. The method of economic analysis seeks to forecast the 
 course of the cycle in exactly the same way that students of the social 
 sciences generally try to forecast the course of events which are not 
 cyclical in character. This method is simply to identify the forces 
 which are making for contraction and those which are making for 
 expansion in business, weigh the one set of factors against the other, 
 and predict the course of events in the light of the relative strength 
 of these opposing factors. No special attention to the cyclical char¬ 
 acter of the fluctuations in business activity is involved, except that 
 the forces engendered by any given stage of prosperity which make 
 for change are recognized along with other factors which originate 
 elsewhere. This method emphasizes the factors which differentiate 
 every situation from those which have preceded it. 
 
 The other method consists of a statistical study of the records of 
 past cycles in the hope of establishing laws by which the course of a 
 given cycle can be predicted by observing its progress and assuming 
 that it will proceed as cycles have proceeded in the past. Advocates 
 of this method urge that the regularities observed in the behavior 
 of certain types of data are so great as to justify forecasters in assum¬ 
 ing that these regularities will continue to show themselves in the 
 future. 
 
 Fundamentally, this is the method of all statistical science; the 
 question of its validity in connection with this particular problem 
 hinges on the degree of regularity in the behavior of the items studied, 
 the length of time, or better, the number of complete cycles, through 
 which the asserted regularity of behavior has been traced, the absence 
 of known causes which may reasonably be expected to alter the 
 sequence of phenomena in the future, and the availability and accu¬ 
 racy of the necessary data. In the following sections, the leading 
 barometric items are described, and their value for forecasting pur¬ 
 poses is estimated. 
 
 Fluctuations in prices are generally considered to constitute the central 
 phenomenon of the business cycle . 1 —Interest centers therefore on 
 
 * For a survey of the literature of the cycle in which this point is developed in 
 detail, cf. J H. Williams, “The Rdle of Prices in the Business Cycle,” Review of 
 
 Economic Statistics , I, 206-10. 
 
BUSINESS FORECASTING 
 
 87 
 
 attempts to forecast the course of prices rather than to use them to 
 forecast other phenomena. Indices constructed by averaging large 
 numbers of prices, however, have few irregular fluctuations, hence 
 a definite change of trend usually is interpreted to forecast a consider¬ 
 able continued movement in the new direction. Prices may therefore 
 be said without great inaccuracy to forecast their own movements. 
 
 To show the trend of prices, averages known as index numbers 
 are compiled. Of these, the most widely used are Bradstreet’s and 
 the Bureau of Labor Statistics’ indices. Bradstreet’s index is obtained 
 by simply adding together the prices per pound of ninety-six commodi¬ 
 ties. This index is published monthly. The Bureau of Labor 
 Statistics’ index is a carefully weighted average of over four hundred 
 prices, each of which has been reduced to a percentage of the average 
 price of the commodity for 1913. The Bureau of Labor index is 
 much the more scientifically constructed of the two, but the difference 
 in results obtained is not as great as the difference in methods of 
 compilation would lead one to expect. Bradstreet’s index tends to 
 precede the Bureau of Labor index in both its upward and its down¬ 
 ward turns, because it contains a larger proportion of prices of raw 
 materials. For this reason, it is somewhat more useful as a barometer 
 of general business conditions. 
 
 The volume of business done by the railways is a good barometer of 
 general business conditions , though it tends rather to lag behind other 
 indicators than to precede them. The figures generally used are those 
 of railway gross earnings, idle cars, and car loadings. Of these, the 
 car loadings are the most accurate and are also the earliest available. 
 Unfortunately they are only available for the last few years. 
 
 Gross earnings are a good indication of the amount of business done, 
 provided care is taken not to overlook the effects of changes in freight 
 rates. For example, the very great increase in railway gross income 
 in the early fall of 1920 was due to the increase in rates and not to 
 any increase in the movement of goods, except the normal seasonal 
 increase. 
 
 Railway earnings generally lag a month or two behind the course 
 of general business on a downswing for the reason that goods which 
 have been contracted for and goods which are drawn on the market 
 under pressure to liquidate keep up the movement of freight during, 
 and after, the crisis. After this movement has spent itself, the earn¬ 
 ings fall off sharply. For instance, after the panic of 1907, which 
 occurred in October the earnings of ten leading railroads remained 
 
88 
 
 RISK AND RISK-BEARING 
 
 above normal until December, and were only 7 per cent below normal 
 in January, but by July were 16 per cent below. Again in 1920 the 
 decline of business activity was not reflected in the railroads’ earnings 
 until late in the fall, though prices reached their maximum in the 
 spring. 
 
 Figures for net earnings of railroads receive a great deal of atten¬ 
 tion, partly because increasing prosperity of railroads is apt to result 
 in increased purchases of equipment and construction materials, and 
 the volume of the railroads purchases is so great that anything which 
 stimulates or depresses their buying is a major cause of prosperity 
 or depression in any other lines. Another reason for the interest in 
 railroad net earnings is the extremely wide investment interests in 
 their securities, and still another is the fact that changes in freight 
 rates are forecast by the movement of railroad net earnings. Under 
 the present law, it is the duty of the Interstate Commerce Commission 
 to allow the railroads to collect such rates as will yield them a fair 
 return (at present figured at 5^ per cent) on the appraised value of 
 their investment; hence a large increase in railroad net earnings 
 creates hope of lower rates, and a decline in them dampens that hope. 
 
 Idle car figures are not very accurate, as the number of roads report¬ 
 ing varies and the figures are affected by activity in car-building and 
 repairing cars, as well as by changes in the number actually used. 
 In spite of these theoretical defects, the figures usually show much the 
 same thing as the other transportation data, and no great risk is 
 involved in using them if they happen to be more readily available 
 than the more accurate indices. 
 
 Industrial corporation reports furnish little barometric assistance .— 
 If accurate data were available at any time concerning the volume 
 of business and the profit margins at which the leading business cor¬ 
 porations o'f the country are doing business, the information would be 
 of incalculable value in gauging the outlook for good or bad business. 
 A clearing-house for the free exchange of such information with 
 power to compel full and accurate statements would be of very great 
 service to its members. The impossibility of securing such an inter¬ 
 change illustrates one of the disadvantages of a competitive system. 
 Each firm has something to lose by imparting a full knowledge of its 
 condition to its competitors, for even though it might gain much more 
 than it would lose if it obtained full knowledge of their condition in 
 the exchange, each would gain still more by securing the information 
 from the others without making public the true facts concerning its 
 
BUSINESS FORECASTING 
 
 89 
 
 own condition, thus securing the benefit of the general publicity while 
 protecting its own business secrets. This being the case, no firm is 
 willing to be the first to abandon its policy of protecting business 
 secrets and each would be suspicious of any other which offered to do 
 so. The result is that business is done largely in ignorance of the 
 extent to which competitors are piling up stocks of goods in anticipa¬ 
 tion of the same demand, accepting duplicate orders and planning 
 expansions which conflict with other producers’ calculations of the 
 extent of the market and the supply of labor and raw materials which 
 will be available for themselves. 
 
 A possible way out of the dilemma is the imparting of confidential 
 information to a public or private statistical bureau with the under¬ 
 standing that the results will be published only in the form of totals 
 or averages, or otherwise so treated as not to indicate the position of 
 individual firms. Much progress has been made by various agencies 
 in the last few years in obtaining the co-operation of business men in 
 such endeavors. Examples are the studies of retailers’ costs made by 
 the Harvard Bureau of Business Research; the data on volume of 
 current production and stocks of goods published monthly by the 
 Department of Commerce in the Survey of Current Business; and 
 numerous surveys of particular industries published by trade journals. 
 Open price associations have also done something to reduce the amount 
 of uncertainty concerning the business outlook, but such organiza¬ 
 tions find it diffcult to steer clear of the antitrust laws. Further 
 progress along this line, it is to be hoped, will afford a better means 
 than we now have for reducing the irregularities of business activity. 
 
 Aside from the data given out in this way, the principal information 
 available concerning the prosperity of individual corporations is 
 found in the annual or more frequent reports of income and statements 
 of assets, the reports of business failures, and changes of dividends. 
 To each of these, consideration will be given. 
 
 The reports of industrial corporations concerning their activities 
 are issued so infrequently, and, as a rule, so long after the period to 
 which they refer that they are of little value as indices of the general 
 business situation, though they are very valuable as records of the 
 course which prosperity and depression have taken in the past. Even 
 in the case of corporations which issue quarterly statements of earn¬ 
 ings, the information is delayed to such an extent that it usually is 
 of value only to investors or speculators who are dealing in the securi¬ 
 ties of the individual corporation, and not to the student of the general 
 
go 
 
 RISK AND RISK-BEARING 
 
 situation. Moreover, the reports of corporations are so apt to be 
 colored by the interest of the management in making a showing of 
 prosperity or of poverty that they must be used with caution. 
 
 The foregoing generalizations have no application to the railroads. 
 Railway earnings are published monthly, and uniform accounting 
 methods are prescribed by the Interstate Commerce Commission so 
 that the results for different roads and for different periods are com¬ 
 parable. 
 
 Dividend payments are even less reliable than statements of net earn¬ 
 ings as indications of business conditions , because changes in dividends 
 lag far behind the changes in business conditions which cause them. 
 This is particularly true of the relation of dividend increases to busi¬ 
 ness recovery. Reduction or passing of dividends follows more 
 promptly on a collapse of prosperity, but so far as the general situa¬ 
 tion is concerned it tells only what is already known. Investors are 
 of course very directly interested in the passing of dividends by corpora¬ 
 tions whose securities they own, but the action of one company is of 
 little value as a forecast of what another company will do. 
 
 Numerous increases of dividend rates and the declaration of extra 
 dividends are often considered to be a sign of better days ahead, 
 but such an interpretation is more likely than not to be incorrect. 
 When business is increasing relatively few concerns find it good policy 
 to make extra large disbursements. Rather they reinvest their earn¬ 
 ings to provide facilities for taking care of their expanding volume of 
 business. It is at the end of a period of prosperity when large profits 
 have been accumulated and there is no prospect of their being needed 
 for further expansion that good policy permits the declaration of 
 abnormally large dividends. 
 
 Moreover, the dividend policies of corporations seem frequently 
 to be regulated with a view to promoting the interest of insiders in 
 stock-market dealings, and extra dividends in the closing days of 
 prosperity are an excellent device for strengthening the market until 
 stocks can be distributed. 
 
 Business failures area useful barometer. —Monthly figures for com¬ 
 mercial failures are published by Dun's Review and Bradstreet's, and 
 these are quite widely reprinted. These are failures involving losses 
 to creditors. There are no statistics of industrial failures and none 
 for failures which result only in the loss of the owners’ capital. The 
 figures, both those for number of failures and those for total liabilities, 
 show a high degree of correspondence with the activity of general 
 
BUSINESS FORECASTING 
 
 91 
 
 business. Failures, which are at a minimum in the latest stages of 
 prosperity, increase very suddenly, reach the maximum while liquida¬ 
 tion is at its height, then decrease gradually through the following 
 periods of depression, recovery, and prosperity. Since 1890 the pro¬ 
 portion of concerns failing has ranged from .38 of 1 per cent in 1919 
 to 1.32 in 1915. 1 
 
 Bradstreet’s classifies its data according to the causes of failure, 
 such as incompetence, lack of capital, competition, etc., giving annu¬ 
 ally the percentage which is accounted for by each cause. The classi¬ 
 fication has no apparent value for barometric purposes; indeed, it is 
 so vague that most failures could properly be classified under two or 
 more captions. There is a pronounced seasonal variation in the 
 statistics, January having by far the most failures, and December 
 ranking second. 
 
 Business failures form a convenient and readily accessible indica¬ 
 tion of the degree of prosperity. Their chief defect as a forecaster 
 is that their increase comes abruptly at a time when liquidation is 
 already obvious, while their decreases are so gradual that it is difficult 
 to judge when the number is approaching a minimum. 
 
 New security issues show some effect of the business cycle , but are of 
 no particular interest as barometers. —In times of prosperity, stock 
 issues predominate. In the earlier part of a depression, there are 
 numerous bond issues designed to enable the issuers to pay off their 
 bank loans. Many of these bond issues are of a highly speculative 
 character. Later in the depression period, high-grade bond issues 
 are brought out by strong corporations in order to refund short-term 
 notes and callable bonds at the low rates then prevailing. These 
 changes, however, merely reflect the changes in the rate of interest 
 and in public confidence, and nothing is added to our understanding 
 of the current situation by tabulating them for study. 
 
 Statistics of the iron and steel trade are given a great deal of attention 
 by students of the trend of business. —This is true because of the extent 
 to which activity in the production of iron and steel is essential to 
 activity in the production of almost everything else. Building of 
 every kind, the construction of railways and of railway equipment, 
 the manufacture of agricultural implements and of nearly all kinds 
 of machinery, all make heavy demands on the steel capacity of the 
 country, so that a marked increase or decrease in the activity of almost 
 any industry is reflected in the orders for iron and steel. 
 
 1 Dun's Review, XXIX, 18-19, quoted by Jordan, Business Forecasting, p. 159. 
 
92 
 
 RISK AND RISK-BEARING 
 
 For recent years, statistics of this industry are available in great 
 variety, but those to which most attention is given are the figures 
 for the production and price of pig iron and the unfilled orders of the 
 United States Steel Corporation. Of these, the most useful are the 
 figures for pig-iron production. Pig-iron production conforms quite 
 closely in its fluctuations to the movement of the business cycle as 
 indicated by other barometers. Normally, its fluctuations are con¬ 
 current with, or slightly in advance of, the major changes in prices. 
 In the cycle of 1919-21, however, pig iron lagged far behind the course 
 of general business, reaching a minimum in the autumn of 1919 and 
 a maximum in the autumn of 1920, some eight months after Brad- 
 street’s index in each case. This irregularity, at least so far as the 
 low figure for 1919 is concerned, is to be accounted for by the strike 
 in the plants of the United States Steel Corporation. 
 
 Pig-iron prices move in fairly close conformity with the fluctua¬ 
 tions in business, but they are so largely subject to control in accord¬ 
 ance with the judgment of a few individuals that they are less trust¬ 
 worthy as business indices than are production figures. 
 
 The unfilled orders of the United States Steel Corporation, pub¬ 
 lished quarterly from 1901 to 1910 and monthly since that date, move 
 in close conformity to the changes in the production of pig iron, 
 normally, however, changing a trifle earlier. In theory, orders should 
 be an earlier index of coming changes than production, but the number 
 of unfilled orders is so affected by changes in the rate of production, 
 quite apart from changes in demand, that the priority of movement 
 is not uniform and the significance of the figures is not always clear. 
 
 Agricultural production gives no clear indication of the business out¬ 
 look .—The influence of agricultural production is perhaps the most 
 difficult factor to analyze in the whole problem of the coming and going 
 of prosperity. The difficulty does not arise, however, from the lack 
 of information, for we have not only excellent statistical data concern¬ 
 ing the volume of output and the prices of leading agricultural prod¬ 
 ucts but also frequent forecasts throughout the crop year, some 
 compiled by private agencies and some by the Federal Department 
 of Agriculture. The difficulty arises from the apparent lack of cor¬ 
 respondence between the actual relations of agricultural production 
 and business prosperity and the relations which economic theory 
 lead us to expect. Nearly all those who have written on the subject 
 of the business cycle have agreed in emphasizing the fundamental 
 importance of crops in determining the prosperity of general business. 
 
BUSINESS FORECASTING 
 
 93 
 
 The generally accepted doctrine has been well summarized, for 
 instance, by J. H. Brookmire: 
 
 Crops affect business: (i) by directly determining the ability of the 
 farmer to buy factory products, his annual purchasing power through 
 crops amounting to about $9,000,000,000; (2) by indirectly determining 
 the amount of merchandise which persons employed in manufacturing and 
 mercantile lines and all other non-agricultural pursuits can purchase, for 
 if they must pay high prices for food there will be less to spend for mer¬ 
 chandise, and vice versa; (3) by determining the earnings of the railroads, 
 for railroad traffic largely consists in hauling farm products or merchandise 
 to be exchanged for farm products, and since the crops largely determine the 
 ability of the railroads to buy new equipment and make improvements, it 
 follows that crops thus indirectly determine the degree of prosperity in 
 the iron and steel business, which is the basic industry of the country. 
 Thus it is evident that activity in transportation, iron and steel, hardware, 
 textiles and all other lines of business finds its stimulative source—its 
 fountain-head—in the agricultural harvests of the country. Prosperity 
 fundamentally depends upon the condition of the soil, and the business men 
 of this country always adjust their commercial commitments to the pros¬ 
 pects of the harvests to a greater extent than to any other one factor. 1 
 
 Mitchell is less emphatic, but says, “good crops tend to bring 
 prosperity and poor crops depression in the seasons which follow. 
 But the numerous exceptions to this rule show that other factors 
 often overbalance the effect of the harvests.” 2 
 
 The theory above outlined seems sound. That abundant agri¬ 
 cultural production is fundamental to the prosperity of the American 
 people can scarcely be questioned, for nearly a third of our employed 
 population are engaged in agriculture and a large proportion of the 
 rest are in business which caters directly to the needs of the farmer. 
 Moreover, more than half of the raw materials used in our manufac- 
 tures are products of the farm. Short crops apparently mean hard¬ 
 ship for the farmer, reduced earnings for the railroad, lighter employ¬ 
 ment for the railroad workers, higher-priced and scarcer raw materials 
 for the manufacturer, and higher costs of living for the people, with¬ 
 out an offsetting gain for anyone. 
 
 And yet it is impossible to find in our business history any con¬ 
 firmation of such a view. Neither as cause nor as effect do the lead- 
 
 1 J. H. Brookmire, “Financial Forecasting,” Moody's Magazine , XVI (1913), 
 19-21. 
 
 2 Business Cycles, p. 239. See also for similar views Jordan, Business Fore¬ 
 casting, p. 80; Jones, Investments, p. 256. 
 
04 
 
 RISK AND RISK-BEARING 
 
 ing crops appear to be related consistently to the fluctuations of busi¬ 
 ness activity. It is true that in 1879 and in 1891 good crops sold at 
 high prices on account of the foreign crop failure proved a direct and 
 unmistakable stimulus to American business. In 1921, moreover, 
 the business depression reacted so unfavorably on the position of the 
 farmer through decrease in agricultural prices as to cause a startling 
 curtailment in farmers’ buying, which in turn struck heavy blows at 
 the prosperity of not only all mail-order houses, implement manu¬ 
 facturers, and fertilizer companies, but of every line of business whose 
 sales territory was in the West or South. But, as a rule, no such con¬ 
 nection between crops and prosperity can be traced. The fluctua¬ 
 tions in the curves of cotton, corn, and wheat production rarely coin¬ 
 cide, and when they do, they do not forecast corresponding changes 
 in general business. Cotton and wheat production were both unusu¬ 
 ally large in 1898, declined greatly in 1899, and recovered in the years 
 immediately following; improvement and prosperity were unbroken 
 from 1897 to 1903. All the major crops declined in volume in 1903, 
 and depression followed in 1904, but they all increased in 1906 to 
 practically the highest figures known up to that time, and though 
 they were somewhat smaller in 1907, were still above normal in that 
 year, yet a severe depression began at the end of 1907. 
 
 The explanation of this lack of harmony between the results of 
 observation and those anticipated from the standpoint of theory is 
 somewhat obscure. It must be remembered however that very large 
 or very small crops of all the leading agricultural commodities seldom 
 occur in- the same year, so that a shortage in cotton is very likely to 
 offset, to a large extent, the effect of a bumper crop of wheat, and 
 vice versa. It must be borne in mind also that the purchasing 
 power of the farmer depends not on the size but on the value of his 
 crop, and that a rise in prices usually offsets part of his loss from a 
 short crop. Indeed sometimes, especially in the case of cotton, the 
 increase in prices more than offsets the loss in production. In 1914, 
 an enormous cotton crop sold at bottom prices caused almost a col¬ 
 lapse of the whole economic structure of the South, while in 1921 a 
 short crop was hailed with delight as promising relief from the prevail¬ 
 ing depression. This does not mean that the loss from short produc¬ 
 tion is less than it would be if prices were not affected by the size of 
 the crop. What the farmer gains by high prices someone else always 
 loses; what he loses by short crops no one else gains. But the high 
 prices do mean that the loss from short crops is in part shifted to for- 
 
BUSINESS FORECASTING 
 
 95 
 
 / 
 
 eign nations, in part diffused among a larger group in this country, and 
 in part distributed into succeeding years through a reduction in the 
 carry over. The loss from higher-priced raw materials is largely ab¬ 
 sorbed in corporation profits without necessitating changes in divi¬ 
 dend rates, or carried into prices of manufactured goods which are 
 not finally sold until later years, and are in part sold abroad. 
 
 The loss to the railroads from crop failure is genuine, but its impor¬ 
 tance is much less than it was a generation ago. No important rail¬ 
 road is now dependent solely on agricultural production for its traffic. 
 Even such a highly specialized grain-carrying road as the Missouri, 
 Kansas, and Texas collects less than one-fourth of its freight revenue 
 from products of the farm. Moreover, such effect as the short crop 
 does have is distributed through several years. Less labor is employed 
 in transportation of crops in the year in which the shortage occurs; 
 equipment purchases are more likely to be reduced in the following 
 year. 
 
 Thus throughout the industrial structure, the influence of several 
 crop years gets averaged, some parts of the country and some lines 
 of business feeling the effect of one year’s short crop while others are 
 feeling the effects of another year’s good crop, and the effect on general 
 business activity of any particular crop becomes so blurred that it is 
 quite hopeless to try to draw any conclusions from the crops as to 
 the outlook for business in general. 
 
 All this is not to say, however, that the crop outlook is of no baro¬ 
 metric significance. It simply means that the crops are among the 
 things which cause one business and one section to prosper while 
 another is depressed, rather than the things which determine the 
 tidal swings of the market as a whole. Each business man has to 
 study not only the outlook for business in general but also the factors 
 which affect peculiarly the lines of business and the locality in which 
 he is interested and make its outlook different from that of business as 
 a whole. In this latter task, a study of the crop outlook is likely to be 
 of primary importance. 
 
 Stock prices have a high reputation as business barometers .—The 
 stock exchanges of the country all publish daily records of the high¬ 
 est and lowest prices paid fo~ each security, together with the number 
 of shares sold, and numerous averages of the prices of selected lists 
 of stocks are published by periodicals and financial services. 
 
 In general, stock prices, particularly prices of industrial stocks, 
 are among the first prices to rise and also the first to fall, in the course 
 
96 
 
 RISK AND RISK-BEARING 
 
 of a business cycle. It is for this reason that so high an estimate 
 is placed upon their barometric significance. For instance, before 
 the crisis of 1907 stock prices showed a downward trend from Janu¬ 
 ary, 1906, and before the crisis of 1920 they turned downward in 
 November, 1919. Likewise in 1904, 1908, 1915, and 1921 they 
 turned upward from four to eight months before the appearance of 
 rising commodity prices and increased business activity. 
 
 Much caution is necessary in using stock prices as an index of the 
 business trend, however, for the reason that the stock market has 
 many minor fluctuations which are quite independent of the course 
 of business in general. Hence it is necessary after a change in the 
 trend of stock prices to wait for some weeks to see whether there has 
 occurred a real reversal of trend or only a minor fluctuation. More¬ 
 over, even the major changes in stock prices are not always followed 
 by similar changes in commodity prices and business activity, though 
 changes in business activity seem always to be preceded by similar 
 changes in the trend of stock prices. For instance, in 1899 and 1900, 
 in 1910, and in 1917 major declines in the stock market gave warning 
 of similar declines in other indices of prosperity, but no such declines 
 occurred. 
 
 The most reliable and hence the most important group of business 
 barometers is the group which relates to the money market. —Credit is the 
 life-blood of modern business, and the banking system constitutes the 
 circulatory apparatus through which credit is made available for the 
 more directly productive parts of the industrial organism. Hence, 
 irregularities in the operation of the banking system are as significant 
 to the student of industrial ills as are irregularities in the pulse beat 
 to the physician. 
 
 Banking barometers fall into three principal classes: indices of 
 the volume of business transacted, of which the clearings and the 
 checks cashed are the most important; statements of the condition 
 of the banks, including the weekly reports of the Federal Reserve 
 System, the reports of the Comptroller of the Currency on the condi¬ 
 tion of national banks, and the reports of state banks and trust com¬ 
 panies; and finally rates of interest on various classes of loans. 
 
 Bank clearings and check transactions furnish a measure of the activity 
 of business in the country , hence are more significant as general business 
 barometers than as indices of the position of the banks. For compari¬ 
 sons extending over a considerable period of time, the best index of 
 the volume of payments is the record of clearings. These figures 
 
BUSINESS FORECASTING 
 
 97 
 
 are collected by the Commercial and Financial Chronicle and by 
 Bradstreefs. For the last few years the figures of individual debits 
 at member banks have been collected by the Federal Reserve Board. 
 This is the figure for the total number of checks cashed and other 
 charges made against individuals’ accounts, and is a more accurate 
 index than the clearings, which include only checks deposited in 
 banks other than the ones on which drawn, and omit a considerable 
 proportion even of these. When the individual debits have been 
 collected for a sufficiently long period to make significant compari¬ 
 sons possible they will presumably supplant the clearings for fore¬ 
 casting purposes. There appears to be little difference in the direction 
 and relative amount of the changes indicated by the two barometers, 
 however. 
 
 In using bank clearings as a barometer of general business, it is 
 customary to omit the figures for New York City, on account of the 
 large influence exerted on those figures by changes in the volume of 
 speculation at the Stock Exchange. Outside clearings fluctuate, in 
 general, in much the same way as pig-iron production, wholesale 
 prices, and business failures; that is, they give a fairly consistent 
 picture of the changes in the volume of business transacted, but do not 
 anticipate changes in such a way as to give them any marked superi¬ 
 ority over the other standard indices. 
 
 Statements of condition of the banks are more diffictdt of interpreta¬ 
 tion than they were before the introduction of the Federal Reserve System. 
 —In former days, when the national banks were required to keep in 
 their vaults a definite proportion of their deposits in lawful money, 
 the surplus reserve over this requirement, particularly the surplus 
 reserve of the New York banks, was regarded as one of the most 
 sensitive barometers of financial weather. Since the introduction 
 of the Federal Reserve System, attention has been shifted to the 
 reserve ratio of the Federal Reserve banks. This item cannot be 
 interpreted with the facility with which the surplus reserve of former 
 days was interpreted, because of the extent to which the control 
 of Federal Reserve credit resources is exercised in accordance with 
 the judgment of a small number of individuals. If it were certain 
 that the Federal Reserve Board would in the future be guided by the 
 Federal Reserve ratio in determining its credit policy in the way that 
 directors of competing banks were guided by their reserve ratios before 
 the Federal Reserve System was established, the ratio of cash reserves 
 to combined notes and deposits of the twelve banks would be better 
 
9 8 
 
 RISK AND RISK-BEARING 
 
 worth watching than any single index which can be obtained. But the 
 Federal Reserve Board is a body with large discretion and has a 
 responsibility to administer the affairs of the system with a view to 
 the public interest rather than with a view to earning the largest 
 profits consistent with safety, and the element of personal judgment 
 makes their action difficult to forecast. So far, the rise and fall of 
 the combined ratio has seemed to be their most important guide, 
 but there is no assurance that it will continue to be so. 
 
 Fluctuations in such items as total gold reserve , national bank 
 notes outstanding , Federal Reserve notes outstanding , and data relative 
 to fiscal operations of the government are now of little barometric 
 importance. Total bills discounted is an item of more significance, 
 as it shows the extent to which the banks are using the rediscounting 
 privilege, and thereby indicates the extent to which interest rates 
 in the near future are likely to be controlled by the policy of the 
 Federal Reserve Board. Turnover of bank deposits is a new statistical 
 item, collected by the Federal Reserve Board from a limited number 
 of banks, which promises to be of considerable value as an index of 
 business activity, but is not yet available for a sufficiently long period 
 to make careful comparative study of its behavior feasible. 
 
 The most valuable single indices of busmess conditions are found in the 
 rates of interest. —This is true partly because of the abundance and 
 accuracy of the data, partly because of the consistency with which 
 changes in the money market precede changes in general business, 
 and partly because the part played by money-market conditions in 
 causing changes in prosperity is great enough to make it possible to 
 make allowance for exceptional conditions more readily than is 
 possible in using forecasters whose relationship to the phenomena 
 forecast is purely empirical. 
 
 Our statistical information in regard to the prices charged for 
 the services of capital is very satisfactory. Data are available 
 for a large number of kinds of financial transactions, and most of the 
 information appears quite promptly, so that the external difficulties 
 in the way of the forecaster are at a minimum in working with this 
 type of barometer. 
 
 The interest rates which receive the most attention from a baro- . 
 metric standpoint are ( a ) the yield on high-grade bonds; ( b ) the rate on 
 prime commercial paper (i.e., notes bought from business houses by 
 note brokers and sold to banks); (c) the rate on thirty -, sixty-, and 
 ninety-day loans “ over the counter ” (i.e., direct by banks to their own 
 
BUSINESS FORECASTING 
 
 99 
 
 customers); ( d) the Federal Reserve rediscount rate; (e) the call-loan 
 rate . 
 
 The rates on brokers’ paper and those on short-time loans over the 
 counter correspond very closely in the direction and time of their 
 changes, so that one will serve as well as the other for forecasting 
 purposes. 
 
 In general, all interest rates rise very late in a period of improve¬ 
 ment or prosperity, reach their maximum during, or soon after, a 
 crisis, and decline only after the liquidating process is fairly well 
 completed. Call loans show by far the widest range of variation, 
 and change the most frequently. They have many ups and downs 
 which are not connected with changes in the activity of business. 
 Bond yields are at the other extreme, showing comparatively little 
 change, as a rule, except in periods of very great change in business 
 conditions. Rates on short-term paper are intermediate in character, 
 and are excellent indices of the trend of business conditions. They 
 move so late in the cycle as to forecast a turn of other indices in the 
 opposite direction. When they turn definitely either up or down after 
 a long trend in the other way, a change in commodity prices and busi¬ 
 ness activity in the opposite direction may generally be expected within 
 a few months. Bond prices are also a fairly good barometer. When 
 the average price of a selected group of high-grade bonds changes the 
 direction of its trend, there generally follows a like movement in the 
 stock market, and less uniformly, there ensues a few months later a 
 similar change in commodity prices and the volume of business. 
 
 Changes in the Federal Reserve rediscount rate, i.e., the rate 
 charged by the Federal Reserve banks to their members in rediscount¬ 
 ing loans, are perhaps destined some day to rank as the most impor¬ 
 tant indicators of the trend of money-market conditions and the 
 consequent outlook for business prosperity, but we have had, as yet, 
 too little experience with the Federal Reserve System to enable us to 
 lay down any final rules for interpreting this index. The object 
 aimed at in establishing the system was that most of the elasticity of 
 credit in the banking system should be in a central reservoir of credit, 
 so that the member banks would have to resort to this central agency 
 in times of expanding buxines? in order to take care of the increasing 
 demands of their customers. In line with this purpose, it is held that 
 any increase in rates or restriction of credit initiated by the Federal 
 Reserve Board will radiate through the system and cause a corre¬ 
 sponding rise in rates and curtailment of credit, which will check the 
 
TOO 
 
 RISK AND RISK-BEARING 
 
 expansion of business. It is the function of the Federal Reserve 
 Board to keep an eye on the progress of business and check inflation 
 before it reaches the point where a collapse is inevitable. Vice 
 versa, in times when business is dull the Federal Reserve Board can 
 supply a stimulus by lowering rates and encouraging expansion 
 through a liberal rediscounting policy. 
 
 To the extent that the banks of the country become dependent 
 on the privilege of rediscounting their customers’ notes at the Federal 
 Reserve bank, it is clear that there do exist great possibilities of con¬ 
 trolling the course of business through control of the supply of credit. 
 At the height of the boom in the autumn of 1919, it was announced 
 that an increase in the discount rate could be expected in the near 
 future, and this was apparently one of the important causes of the 
 decline in stock prices which started in November of that year. The 
 rate was actually increased in January and again in June of 1920, and 
 it is generally believed that this action was one of the major causes 
 of the commodity liquidation, which was evidenced by the downward 
 turn of Bradstreet’s index in February of 1920, and of the credit 
 collapse which followed. 
 
 As our analysis of the cycle in chapter v has indicated, there is a 
 considerable amount of exaggeration in this view, though it contains 
 a large element of truth. The speculative accumulation of securities 
 and commodities in anticipation of further and further increases in 
 price, and the continuous expansion of certain types of productive 
 capacity, could not continue indefinitely, and the decline once started 
 was bound to gain momentum. But it was in the power of the Federal 
 Reserve Board to hasten by positive action the downward turn which 
 it could not prevent by keeping its hands off. 
 
 On the other hand, the power of the Board to hasten the return of 
 prosperity by lowering discount rates is not so clear. The rate was 
 reduced twice in 1921 without stimulating any considerable increase 
 in rediscounting, so that any effect the reduction had in stimulating 
 business must have been sentimental. The difficulty in the way of 
 stimulating a rise is very much greater than that involved in checking 
 a rise. When business is active the banks are led to utilize their own 
 resources and are put in a position of dependence on the rediscounting 
 agency. In a period of depression, however, they have unused 
 resources of their own, and are in a position to take care of a con¬ 
 siderable increase in customers’ demands without borrowing. No 
 matter how low the rate, they will not rediscount so long as their own 
 
BUSINESS FORECASTING 
 
 IOI 
 
 funds are lying idle. Hence a lowering of the rediscount rate is like 
 an importation of gold in times when reserves are already superabun¬ 
 dant, or an immigration of labor in times when our own labor forces 
 are largely unemployed, or the opening of new land for settlement in 
 a pioneer country where there is already good, free land. It has no 
 immediate, direct effect; it only gives assurance that there are larger 
 resources to be drawn upon in case of need. 
 
 The call-loan rates are of no barometric significance except to 
 stock-market speculators, and of very little significance even to them. 1 
 Very high call rates precede, and still higher rates accompany, a panic, 
 but there are many extreme fluctuations in call-loan rates which are 
 not the accompaniment of important changes in business, so that con¬ 
 clusions based on the call rates necessarily involve a large margin of 
 error. 
 
 The rates of foreign exchange do not constitute a reliable business 
 barometer , but they deserve brief notice because so many people 
 attempt to make barometric use of them. Under normal conditions, 
 the rates of exchange reflect changes in the volume of payments to 
 be made between countries, but these changes are rarely of any 
 importance from the standpoint of the outlook for prosperity in this 
 country. During and since the war, the European exchanges have in 
 many cases been maintained by deliberate action of governments at 
 certain levels, and where this is not the case they reflect speculators’ 
 estimates of the financial and political prospects of European govern¬ 
 ment rather than business conditions or prospects. This is not 
 true of some of the neutral countries, but in the disturbed condition 
 of European finances it is quite hopeless to undertake a business 
 forecast on the basis of the evidence furnished by any type of foreign 
 exchange. 
 
 Numerous indices may be combined into a single 11 composite barom¬ 
 eter .”—There are so many kinds of business statistics, and it is so 
 . difficult to estimate the relative importance to be attached to each of 
 them, that it has occurred to many students of business conditions 
 to try to cut short the task of interpretation by combining the whole 
 body of data into one or more averages. Their idea is that if proper 
 weight is given to each item in constructing the average, the result 
 will be a more dependable indication of the general outlook than will 
 any single item. Such averages are known as composite barometers. 
 Supporters of this method of studying the business outlook point out 
 
 ‘The point is discussed more fully in chap. ix. 
 
102 
 
 RISK AND RISK-BEARING 
 
 that all use of statistics rests upon a process of throwing together, into 
 a single class, items which are not exactly alike, and that making a 
 composite barometer in which, for example, pig-iron production is 
 combined with bank clearings, is only a step further than the combin¬ 
 ing of different kinds of pig iron or the clearings of different cities into 
 a single item. In the latter case, the items combined differ in some 
 ways but are alike in the characteristics in which we are at the mo¬ 
 ment interested, hence, we are justified in throwing them together; 
 if changes in pig-iron production and in bank clearings actually do 
 have the same significance for our problem, we are equally justified 
 in combining them. It is of course important that the figures shall 
 be so handled that each shall have its proper importance in compari¬ 
 son with the others, but it is perhaps no more difficult to determine 
 their relative importance for the purpose of making the composite 
 barometer than it is to determine the relative importance to be ascribed 
 to each item when they are studied separately. The composite 
 barometer has the great advantage that once the averaging is done 
 anyone can use the results without repeating the whole process of 
 weighing and comparing the data. 
 
 On the other hand, the differences between items always have some 
 significance, and the more averaging we do the more details of the evi¬ 
 dence we lose. How far it is best to combine data depends on the 
 amount of time the users of the reports are willing to spend in com¬ 
 paring items, and on the relative importance attached to the similari¬ 
 ties and the differences in the data. No one can make anything out of 
 a mass of raw statistics without some classification, while an excessive 
 amount of combination squanders part of the evidence. 
 
 In the construction of all such composite barometers, two adjust¬ 
 ments are necessary. In the first place, allowance must be made for 
 “seasonal fluctuation,” that is, the change which occurs regularly at 
 the same season of year. In many cases, this allowance must also 
 be made in interpreting data without the use of composite indices. 
 For instance, in 1921, very gloomy predictions concerning the outlook 
 for the finances of the railways were made in the press on account of 
 the falling off in traffic during the winter months, disregarding the 
 fact that most of the decline was to be accounted for as a normal 
 seasonal tendency. 
 
 The other correction which must usually be made is an allowance 
 for the normal increase in the volume of business, which occurs from 
 year to year with the growth of the country. For example, between 
 
BUSINESS FORECASTING 
 
 103 
 
 1903 and 1915, the production of pig iron in this country increased 
 from 17,000,000 to 20,000,000 tons. Yet during this interval there 
 were four years when the production was smaller than in the preceding 
 year. Clearly we have to deal here with at least two distinct types 
 of variation, the general increase running on from year to year, and 
 the fluctuation which accompanies the coming and going of pros¬ 
 perity. The correction of the statistics for this growth element is 
 made by estimating the normal increase and converting the actual 
 figures into deviations from this normal figure. In making a com¬ 
 posite index, the trend may be removed from the composite figure, or, 
 better, removed from each item separately before the average is com¬ 
 puted. 
 
 The earliest composite barometers in the United States were com¬ 
 piled by commercial organizations whose business was the sale of 
 
 * 
 
 statistics and advice to business men for their aid in deciding questions 
 of business policy and especially investment questions. Of these 
 barometers, the best known and the simplest is the Babson Composit- 
 plot,” published by the Babson Statistical Organization as one feature 
 of an extensive business, investment, and speculative service. 
 
 The “Babson Compositplot” is based on the theory that “action 
 equals reaction .”—The “Compositplot” consists of a line drawn on a 
 chart to represent the average of certain business items for successive 
 periods, beginning with 1904, through which line is drawn another 
 representing the normal growth of business for the same period, the 
 area between the line of normal growth and the line of actual growth 
 being heavily shaded. The interpretation of the “Compositplot” 
 is that the formation of an area above the line of normal growth fore¬ 
 casts the formation of an area of similar size below the line of normal 
 growth, and vice versa. The construction of the chart has been 
 described by its inventor, Mr. Roger W. Babson, as follows: 
 
 In recent years there has developed a school of thought which bases its 
 prognostications on what is known as the “area theory.” This area theory 
 considers both the factor of time and the factor of intensity, or prices. 
 Their prognostications of prices are based on the product of these factors 
 of time and prices, or, in other words, on the area consumed. 
 
 In short, this new school draws an oblique line, with a slope based on 
 the normal increase in the nation’s volume of trade. Starting at a time 
 when the business of the country is practically normal, such as early in 
 1903, actual business conditions are plotted from month to month. This 
 gives certain areas below and above this line of normal growth. 
 
104 
 
 RISK AND RISK-BEARING 
 
 This Composite plot, therefore, shows merchants the actual condi¬ 
 tions existing at any given time and, on the assumption that these areas 
 tend to be equal in area, not in shape, it aids them in forecasting future 
 conditions by showing whether the next area may be expected above 
 or below the line of normal growth and about how long before it will 
 come. 
 
 A little thought shows how reasonable is this theory and how it auto¬ 
 matically adjusts itself to conditions the same as a “governor” on an engine. 
 For instance, if prices increase twenty-five per cent above normal, it is not 
 reasonable to think that they will continue to go up until they reach the 
 last previous high price of one hundred per cent, irrespective of the time 
 consumed, but it is reasonable to suppose that after prices have held this 
 increase of twenty-five per cent for a period of four times as long as they had 
 when selling at the previous high advance of one hundred per cent, that the 
 time has arrived when logically they should fall. 
 
 In other words, the theory is that business conditions, as a whole, can 
 continue with “the throttle one-fourth open” about four times as long as 
 with the throttle wide open; or, to word it another way, when conditions 
 are “doubly prosperous,” said prosperity can last only one-half the period 
 of time that it could if conditions were only moderately prosperous. This 
 school believes that if the country would be willing to run along at a normal 
 rate of speed so that the line for actual business would correspond with the 
 line of normal growth, we would always have moderately prosperous con¬ 
 ditions with a steady, slow advance. On the other hand, the higher the line 
 for actual business rises above the line of normal growth, the shorter length 
 of time prices will remain high and conditions abnormally prosperous. 1 
 
 The “ Compositplot” is compiled in the following way: The 
 actual figures for the data which enter into the plot are reduced to 
 “index figures” through the use of technical methods which are the 
 invention of the Babson Organization. The data are then segregated 
 into the following groups: 
 
 Mercantile conditions 
 
 i Immigration 
 
 2. New building 
 
 3. Failures 
 
 4. Check transactions 2 
 
 Monetary conditions 
 
 1. Commodity prices 
 
 2. Total foreign trade 
 
 3. Foreign money rates 
 
 4. Domestic money rates 
 
 1 Annals of the American Academy of Political and Social Science, xxxviii, 
 180-83. (Philadelphia, 1911.) 
 
 2 Check transactions substituted for bank clearings January i, 1922. 
 
BUSINESS FORECASTING 
 
 105 
 
 Investment conditions 
 
 1. Yield of leading crops 
 
 2. Railroad earnings 
 
 3. Canadian conditions 
 
 4. Stock-market conditions 
 
 Then the figures in each group are combined to give an index number 
 which reflects the activity of business in general. 
 
 After the index numbers are compiled and plotted it remains to 
 locate the X-Y line, or line of normal growth, in order that the areas 
 above and below the line may be compared. In doing this, bank 
 clearings outside New York City are used as an indicator, but the 
 trend shown by the clearings is modified by observation of the other 
 data. As the compilers have stated it: 
 
 As it is always dangerous to use one subject alone, especially a subject 
 reflecting surface movements, it is necessary to take bank clearings as an 
 indicator only, and to check conclusions based upon it, at the end of each 
 year, by all the important barometers of wealth which report annually; 
 and again, at the end of each cycle, by the area of the Compositplot. 
 In other words, we endeavor to rely only on our statistics in locating this 
 X-Y line and thus far we have usually been able to do this, but we frankly 
 assume that the areas should be equal. Therefore, this chart does not 
 prove that the law of action and reaction applies to business, but rather 
 assumes it. 
 
 The location of this line is fundamentally based on the assumption that 
 action and reaction are equal when the total force involved is considered, 
 which force may be expressed graphically by an area. If this assumption is 
 correct, the sum of the areas below the line of normal growth must approxi¬ 
 mately be equal to the sum of the areas above the line of normal growth; 
 and by the law of averages all of the areas tend to be approximately equal. 
 In other words, if the law of equal reaction is applicable in economics as in 
 every other science, then our line is located with sufficient correctness; 
 on the other hand, if this law of action and reaction does not apply to 
 economics, then of course the Area Theory cannot be relied upon for fore¬ 
 casting business changes and these areas are of use simply as a general 
 bird’s-eye view of conditions. At the end of the last cycle , however , no readjust¬ 
 ment was necessary to make Areas “D” and “E” equal. This fact is a most 
 interesting testimonial for the Area Theory. 
 
 It appears from the foregoing discussion that the so-called line 
 of normal growth does not in fact represent merely the normal growth 
 of the country, irrespective of temporary conditions of prosperity and 
 depression, but is itself in part an expression of the prosperous or 
 
io6 
 
 RISK AND RISK-BEARING 
 
 depressed state of business at a particular time. This throws some 
 doubt on the propriety of using the X-Y line as a base from which to 
 measure areas representing the extent of prosperity or depression. 
 
 A more serious defect of the Babson chart, however, from the 
 standpoint of scientific method, is the lack of satisfactory proof of 
 the fundamental principle of “action equals reaction.” It may be 
 true that “the law of action and reaction applies to economics and 
 human relations, en masse , as it applies to mechanics.” The facts 
 available are not conspicuously inconsistent with the theory. But 
 there has been no satisfactory investigation to determine the weight 
 of evidence in favor of the theory, and it cannot at present be regarded 
 as more than an interesting hypothesis. Until such research is accom¬ 
 plished, students of social science will remain skeptical of the validity 
 of forecasting methods which depend on its detailed application. 
 
 The Brookmire barometers combine data which have been classified 
 according to the sequence of their fluctuations .—The theory of forecasting 
 upon w T hich the methods followed by the Brookmire Economic Sendee 
 are based, instead of combining all the statistical data into a single 
 index, postulates a chronological sequence of business events, and 
 combines only those which tend to fluctuate at the same time. The 
 data for most of the barometric indices constructed by this service 
 have therefore been selected because movement in them occurs in 
 point of time prior to some price index or other statistical factor 
 which it is desired to forecast, rather than in an attempt to portray 
 the entire field of business conditions in a single picture. The Brook¬ 
 mire organization claims that one great fundamental factor which 
 James H. Brookmire, the founder of this service, brought as a new 
 contribution to the science of business forecasting was the con¬ 
 ception that changes in financial and business conditions do not all 
 occur at one time but do occur in a chronological sequence. 
 
 Both seasonal variation and secular trend are mathematically 
 eliminated from the data used in the final presentation before they 
 enter into the Brookmire barometric chart. Of the many barometric 
 charts which have been constructed in seeking statistical measures 
 which move prior to many factors which an economic service seeks to 
 forecast in its regular work, only the two which are now being pub¬ 
 lished and one important forerunner will be described. 
 
 “Barometer No. i ” is a chart which is intended to forecast the 
 movement of industrial stock prices and of commodity prices. The 
 theory of the barometer is that whenever the forecasting line turns 
 
BUSINESS FORECASTING 
 
 . 107 
 
 upward, industrial stocks will rise almost at once and commodity 
 prices about six months later than industrial stock prices, with the 
 qualifications (a) that the change in commodity prices is more accu¬ 
 rately forecast by the turn of the stocks than by the turn of the 
 forecasting line and ( b) that in cases where the upward or downward 
 movement of stock prices reverses itself within six months, the 
 corresponding movement of commodity prices is likely to be too small 
 to be of any practical importance. The forecasting line is a mathe¬ 
 matical composite of the following six factors, each given the weight 
 “which past experience indicates that they really have” in every 
 change of business and investment conditions: 
 
 1. A combination of industrial and railroad stock prices. These 
 are included on the theory that when stocks are selling at higher 
 than average prices they are likely to move downward, and vice versa. 
 
 2. Physical volume of commodities coming into the market. 
 Eight measures of volume are used to test this factor. The theory 
 is that accumulation of excess stock is likely to lead to liquidation, 
 and shortage is likely to lead to increased production. 
 
 3. The ratio of merchandise imports to merchandise exports. 
 Exceptional imports are considered to be equivalent to exceptionally 
 heavy volume of production. 
 
 4. Turnover of bank deposits. 
 
 5. Commercial paper rates. 
 
 6. Interest rates in London. 
 
 “Barometer No. 2” is a similar forecasting line which is intended 
 to forecast the movement of the prices of bonds and of railroad stock. 
 This barometer is constructed in the same way as Barometer No. 1 
 except that commodity prices are introduced as a seventh factor, on 
 the theory that advancing prices of commodities are unfavorable to 
 bonds and to railroad stocks. 
 
 Notice should also be taken of a chart formerly published by the 
 Brookmire Service, “The United States Barometer Chart,” which 
 is important as a forerunner of the chart now published by the Harvard 
 Economic Service. This chart contained three factors, which were 
 plotted separately: '(1) the index of banking funds; (2) the index of 
 security prices; (3) the index of general business. It was stated that 
 these three graphs moved in chronological order, the banking index 
 rising first, followed by the stock-market index, and finally by the 
 business index. A great rise in the business index, in turn, produced a 
 fall in the banking index, and this was followed in turn by the stock- 
 
RISK AND RISK-BEARING 
 
 108 . 
 
 market index, and the business index, and the cycle was ready to 
 start again. 
 
 The banking index was based upon (a) the total cash and reserves 
 of New York clearing-house banks; (b) the percentage of these reserves 
 to loans; (c) the percentage of loans to deposits; ( d ) the rate on first- 
 class commercial paper in New York (6, c, and d reversed in sign). 
 The index of security prices was an average of prices of thirty-two 
 leading stocks. The index of general business was based on bank 
 clearings, railroad earnings, pig-iron production and prices, commodity 
 prices, imports, building, and immigration. 
 
 This sequence, it will be noted, is practically that which was indi¬ 
 cated as typical in an earlier section of this chapter, and has in most 
 respects been verified by the investigations of the Harvard Committee 
 on Economic Research. The introduction of the Federal Reserve 
 System and the restriction of immigration, however, have destroyed 
 the former relationship between certain of the items. 
 
 The Harvard 11 Index of General Business Conditions” represents 
 the most ambitious and painstaking effort yet made to establish a 
 relationship between the coming and going of prosperity and the fluctua¬ 
 tions of selected data which may be used as forecasters. —This index was 
 developed by the Harvard Committee on Economic Research and is 
 published in the Review of Economic Statistics and in the Harvard 
 Economic Service. 
 
 In brief, this investigation is an attempt to apply the method 
 utilized at an earlier date by Brookmire, of classifying the data with 
 respect to the time of their typical fluctuations, putting into one group 
 those items which tend to move ahead of changes in the volume of 
 general business, into a second those which serve as thermometers 
 reporting the activity of business at a given time, and into a third 
 those which generally lag behind; then combining those which move 
 together into a composite index so that the effect of accidental varia¬ 
 tion in one item may be reduced or eliminated. The movement of one 
 index is regarded as a forecaster of the next. A more minute classi¬ 
 fication into five groups has also been made, though the three-group 
 classification has so far appeared to be most useful. 
 
 The principal differences between this investigation and those 
 which have preceded it, particularly Brookmire’s, are first, the much 
 more elaborate and scientific methods used to get rid of the seasonal 
 fluctuations and the secular trend, and second, the classification of the 
 
BUSINESS FORECASTING 
 
 109 
 
 data into groups according to the results of a very minute study of the 
 order in which they have preceded one another in the past. 
 
 Every effort has been made to treat the statistical data in an imper¬ 
 sonal way so that the element of personal judgment may be reduced 
 to the minimum and the results may be the same that any scholar 
 would get from the same data. The question whether one item 
 typically precedes another in its rise and fall has been determined, 
 not by analysis of the cause and effect relation between them, but by 
 figuring mathematically the degree of correspondence between their 
 fluctuations when they are compared as they occurred, then moving 
 the record of one of them two, four, six, or more months ahead of the 
 other and calculating the degree of correspondence again. The degree 
 of correspondence is figured by the use of the “coefficient of correla¬ 
 tion,” a device widely used in biological studies and introduced into 
 social and business studies within the last fifteen years, chiefly by 
 English statisticians. 
 
 The validity of these mathematical methods of treating statistical 
 data depends on the utilization of statistics covering quite a large 
 number of cases, hence the choice of data is limited to those items for 
 which comparable data are available over a long period. For com¬ 
 parison involving annual data, only those items have been used which 
 could be traced back in comparable form to 1879, while monthly 
 data running back to 1903 have been considered sufficient. Seventeen 
 series of annual data for the years 1879-1913 and twenty-three series 
 of monthly data for the years 1903-16 or for longer periods were 
 included. The twenty-three series are as follows: 
 
 1. Bank clearings of New York City 
 
 2. Tonnage of pig iron produced in United States 
 
 3. Bank clearings outside of New York City 
 
 4. Bradstreet’s index of commodity prices 
 
 5. Imports of merchandise into United States, values 
 
 6. Values of building permits issued for twenty leading cities 
 
 7. Gross earnings of ten leading railroads 
 
 8. Number of shares sold on the New York Stock Exchange 
 
 9. Unfilled orders of United States Steel Corporation 
 
 10. Tonnage, less lake traffic, of vessels entered in the foreign commerce 
 of the United States 
 
 11. Bradstreet’s number of business failures 
 
no 
 
 RISK AND RISK-BEARING 
 
 12. Rate of interest on ten American railroad bonds 
 
 13. Rate of interest on four to six months’ commercial paper 
 
 14. Rate of interest on sixty- to ninety-day commercial paper in New York 
 
 15. Rate of interest on call loans at the New York Stock Exchange 
 
 16. Bureau of Labor Statistics’ prices 
 
 17. Dividend payments 
 
 18. Prices of industrial stocks 
 
 19. Prices of railroad stocks 
 
 20. Incorporations in eastern states 
 
 21. Loans of New York banks 
 
 22. Reserves of New York banks 
 
 23. Deposits of New York banks 
 
 The first step in the analysis was the isolation of the various types 
 of fluctuation which are found in the data. As a working hypothesis, 
 these were considered as fourfold: (1) A long-time tendency to 
 increase or decrease, which in technical language is termed the secular 
 trend; (2) a cyclical movement superimposed upon the first, the 
 extremes being found in periods of prosperity and depression; (3) a 
 seasonal movement within the year; and (4) irregular variations. The 
 four types of fluctuation are however not uniform in the different 
 series, and in consequence individual treatment of each series was 
 required. It became necessary first to measure the secular trend. 
 This was accomplished by “fitting” a straight line or other curve to 
 tjie graph representing the original series. For example, in treating 
 bank clearings, a dot was placed on a chart so that its distance from 
 the base indicated the volume of clearings in a given year, the years 
 being measured off in equal spaces from the left side of the chart. 
 It is obvious that if the increase in clearings were exactly the same 
 in each successive year the dots would all lie on the same straight 
 line, and the slope of this line would indicate the rapidity of the 
 increase in bank clearings. The method of “curve fitting” consists 
 in drawing a line so that it comes as near as possible to passing through 
 all the dots. This can be done with great accuracy by the use of 
 mathematical formulas. The slope of the fitted line is considered to 
 measure the secular trend or normal growth, and the deviation of the 
 dots from the line to measure the fluctuation not due to growth. The 
 assumption is that a rate of growth, shown by examining data of a 
 number of years in the past, will continue to be the rate of normal 
 growth in the future, so the line is carried forward with a uniform 
 
BUSINESS FORECASTING 
 
 in 
 
 slope. It is recognized however that this trend can really be deter¬ 
 mined only for the past period, and in certain cases may by no means 
 afford a good basis for estimating future trend. 
 
 The determination of normal seasonal variation in the data was 
 next undertaken. The method used is very involved and may con¬ 
 veniently be divided into the following steps: (i) Relative figures 
 are first calculated expressing the absolute figure for each month as a 
 percentage of the absolute figure for the previous month; (2) medians 
 of the month-to-month percentages are then calculated for each of the 
 twelve months. The median is the item midway of the series. Thus 
 it was found that in twenty-four years the business failures reported by 
 Bradstreet’s for April ranged from 77 per cent to 117 per cent of the 
 figures for March of the same year, but that in half the years the per¬ 
 centage was less than 96 and in half more than that figure. Ninety- 
 six per cent is therefore considered the typical ratio of failures for 
 April to those for March, though it appears that in no year was the 
 percentage exactly 96; (3) the medians are expressed as a continuous 
 series using January as base; (4) they are then adjusted so that the 
 discrepancy between consecutive January relatives (due to the secular 
 trend) is o; (5) they are changed to a new base by dividing each item 
 in the fourth series by the arithmetic average of that series. These 
 adjustments are technically necessary in order to get the results into 
 a form to use them as corrective factors. 
 
 The series of items is modified by this seasonal corrective factor, 
 and the resulting series gives the data with the influence of both secular 
 trend and seasonal fluctuation eliminated. This is done as follows: 
 Each of the “monthly ordinates of the secular trend” is multiplied 
 by the index of seasonal variation for that month, obtained in the 
 manner stated above. , In other words, the line which depicts the 
 normal growth.of the item from year to year is modified so as to repre¬ 
 sent the normal growth plus or minus, the normal seasonal fluctuation. 
 The normal monthly figures obtained in this way are then subtracted 
 from the actual figures and the result is a series of figures representing 
 the deviation of the movement of the item, bank clearings, for instance, 
 from what it would be if it were affected only by seasonal factors and 
 the growth of business. 
 
 This series of deviations comprises the fluctuation due to the busi¬ 
 ness cycle and also the irregular fluctuation caused by conditions 
 special to the particular business from which the data are drawn. 
 No attempt is made to separate the irregular from the cyclical factor, 
 
112 
 
 RISK AND RISK-BEARING 
 
 but it is assumed in combining the data into a composite index the 
 irregular changes in each separate series will tend to disappear and the 
 general average will reflect the effect of conditions common to all 
 lines of business, that is, of the coming and going of prosperity and 
 depression. 
 
 Before the comparisons can be made, one other correction is 
 necessary. Some of the series fluctuate widely, for instance, pig-iron 
 production and call-loan rates. Others have a very narrow range of 
 fluctuation, for instance, the yield on railroad bonds. Each series 
 is therefore divided throughout by a figure representing its own aver¬ 
 age deviation from its own average. This makes the average fluctua¬ 
 tions equal and facilitates comparison of the time of the fluctuations, 
 which is the only thing we are interested in. 
 
 For technical reasons the standard deviation, which is the square 
 root of the sum of the squares of the deviations divided by their 
 number, is used rather than their simple average. 
 
 It was found that the series fall into three quite distinct groups 
 when arranged in the order of their fluctuation. There were variations 
 within the groups, particularly the middle one, but the degree of corre¬ 
 spondence in each group was much greater than the difference between 
 the groups so that the classification was unmistakable. The series 
 which fluctuate first, either upward or downward, are all series depend¬ 
 ing upon investment and speculation, such as the average price of ten 
 railroad bonds, the average price of industrial and of railroad stocks, 
 the volume of sales on the New York Stock Exchange, and New 
 York clearings. This is the speculative group. 
 
 The series in which the fluctuations follow or lag behind the 
 fluctuation of the speculative group all have to do with business and 
 industrial activity, such as pig-iron production, bank clearings outside 
 of New York City, and wholesale prices. 
 
 The third group, in which the items lag behind the business group 
 in their rise or fall, are items having to do with the banking business. 
 They consist of interest rates, variously classified, bank reserves, 
 loans, and deposits. 
 
 The final step in the preparation of the general index is to construct 
 a curve portraying the combined data for each of the three groups of 
 data. Curve A, representing the speculative group, forecasts by its 
 rise or fall, a rise or fall in curve B, the business group; curve B like¬ 
 wise by its changes forecasts corresponding changes in curve C, the 
 money group; curve C by its changes forecasts opposite changes in 
 curve A. 
 
BUSINESS FORECASTING 
 
 113 
 
 It will be noticed that in the final classification and utilization of 
 the data, this system bears a striking resemblance to the Brookmire 
 method which was described on page 106. The Brookmire system 
 was based apparently on observations and economic analysis; the 
 Harvard system based on minute impersonal statistical analysis gives 
 a striking confirmation of its most important conclusions. 
 
 The question next arises, what is the degree of success in forecasting 
 by means of this system? For the period from 1903 to 1914, the 
 curves show striking regularity. Both in the depressions of 1904, 
 1908, and 1911, and in the prosperity periods of 1905-6, 1909-10, 
 and 1912, the curves turn up and down in invariable order and with a 
 high degree of regularity in the time interval between them. This 
 was only to be expected, however, as the indices were made chiefly 
 on the basis of the actual course of events during this period. For 
 the period from 1914 to 1918, the index proved to be valueless. The 
 fluctuations of the data were determined by the exigencies of war prod¬ 
 uction and war finance to such an extent that the normal relationships 
 of the business cycle were entirely obscured. No conclusion as to 
 the value of the barometer could be drawn from such an abnormal 
 period. 
 
 For the years from 1919 through 1921, the charts ran quite true 
 to form, thereby meeting their first real test. Curve A reached a 
 maximum in October of 1919, curve B in February of 1920, curve C 
 in July of 1920 and February of 1921. Curve A reached a minimum 
 in July and October, 1921, curve B in May, 1921, and January, 1922, 
 curve C apparently in September, 1922. 
 
 In conclusion, it may be said that the confidence to be placed in 
 such a mechanical forecaster is a question which as yet cannot be 
 answered, except from the standpoint of theory; there is not evidence 
 enough to prove or disprove its pretensions. It should be added, 
 however, that the publishers of the Harvard Index do not claim for 
 it infallibility. They point out that such factors as the establish¬ 
 ment of the Federal Reserve System, the destruction of capital 
 during the war, and the change of the United States from a debtor to 
 a creditor nation make it impossible to rely implicitly on forecasts 
 based on the compilation of precedents and make it necessary to 
 supplement the forecaster with the results of economic analysis. 
 A similar attitude is taken by the publishers of the Babson and Brook¬ 
 mire charts. The charts are furnished in each of these three cases 
 as one feature of an extensive service, other features of which include 
 discussion of the extent to which special considerations necessitate 
 
RISK AND RISK-BEARING 
 
 114 
 
 modifying the conclusions which might be drawn from the sequence 
 of events in the past. 
 
 NOTE 
 
 SOURCES OF BAROMETRIC DATA 
 
 The essential barometric data are easily obtainable. —The available 
 sources of barometric data fell into three general classes: first, the publica¬ 
 tions of government bureaus and of banks and other business institutions, 
 which are available gratis or at nominal cost; second, the periodicals which 
 deal with financial and business conditions; third, the special “business 
 services.” 
 
 Of the first class, there is a considerable number, of which the following 
 are among the most valuable: the Monthly Review of Credit and Business 
 Conditions by the Federal Reserve Agent of the Federal Reserve Bank of 
 New York, the Federal Reserve Bulletin , the Survey of Current Business , 
 published by the Department of Commerce, the Monthly Bulletin published 
 by the National City Bank of New York. 
 
 Of the periodicals, the weeklies are by far the most valuable for fore¬ 
 casting purposes. The following are worthy of special mention: the Com¬ 
 mercial and Financial Chronicle, the New York Times Annalist, Commerce 
 and Finance, the Economic World, Bradstreets, Dun’s Review, the Saturday 
 edition of the New York Evening Post, the Chicago Economist. All these 
 publish weekly summaries of most of the important data; a very brief 
 comparison is sufficient to indicate which of them furnish the items in which 
 one is particularly interested. 
 
 For those who wish more complete and earlier information as to the 
 trend of business conditions and are willing to pay for having the data 
 interpreted as well as collected, a number of special business services are 
 available. The Harvard Economic Service, the service sold by the Babson 
 Statistical Organization, and the Brookmire Service have already been 
 mentioned in connection with the subject of composite barometers. In 
 addition to the barometers described, each of these services furnishes bulletins 
 dealing with current developments and offers interpretations and forecasts. 
 
 The Babson Service consists of a General Barometric Bulletin, contain¬ 
 ing the “ Compositplot ” with brief comments and a few notes on important 
 developments affecting business in general; a Buyers’ Bulletin, on commodi¬ 
 ties and prices; an Industries Bulletin, forecasting conditions in specific 
 industries; a Sellers' Bulletin, which deals with business and credit condi¬ 
 tions in specific localities all over the country; a special Labor Bulletin; and a 
 Bulletin dealing with speculative securities and investments. The organiza¬ 
 tion maintains a large statistical force, and furnishes a large amount of 
 information concerning the general situation and also the specific details 
 needed in modifying general conclusions to determine their application to 
 the problems of the individual business. The Babson forecasts are very 
 definite and specific. 
 
 The Brookmire Service furnishes an Investment Opportunities Bulletin, 
 a Speculative Bulletin, a Building Bulletin, a Sales and Credit Map, a Trade 
 
BUSINESS FORECASTING 
 
 TI S 
 
 Bulletin , and a Financial Bulletin. These bulletins cover somewhat the same 
 general field as is covered by the Babson Bulletins, though as the titles indi¬ 
 cate there are some differences of emphasis. Like the Babson Service, the 
 Brookmire Service makes very definite and intelligible recommendations 
 concerning the specific securities to be bought and business opportunities 
 to be cultivated or avoided. 
 
 The Harvard Service is relatively new, and represents the first effort 
 on the part of an educational institution to enter the field of professional 
 business advice. The principal features of the service are a weekly letter 
 and monthly desk sheet, which include data of current barometric interest, 
 both the actual figures and the items adjusted for seasonal and secular 
 variation; the barometric curves discussed above and discussion of their 
 significance; special articles dealing with current developments of impor¬ 
 tance, such as foreign financial conditions, tendencies in trade, etc.; other 
 articles which present the result of special investigations, such as the tend¬ 
 encies of a particular industry during business depressions; and a quarterly 
 publication, the Review of Economic Statistics, which contains more extended 
 articles dealing with the theory and history of business cycles and kindred 
 topics. The material published in connection with this service represents 
 a very high standard of scholarship and has already included numerous 
 valuable additions to our stock of knowledge of the phenomena of pros¬ 
 perity and depression. There is no attempt to recommend specific invest¬ 
 ments or details of business policy. 
 
 QUESTIONS 
 
 1. Show how the justification of the use of the sampling method in studying 
 barometric data involves application of the law of large numbers. 
 
 2. “The changes wrought by the war make it necessary to supplement sta¬ 
 tistical comparisons with the results of economic analysis.” 
 
 3. “Price changes may be said to forecast their own movements.” Explain. 
 
 4. Compare the significance of railway gross earnings and of car loadings, 
 as barometers of the volume of trade. 
 
 5. Under what conditions might the management of an industrial corpora¬ 
 tion have an interest in coloring the reports of the corporation to make it 
 appear more prosperous ? less prosperous ? 
 
 6. Does the fact that staple agricultural products are sold in a world-wide 
 market affect the barometric significance of the volume of production 
 in this country ? 
 
 7. Why do cotton prices show more tendency than do wheat prices to rise 
 greatly in years of small production in this country ? 
 
 8. Under what conditions may a heavy importation of gold result in an 
 easing of credit in this country ? 
 
 9. “Rising interest rates forecast falling bond prices.” Why? 
 
CHAPTER VII 
 
 RISK AND THE MANAGEMENT OF CAPITAL 
 
 In no other field of business management does the factor of uncer¬ 
 tainty absorb so much attention as in the investment 1 of capital. It 
 is true that the control of production, the administration of labor 
 relations, and the determination of market policies constantly involve 
 the making of decisions on the basis of evidence which is not sufficient 
 to establish the truth with scientific certainty, but they also involve 
 to a large and increasing extent the application of scientific methods 
 in the elimination of risk. In the investment of capital, on the other 
 hand, it is nearly always the case that the final decision rests on proba¬ 
 bility rather than on knowledge. The exceptional case is the case 
 where the investor is interested only in securing absolute safety, and 
 disregards considerations of yield, but this situation is very rare. 
 Ordinarily the investor’s objective is to get something more than the 
 yield which can be had on absolutely safe investments, and his choice, 
 therefore, rests upon a balancing of the prospective profits against the 
 degree of risk. In this chapter, an attempt will be made to compare 
 the various methods of securing a return on capital with reference to 
 the amount and kind of risk involved in each. 
 
 Opportunities for securing a return for the use of one’s capital 
 fall into the following general classes: 
 
 1. Investment directly in one’s own personally-directed business. 
 
 a) Investment in new enterprise. 
 
 b) Investment in extension of the range or volume of business. 
 
 c ) Investment to reduce the costs or risks of business to which 
 one is already committed. 
 
 2. Repayment of one’s own indebtedness (to curtail outgo for 
 interest). 
 
 3. Deposit of money with banks, savings institutions, building 
 and loan associations, purchase of insurance, etc. 
 
 4. Purchase of securities with a view to obtaining income from 
 interest or dividends. 
 
 1 Except as otherwise noted the term “investment” is used in its original broad 
 sense to designate all methods of putting money into enterprise, without the 
 usual implication of safety. 
 
 u6 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 117 
 
 5. Personal loans, made for the sake of interest. 
 
 6. Purchase or sale of securities, land, contracts, or commodities, 
 with a view to profit from price changes. 
 
 7. Gambling transactions. 
 
 Let us examine these types of “investment” with a view to deter¬ 
 mining the relative degrees of risk which they involve. 
 
 1. The investment of money in one’s own business affords illustra¬ 
 tions of all possible degrees of risk. —Investments to start new businesses 
 are nearly always speculative. The very fact that an opportunity 
 has not been developed already usually means that its results are 
 uncertain. As businesses grow older they become less speculative, 
 more and more of their problems having been solved. Nevertheless, 
 numerous risks assail nearly every type of enterprise, and it is not at 
 all certain that business as a whole any more than pays its own 
 interest and wages. Statistics of failures are available in the United 
 States only for commercial, not for industrial, agricultural, or public- 
 service institutions; these statistics indicate that the proportion of 
 failures runs from one-third of 1 per cent in good years to nearly 2 
 per cent in bad years. These figures, however, embrace only failures 
 which cause loss to creditors; if we had data showing the number of 
 businesses which fail to earn fair interest on their capital and wages for 
 their owners the figures would doubtless run vastly higher. 
 
 The investment of capital in one’s own business may offer an oppor¬ 
 tunity for investment which is virtually free from risk, when its effect 
 is to provide safeguard against risks already incurred. For instance, 
 when $20,000 has once been invested in the equipment of a plant, 
 $2,500 invested in an additional machine may return much more than 
 normal interest through the addition it makes to the efficiency of the 
 plant, and the risk may actually be decreased by the new investment. 
 After the new investment $22,500 is at risk instead of $20,000 but the 
 probability of total failure in the next season of poor business has been 
 reduced by the increased plant efficiency, let us say from 8 chances in 
 a thousand to 6 in a thousand. Whereas the risk before was mathe¬ 
 matically equivalent to a cost of $160 per year, it now amounts to 
 $135.00. The burden of the risk of total failure has been lessened by 
 $25.00 a year, quite apart from the added income which will result 
 from the decreased cost of operation in years of prosperity. 
 
 2. The safest investment is the repayment of one’s own debts. —When 
 a debtor pays off his interest-bearing obligations he makes an invest¬ 
 ment on which the return is the amount of interest saved. He incurs 
 
118 
 
 RISK AND RISK-BEARING 
 
 absolutely no risk of losing his investment (unless the chance that he 
 might otherwise evade payment be counted as creating a risk in 
 repayment), nor does he run any risk of having his investment return 
 to him and lie idle on his hands. Moreover, he pays no taxes on the 
 investment (unless he was previously getting a deduction from his 
 taxes on account of the debt). An absolutely safe, permanent, and 
 tax-free investment of other types would net him from 3 to 5 per cent; 
 this one will net him 6 or 8 per cent. The reason for this discrepancy 
 is that the creditor’s charge for the loan includes a compensation for 
 his uncertainty as to whether he will be able to collect his principal; 
 he figures his claim as a more or less risky asset, while the debtor 
 figures his liability as absolute. Thus the repayment of the debts 
 relieves the creditor of a risk without creating a corresponding risk 
 for the debtor. From the standpoint of risk, there is therefore a real 
 social gain in the liquidation of debts. This may, of course, be more 
 than offset by a loss in productivity, if the capital could produce more 
 in the hands of the debtor than in the hands of the owner. 
 
 3. Deposits with financial institutions are usually very safe .— 
 Deposits of funds with banks, investments through building and loan 
 associations and investment trusts, and the purchase of investment 
 insurance and of annuities, if the institutions are honestly managed, 
 offer an almost perfect assurance of safety, largely because their 
 success depends on the success of a great number and variety of 
 enterprises, some of which will almost certainly fail but the great 
 majority of which will not, unless as the result of a collapse of the 
 present organization of industry. An equivalent diversification of 
 investments would, of course, obtain the same safety for the indi¬ 
 vidual investor if he were able to secure it, but the financial institutions 
 under consideration have the advantage in their ability to pool the 
 resources of a large number of small investors and spread them over a 
 much larger number of different investments than the average investor 
 could include in his list. 
 
 Moreover, such institutions are usually conservative in their 
 choice of investments, and frequently are restricted closely by law in 
 their selection. This is true especially of savings banks, which as a 
 result are able to secure only a low return on their investments, but 
 run very little risk. Some advantage is gained also by the specializa¬ 
 tion of savings bank officers in judging the quality of investments. 
 The chief advantage, nevertheless, is in the better diversification which 
 is gained through the pooling of individual resources. Individuals 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 lT 9 
 
 whose income is large enough so that they can secure diversification 
 in their investments seldom find it advantageous to use the savings 
 bank. 
 
 4. Investment in securities makes possible minute specialization in 
 risk-bearing. —Incorporation is a device for making possible, among 
 other things, a more minute specialization in risk-bearing than is pos¬ 
 sible under the “ single entrepreneur ” system. The issuance of various 
 types of securities makes it possible for the risk to be divided among 
 a large number of specialists, each of whom takes only a small share in 
 the risk of any particular business, and moreover takes in each business 
 pretty much the kind of risk he chooses, some capitalists preferring 
 to take preferred stocks or bonds offering a high degree of safety with 
 comparatively low return, while others take common stocks which 
 offer the possibility of larger return but a larger degree of risk. By 
 varying the proportion of stocks and bonds and by special contract 
 provisions, the risk can be divided in almost as many ways as there 
 are investors. 
 
 At the same time incorporation, by bringing in the principle of 
 limited liability, cuts the bond between control and the bearing of 
 risk, and makes it possible for the individual to invest his capital in 
 lines of business concerning whose management he knows nothing, 
 and in which he would never invest his capital if it were necessary 
 for him to learn. This makes possible, of course, a much wider 
 spreading of investments and a corresponding reduction of the indi¬ 
 vidual’s risk of loss. This whole subject is well discussed by Pigou: 1 
 
 So long as liability was unlimited, it was often against a man’s interest 
 to spread his investments; for, if he did so, he multiplied the points from 
 which an unlimited call on his resources might be made. The English Limited 
 Liability Act of 1862 and its foreign counterparts enabled investments to 
 be spread, without evoking this danger. Now, the spreading of invest¬ 
 ments obviously means a combination of uncertainties on the part of all 
 investors who hold shares in more than one company. But spreading, on 
 the basis of limited liability, carries with it yet another element of com¬ 
 bination. For, in general, each business deals directly or indirectly with 
 many businesses. If one of them fails for a million pounds, under unlimited 
 liability the whole of the loss falls on the shareholders or partners; but 
 under limited liability a part of it is scattered among the shareholders or 
 partners of a great number of businesses. Hence, any shareholder in one 
 business combines with the uncertainty proper to his own business some of 
 that proper to other businesses also. It follows that the range of uncer- 
 
 1 Wealth and Welfare , p. 101. 
 
120 
 
 RISK AND RISK-BEARING 
 
 tainty, to which a normal ioo pounds invested in industry is subjected by 
 reason of failures, is still further diminished in amount. 
 
 High-grade bonds of industrial ana public-utility enterprises offer 
 a high degree of safety, chiefly because of the large margin which 
 usually exists between the income required to meet charges on them 
 and the normal income of the businesses, secondarily because they 
 are usually secured by direct claims on assets of ample value. Here 
 it will be noted that the risk against which the investor is protected is 
 that of a partial failure of the business. If there is a complete col¬ 
 lapse the charges cannot be met, unless out of accumulated earnings 
 of the past, and ordinarily the assets pledged lose much of their value. 
 All forms of security depend ultimately on earning power, and are 
 subject to the hazards of the business in greater or less degree. But 
 when the interest on a bond requires, say 25 per cent of the anticipated 
 earnings, a shrinkage of 80 per cent in net means only a 20 per cent 
 shrinkage in the amount available for interest, while a 60 per cent 
 shrinkage leaves enough to pay the bondholder his interest in full. 
 A complete failure wipes out the bondholder just as it does the stock¬ 
 holder, unless the investment can be extricated and the assets applied 
 to some other use. The probability of loss is thus roughly calculable 
 on the basis of ( a ) the variability of the earnings, ( b ) the extent of 
 the margin of safety, and ( c ) the degree of specialization of the capital. 
 The same considerations apply to the purchase of real-estate mort¬ 
 gages, and to loans to individuals. 
 
 On the other hand, final equities, such as ownership of individual 
 businesses or of common stocks of corporations, have their speculative 
 character increased by the creation of prior liens. In the case cited 
 above, the issuance of bonds sufficient to absorb 25 per cent of net 
 income in fixed charges means that a 60 per cent shrinkage in net 
 income cuts off 80 per cent of the stockholders’ return, and a 75 per 
 cent shrinkage wipes it out entirely. The thinner the equity the 
 greater the risk to both parties. 1 Common stocks, however, are 
 always speculative, even if preceded by no prior liens of any kind; 
 for the accumulated assets and the prospects of earnings of any busi¬ 
 ness, no matter how stable, are always changing, and the full weight 
 
 1 That is, provided there is only one prior lien. The bigger the first mortgage 
 bond issue the more the risk of failure to earn the interest, and the wider the relative 
 range of fluctuation of the remainder. Issuing a junior lien bond does not as a rule 
 weaken the first mortgage bond. 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 121 
 
 of these changes falls on the common stock. Prior liens intensify 
 the risk; they do not create it. 
 
 In this connection a distinction may be noted between the customary 
 adjustment of interest rates to risk in the market for long-time loans and 
 in that for short-time loans. 1 In general, commercial money lenders do 
 not make a charge for interest varying with the assumed degree of 
 risk but establish a single rate and classify applications for credit 
 into those which do and those which do not appear safe enough to 
 be graded at this rate. In the investment market, on the other hand, 
 there is an accurate adjustment of the interest rate to the assumed 
 degree of risk, so that in the same market the rate of interest on bonds 
 or other long-time securities varies within wide limits and adjusts 
 itself to very minute differences in the security. 2 
 
 5. The return to makers of personal loans is increased by the lack of 
 general knowledge concerning the probability of repayment .—The busi¬ 
 ness of loaning money to individuals and corporations with the 
 expectation of early repayment, as distinguished from relatively 
 permanent investment through the purchase of stocks or bonds, takes 
 a wide variety of forms. Its most important form is the extension 
 pf credit to business men by banks, but it also includes the activities 
 of private money lenders, discount houses, and loan sharks, and a 
 vast amount of lending by individuals who are not professional 
 lenders at all. In general it may be said that loans to private indi¬ 
 viduals and businesses of moderate size are apt to yield a higher return 
 in proportion to the risk of loss than that obtainable through invest¬ 
 ment in securities. This refers, however, to the risk as estimated by 
 
 1 In the strict terminology of economics, interest contains no element of com¬ 
 pensation for risk for the reason that all compensation for risk is treated as profit 
 just as in the return of the business man for his own efforts the compensation for 
 his services is treated as wages and “p r °fit” includes only the return due to risk. 
 In the ordinary language of business, however, this distinction is not observed. 
 Interest is the return paid for capital invested under a control other than that of 
 the owner for a stipulated return (or a charge against one’s own capital for the 
 interest which could have been obtained by loaning it out). Commercial interest 
 obviously varies with the estimated degree of risk. 
 
 2 This difference is parallel to that existing between the practice in life and in 
 fire insurance. In life insurance a single normal rate is established and most 
 applications are either accepted or rejected, comparatively little attention being 
 given by most companies to the adjustment of rates for sub-standard risks. In 
 fire insurance, on the other hand, there is an adjustment of the risk premium to 
 almost every conceivable degree of safety. 
 
122 
 
 RISK AND RISK-BEARING 
 
 the comparatively small number of possible lenders who are able to 
 form an estimate on the basis of adequate information. The more 
 widely known are the facts concerning the financial strength and 
 reliability of the borrower, assuming that his record is good, the 
 more closely will the rate he is obliged to pay correspond to the hazards 
 involved in the business in which he is engaged. If the number of 
 possible lenders whom he may approach is small, as is usually the 
 case, he is less likely to obtain a favorable rate, simply because of 
 lack of competition for his business. Moreover, the time risk to lenders 
 is greater in short-time loans than in security investments, not only 
 because the marketability of securities enables holders to withdraw 
 their capital from them more readily, but also because short-term 
 borrowers are more apt than are corporations to be slow in meeting 
 their obligations, and extensions are more apt to be necessary. 
 
 Loans secured by mortgages on real estate are generally considered 
 the safest type of personal loan available for the ordinary lender. 
 In most markets these yield a return very high in proportion to the risk 
 of ultimate loss. They lack liquidity, and there is no adequate social 
 machinery for securing a broad market for them. For those lenders 
 who do not need a high degree of liquidity in their investments and 
 are able to assure themselves of the quality of the mortgages offered 
 them, they frequently form the ideal investment. It should be 
 noted, however, that the return on such loans does not fluctuate as 
 much as on most classes of investments, so that in periods of high 
 interest rates other types of investment become relatively more 
 attractive. 
 
 Uncertainty as to time of repayment of loans is a source of risk .— 
 The foregoing discussion has reference to the risk of loss of capital 
 resulting from mistakes of investors and managers. Another risk is 
 involved in investments of capital, however, the risk that one will not 
 be able to get his capital back at the time he wants it even though the 
 investment be perfectly good. From the standpoint of the debtor 
 there is a similar risk in the possibility that he may be called upon to 
 repay the loan at an inconvenient time. Every commercial crisis 
 results in numerous financial embarrassments, arising on the one hand 
 from unexpected failures to secure renewals of loans which have been 
 counted on by debtors, and on the other hand from the failure of 
 debtors to furnish promptly the funds which have been counted on by 
 creditors. It is obvious that this risk, which for convenience we may 
 call time risk , cannot be entirely eliminated so long as we employ a 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 123 
 
 credit system, for if debtors are secure against having to repay 
 advances at inconvenient times, creditors cannot at the same time be 
 secure against the risk of failure to collect when they need the funds. 
 
 All that can be done is to adjust the interest rate to fit the distri¬ 
 bution of the risk. This is done in various ways. In ordinary bank 
 deposits the time risk is all on the borrower—the bank must repay 
 the loan on demand. Consequently depositors can expect little or no 
 interest on their balances. In the case of a callable bond, i.e., a bond 
 which may be called in for payment at any time the issuer chooses to 
 do so, on the other hand, the time risk is all on the lender. So great 
 is the advantage which this gives the borrower that callable bonds 
 cannot be sold at ordinary rates of interest except by making them 
 callable at a price somewhat above par. Ordinary call loans 1 can be 
 terminated immediately at the option of either party. Such con¬ 
 tracts exhibit the greatest variation in interest rates. Sometimes the 
 condition of the market is such that the callability of the loan makes 
 it very desirable from the lender’s standpoint, and call rates are very 
 low. At other times the demand for such loans far outruns the supply 
 and the rate runs up to figures never approached in any other type of 
 loan. In long-time loans, such as bonds and mortgage loans, the 
 contract cannot be terminated by either party without the consent of 
 the other. Time risk is divided. Here again, as in the case of call 
 loans, the rate charged depends on the condition of the market. 
 Usually a large number of lenders prefer to carry the risk of wanting 
 their money before they can get it rather than the risk of having it 
 repaid before they want it on their hands. Consequently the rate on 
 long-time loans tends to be low. When rates are expected to rise, 
 however, the time risk is considered heavier from the lender’s stand¬ 
 point on the long loans and from the borrower’s standpoint on the 
 short loans, and rates on long loans are apt to be higher. 
 
 Incorporation and the stock exchange make possible great reduc¬ 
 tion in this sort of risk. By investing in a bond or share of stock 
 which has a continuous market, the investor can gain most of the 
 advantages of freedom from time risk which are afforded by call loans, 
 while at the same time the issuing corporation is free from the incon¬ 
 venience of sudden and unexpected calls for the return of the capital 
 which it is using. Of course, the investor pays for this advantage. 
 A security which is readily marketable will sell at a higher price, or, 
 
 1 Such loans are common in this country only in the financial district of New 
 York City. 
 
124 
 
 RISK AND RISK-BEARING 
 
 to state the same thing in another way, will yield a lower rate on the 
 investment. Hence it is important for the investor to consider before 
 buying a security whether he really needs the advantages of market¬ 
 ability. If he does not, it is a waste of money to pay for it. 
 
 6 . Speculation on changes in prices is always risky. —It is easy to 
 draw a distinction between “speculation” and “investment,” but it 
 is impossible to define the terms with such accuracy that they shall 
 never both be applicable properly to the same transaction. Col¬ 
 loquially the terms are used to indicate degrees of recognized risk and 
 no sharp line is drawn between them. The one shades off imper¬ 
 ceptibly into the other, and there is a wide area of common ground 
 along the border. Nor can we draw the line sharply so long as we 
 seek an external test in the form of the transaction or the character 
 of the enterprise. The only clear-cut distinction is a distinction as to 
 the purpose: Is the transaction intended to obtain only a payment 
 for the use of capital invested in an enterprise, with the outcome 
 fully known and fully taken account of, or is there an attempt to realize 
 an economic profit—to get more in return than we could if all parties 
 to the transaction, actual and potential, were certain of its outcome ? 
 In practice pure investment in this sense is rare; nearly every investor 
 tries to combine safety with some degree of profit. 
 
 Investment and speculation, whether in land, contracts, com¬ 
 modities, or securities, involve much more exclusive attention to the 
 problem of risk reduction than do most types of business activity. 
 From the “shoestring” speculator, who tries to make a living without 
 work by guessing the hourly fluctuations of the Curb price of an oil 
 stock, to the president of a trust company, who shifts the proportion 
 of railroad bonds and short-term paper in his holdings in accordance 
 with his judgment of the future course of the interest rate, the whole 
 army of investors and speculators are engaged in risk bearing; that 
 is, in an attempt to profit by the uncertainty in other men’s minds 
 and to get a better return for the use of their capital than they could 
 if those from whom they buy and to whom they sell had as good 
 knowledge of the present and as good judgment of the future as they 
 themselves possess. 
 
 Success in all these lines depends on ability to forecast price 
 changes, which in turn depends upon ability to weigh the importance 
 of complicated and conflicting indications of the movement of demand 
 and supply, not with absolute accuracy, but with greater accuracy 
 than someone else does it. All speculation on the price of anything is 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 125 
 
 essentially a contest. For we cannot buy except at a price at which 
 someone else considers the commodity or security a good sale, and 
 we cannot sell except at a price which someone else considers to 
 offer value for his money. Whatever the price is, that price repre¬ 
 sents the consensus of market opinion at the moment as to what 
 the price ought to be, and the attempt to make a speculative profit 
 is a matching of one’s knowledge, judgment, skill, and luck against 
 the composite judgment of the world. Risk is not merely incidental 
 to this type of enterprise; it is of the essence. 
 
 For this reason all speculative activity is often condemned by 
 moralists as a species of gambling. Speculation is not a form of gam¬ 
 bling; gambling is a form of speculation. All forms of speculation 
 are attempts to secure profits, to get for the service of one’s capital 
 (or labor) more than they are worth; that is, more than they would 
 be worth if the relevant facts were generally known and account taken 
 of them. 
 
 7. Gambling is speculating on artificial risks. —The only thing which 
 differentiates gambling from “legitimate” speculation (hereafter 
 referred to for brevity’s sake as speculation) is that in speculation 
 the risks are inherent risks of industry, and must be borne by someone 
 if production is to go on. The speculator who buys a carload of sugar 
 and holds it for a rise carries a risk which he need not carry, but which 
 someone must; the more efficiently he judges the trend of the market, 
 the less will the price fluctuations be. One speculator gains what 
 another loses, but the gain of the first does not cause the loss of the 
 second. 1 
 
 In gambling, on the other hand, nothing of this sort is true. The 
 risk is 'an artificial risk, created by the gambling transaction itself. 
 Risk is increased for the sake of the risk and for the sake of profiting 
 by one’s luck and skill at the expense of another. The losses of the 
 unsuccessful are not compensated for by any gain to themselves, 
 except the direct utility of the excitement. 
 
 1 Indeed it tends slightly to decrease it. If A buys at the bottom and sells at 
 the top, his operations make the bottom a little higher and the top a little lower 
 than it would otherwise have been, and so reduce the losses of B, who buys at the 
 top and sells at the bottom. However, it should be noted that this analysis of 
 speculation is partial. Certain risks are increased by the fact that speculators have 
 an interest in concealing the true situation from one another. Moreover, the 
 inflation of the volume of trade through short sales multiplies the points at which 
 risk appears. The whole question will be discussed more fully in a later section. 
 See chap, xviii. 
 
126 
 
 RISK AND RISK-BEARING 
 
 Except for the few who possess superior information concerning the 
 probabilities of a favorable outcome , gambling enterprises involve a 
 greater risk than is justified by the chance of profit. —We are not con¬ 
 cerned at this point with the sporting type of gambler who engages 
 in betting as a form of recreation and counts his losses a fair payment 
 for the amusement he receives. Nor are we concerned with the pro¬ 
 fessional gambling-house keeper who runs his game squarely and 
 obtains his profit from a “percentage” in favor of the “house.” He is 
 a business man engaged in selling amusement for a price, and so 
 long as he plays the game squarely and the odds in favor of the house 
 are known to his patrons, they have no cause to revile him for their 
 inevitable final misfortunes. Finally, we are not concerned with the 
 “gambler,” professional or otherwise, who creates a probability in 
 his own favor by cheating. As in any other type of dishonesty, the 
 man who is skilful is likely to find that the risks of his business and the 
 social disapproval with which it is affected serve to keep down com¬ 
 petition and make his profits relatively large. The point at issue here 
 is the financial soundness of true gambling transactions, that is, of 
 the staking of money on events whose outcome is uncertain, as a 
 method of securing income. 
 
 In such cases the gambler’s decision to risk his money on a certain 
 outcome is determined by a consideration of the odds offered as com¬ 
 pared with his judgment of the relative probabilities of the alternative 
 possible outcomes. Gamblers as a class cannot win, but the indi¬ 
 vidual gambler whose judgment is better than the average of the group 
 whose decisions determine the odds is sure to make money in the long 
 run; provided, first, that his stake in any one transaction is so small 
 that no accidental adverse run cripples him; and, second, that he 
 resists the temptation to enlarge his scale of operations after each 
 successful venture and decrease it after the unsuccessful one. As a 
 matter of fact, the probability of a given individual’s attaining success 
 in an effort to make money continuously out of gambling transactions 
 is of very much the same sort as his chance of making money by 
 taking advantage of any kind of price fluctuations. In the one 
 case the prices, in the other case the odds, are the result of a composite 
 judgment of the entire group of persons who are trying to piofit 
 by their forecasting skill; in each case success depends upon one’s 
 relative ability to form a correct judgment as to the probability of a 
 given outcome, relative that is to the ability of the rest of the group 
 to form similar judgments. So far as the kind and degree of risk 
 
RISK AND THE MANAGEMENT OF CAPITAL 
 
 127 
 
 are concerned, the respective chances of the man who takes “flyers,” 
 trusting wholly to his luck, the man who relies on the current gossip to 
 obtain a basis of judgment, and the man who bases his operations on 
 a careful study of all available information, are about the same in the 
 wheat pit, the land market, the stock exchange, and on the race 
 track. In each case, in the absence of “inside information” or of 
 some method of controlling the outcome of the event, risk even to the 
 most careful student is very great, while the chances of the average 
 man’s attaining consistent success are negligibly small. 1 
 
 QUESTIONS 
 
 1. Are losses smaller in a diversified list of investments? Is risk less? 
 
 2. “Gambling is a form of speculation.” Explain. 
 
 3. What is the character of the “time risk” in a purchase of real estate 
 mortgages ? in a purchase of well-known speculative stocks ? in a purchase 
 of a life annuity ? 
 
 4. Explain the relationship between limited liability and the diversification 
 of investments. 
 
 1 Attention is given to the social and moral aspects of gambling in chapter xviii. 
 The methods used in analyzing the trend of speculative markets are considered 
 in chapters ix and x. 
 
CHAPTER VIII 
 
 THE SECURITY MARKETS 
 
 As was indicated in chapter vii, the place in our business system 
 where the attention of the profit-seeker is most closely centered on 
 the problem of reducing risk through the elimination of uncertainty 
 is in the field of speculation and investment. For this reason the sub¬ 
 ject is given detailed attention in this and the following chapters. 
 We will first survey the organization of the securities market and the 
 technical devices used in speculative and investment operations. This 
 will be followed by a survey of the methods used by operators in these 
 markets in deciding when to buy and when to sell, chapter ix dealing 
 with speculative operations and chapter x with those of a more con¬ 
 servative character. Finally, in chapter xi we will examine the 
 speculative markets for commodities, and the methods used in 
 operating through them. 
 
 I. THE MARKET FOR OLD SECURITIES 
 
 The market for old securities presents the widest variation in char¬ 
 acter. At the one extreme are the securities of thousands of corpora¬ 
 tions for which there is no quotable market whatever. The investors 
 who hold the stocks or bonds of these corporations are practically 
 in the position of partners in the enterprises, so far as their ability 
 to liquidate their holdings is concerned. At the other extreme, in 
 marketability, are a dozen or more of the most active stocks which it 
 is possible to buy or sell in lots of anywhere from one to a thousand 
 shares with only a fraction of a per cent’s variation in the price. 
 Between these extremes there are all degrees of marketability. 
 
 The most conspicuous institution which has been developed for 
 the purpose of facilitating trade in old securities is the stock exchange, 
 and the market for active securities can therefore be understood best 
 through a study of the organization and work of a typical exchange. 
 The New York Stock Exchange will be described in considerable 
 detail for the reason that its activities completely overshadow those 
 of the other stock exchanges of the United States. Other exchanges 
 will be described more briefly. 
 
 128 
 
THE SECURITY MARKETS 
 
 129 
 
 The New York Stock Exchange is a voluntary association whose 
 purpose is to facilitate the purchase and sale of securities by its members .— 
 The fact must be emphasized at the outset that the Exchange is an 
 organization formed by a limited group of individuals to advance their 
 own business interests. Its principal function is to help its members 
 to buy and sell stocks and bonds with the minimum expenditure of 
 time and labor, and with the maximum amount of relevant informa¬ 
 tion to guide their decisions. Incidentally it renders numerous other 
 services, not only for its members but for the public, but these other 
 services are supplemental to, rather than independent of, its principal 
 business. The Exchange itself does not buy nor sell securities, nor, 
 except in rare emergencies, does it place any restrictions upon the 
 prices at which trades are made, or influence them in any direct way. 
 It is not its business to direct the flow of investment, nor to furnish 
 the public with a barometer of prosperity, nor to protect speculators 
 from their own folly or investors from the dishonesty or incapacity 
 of the managers of their property. 
 
 More specifically, the Exchange’s functions are the following: 
 
 1. It furnishes a place of meeting for traders. 
 
 2. It prescribes standard types of contract and rules of interpreta¬ 
 tion, the provisions of which are implied in all trades made on the 
 floor of the Exchange; and provides rules for conducting its business 
 in an orderly way. 
 
 3. It regulates the business methods of those of its members 
 who are engaged in brokerage. 
 
 4. It provides facilities for “clearing” trades, thus reducing the 
 labor of delivery of securities and payment for them. 
 
 5. It furnishes an elaborate equipment for obtaining and dis¬ 
 seminating information. 
 
 6. It attempts to influence legislation and the growth of public 
 opinion in ways favorable to the interests of its members, and combats 
 the activities of “bucket shops” and other agencies which tend to 
 injure or discredit the business of legitimate brokerage, investment, 
 and speculation. 
 
 1. The Exchange furnishes a meeting place for traders. —The pro¬ 
 vision of a place to carry on trade is perhaps the most important, as 
 well as the earliest, function performed by an organized exchange. 
 In an early stage of the development of a security market, brokers, 
 dealers, and private investors can get in touch with one another by 
 correspondence, by advertising, or by making the rounds of the 
 
130 
 
 RISK AND RISK-BEARING 
 
 financial district in person. Telephone and telegraph also still serve 
 even in the largest markets to make possible an immense volume of 
 trading without the use of an exchange. As the number of professional 
 brokers in a city increases, however, it becomes desirable for them to 
 get together for a part of the day to match their orders. A large 
 office or the lobby of some convenient hotel may serve for a time as 
 a meeting place. 'In New York the Broad Street Curb served for 
 many years as a meeting place for dealers in certain stocks (see 
 below, p. 147), while the original meeting place of the New York 
 Stock Exchange was under a tree in Wall Street. Increasing numbers 
 made it necessary in New York, as they have at many other points, 
 to adopt some formal organization to share the responsibility and 
 expense of maintaining a regular meeting place. 
 
 2. The Exchange exercises control over trading. —Once the practice 
 of meeting to trade is begun, it becomes necessary immediately to 
 regulate to some extent the trade carried on in the common place of 
 meeting. Hours of trading are prescribed, and penalties fixed for 
 trading in listed securities outside these hours. On the New York 
 Exchange, the present hours are from ten to three (on Saturday from 
 ten to twelve), and outside trading (in listed securities) is punished 
 by fines. The object of the penalty for outside trading is twofold: 
 first, it insures to every member a fairer chance at other members’ 
 offerings, and second, it restrains the severity of competition between 
 brokers. 
 
 The manner of executing trades is regulated in some detail. The 
 standard unit of trading is 100 shares, and all bids and offers are under¬ 
 stood to be for that amount, unless otherwise specified. Moreover, 
 anyone who makes a bid or offer for a larger amount must accept a 
 trade for 100 shares or any multiple thereof smaller than his offer. 
 Offers not otherwise designated are understood to be “regular way,” 
 that is, delivery and payment to be made on the next business day, 
 except that deliveries on Friday trades are made on Monday. Trades 
 may be made also for “cash,” that is, delivery and payment same 
 day, or “seller three,” “seller thirty,” “buyer sixty,” etc., which 
 means that the seller has three, thirty, or sixty days within which 
 to make delivery, or the buyer to call for delivery, as the case may be. 
 Such dealings are not frequent. 1 
 
 1 During the early days of the Great War a great many sales were made “seller 
 thirty” in order to allow time for importation of certificates. 
 
THE SECURITY MARKETS 
 
 13 1 
 
 “ Wash sales,” that is, trades where the buyer and seller are identi¬ 
 cal, are prohibited, but the prohibition is difficult of enforcement, for 
 the broker has usually no way of knowing whether his principal is 
 also trading through another member. “Cornering” and other 
 obvious ways of establishing an artificial price are also prohibited. 
 All offers must be open for acceptance by any other member. 
 
 3. Relations of brokers with customers are regulated. —The most 
 important rule governing the relations of brokers and their principals 
 is the stringent rule against cutting commissions, the object of which 
 is obvious. There are also rules requiring the broker to make good 
 to clients the losses resulting from errors on the broker’s part, and 
 from failure to obtain the proper execution of orders; rules prohibiting 
 the filling of orders from the broker’s own stock, and similar regula¬ 
 tions designed to maintain the reputation of the Exchange as a home 
 of fair dealing. 
 
 4. Delivery of stock is simplified. —The delivery system of the 
 New York Stock Exchange is one of the most efficient in the world. 
 Its operation in brief is as follows: Since delivery of stock must be 
 made daily, it is impossible for all transfers of ownership of active 
 stocks to be recorded on the books of the issuing corporations. Stock 
 certificates are transferable by indorsement, and in the case of active 
 speculative securities certificates issued in the name of brokerage 
 houses and indorsed in blank are frequently exchanged by mere 
 delivery of the certificate. In the case of dividend paying stocks, 
 this results in the dividends being paid to houses which are not the 
 actual owners of the stock, and it is the business of the broker who 
 owns stock at the time it “goes ex-dividend” to collect the dividend 
 from the one to whom it is paid. In the case of non-dividend stocks, 
 no inconvenience results from leaving the stock in “street name,” 
 and frequently the stock is so left even when bought by investors and 
 taken out of the market. 
 
 The most important device for reducing the labor connected with 
 the • delivery of stocks is the Stock Clearing Corporation. This 
 organization functions in two branches, known respectively as the 
 night-clearing and the day-clearing branches. The night-clearing 
 branch receives from brokers reports of the stock bought and sold 
 during each trading day, and makes up a schedule of deliveries so 
 that settlement can be effected with the minimum of labor. Thus, 
 if A has sold a certain security to B, and B to C, and C to D, A may 
 be directed to deliver the security direct to D. D will then make 
 
132 
 
 RISK AND RISK-BEARING 
 
 payment to A at an arbitrary settlement price which is established 
 each day as a basis for that day’s settlements. If in the foregoing 
 illustration A has sold, say, Southern Pacific stock at 90, B at 91, and 
 C at 92, and the “settlement price” is 93, A will deliver the stock to 
 D and collect $93 a share. The differences between the contract 
 price and the clearing price are settled between the clearing members 
 and the clearing corporation. A, having sold at 90 and collected $93, 
 will owe the clearing corporation $3 per share B, having bought at 
 91 and sold at 92, will have a claim on the clearing house for $1 per 
 share. C, likewise, has a claim for $1 per share and D, having bought 
 at 92 and made payment at 93, has a claim to $1. The clearing 
 house, therefore, collects $3 from A, and pays $1 to each of the other 
 three. Thus, a member who has bought and sold the same amount 
 during the day is relieved of all responsibility for delivery and pay¬ 
 ment except the collecting of profits or the payment of losses, and an 
 enormous saving of labor in the certification and payment of checks 
 is effected. 
 
 Systems substantially the same as this are used in most of the 
 stock exchanges throughout the country. In New York, however, 
 a unique feature was added in 1920, a second clearing system, known 
 as the day clearing, for settling the balances due between traders 
 who accept and deliver stocks. Thus, in the foregoing illustration D 
 owed A a balance of $93 per share on delivery of the stock. Quite 
 probably, however, A owed a similar balance to E on other transac¬ 
 tions, E to F, and F to D. By reporting to the clearing house the 
 balance due and paying in, or drawing out, the net balance of pay¬ 
 ments, a second material reduction of the labor connected with 
 check certification and deposit is effected. This second operation is 
 worked out during the day following the delivery in the morning of 
 stocks which have been bought and sold the previous day. This 
 secondary clearing operation is unknown in the lesser stock exchanges 
 of the country. 
 
 5. The Exchange assists its members in securing information .— 
 The Exchange’s service in providing its members with information 
 consists chiefly of two activities, namely, the quotation service and 
 the requirement of publicity from corporations whose securities are 
 listed. The quotation service has been described as follows: 
 
 In among the posts are four “pedestals,” each bearing the regulation 
 “ticker” and a telegraph key. These are the sending stations of the great 
 ticker service that records in brokers’ offices and banks all over the country 
 
THE SECURITY MARKETS 
 
 133 
 
 each sale of stock as it is completed on the New York Stock Exchange. 
 When the Exchange has opened, we shall see scattered about the floor 
 uniformed attendants, each wearing on his cap a broad gold band and a 
 plate with the word “reporter” on it. At intervals, more or less frequent 
 as business waxes and wanes, the reporters converge upon the pedestals 
 and hand to one of their number at the telegraph key slips on which they 
 have hurriedly penciled the particulars of sales which they have just heard 
 made in the crowds about the different posts. Briskly the reports they 
 bring in are “pounded out” by the man at the key, and back they dart to 
 eavesdrop again. In two rooms on the top floor of the building is to be 
 found the next stage in the ticker service. One is occupied by the New 
 York Quotation Company, which is controlled by the Stock Exchange, the 
 other by the Gold and Stock Quotation Company, a subsidiary of the 
 Western Union. The first supplies the reports of the transactions on the 
 Floor to the offices of members of the Exchange below Chambers Street; 
 the second to all the other tickers in New York and in fifty cities throughout 
 the country. 
 
 In each room sit two groups of men, one active, the others in reserve. 
 There are five men to a team. One sits before a round disc studded with 
 red and white push-buttons lettered and numbered like the keys of a type¬ 
 writer. The other four sit around him, each with one ear close to a telegraph 
 sounder in its wooden box. The wires to each sounder are the wires com¬ 
 ing from one of the four pedestals downstairs. As first one then another 
 of the instruments chatters out a metallic message of some sale on the 
 Floor, the central operator's hands with their long, facile fingers spell out 
 the message again on the buttons before him. He has taken the message 
 “by ear,” as he regularly does in dull times when selling is slow and only 
 one sounder speaks at a time. But the listening operator whose instrument 
 has spoken also writes the particulars of the sale on a slip of paper and 
 sets it before his partner. In quiet times this is only necessary in order 
 to help the sending operator in checking his work. On busy days, however, 
 it saves him from the impossible task of listening to four instruments at 
 once and disentangling their dots and dashes. 
 
 As he spells out each sale on the red and white buttons the ticker on 
 the table before him prints on the tape the record US 57! U 145! K 500.20 
 Pa 108 BO 200.97 K 20 R i6f U 145! MP 315. As we watch the record 
 grow on the marching tape we know that on just such a tape at precisely 
 the same instant in 500 offices precisely the same record is being printed. 
 In the next room the same process is sending the same word to probably 
 ten thousand offices and banks in fifty cities and towns of the country. 
 
 Like the winking blackboards on the walls downstairs, these rooms, 
 with their staccato sounders and the nimble fingers of the operators playing 
 on their parti-colored discs, seem symbolic too. They remind us that every 
 transaction on the Floor, every purchase, every sale, is known to the 
 
134 
 
 RISK AND RISK-BEARING 
 
 public hardly more than an instant after it is made. It is little exaggera¬ 
 tion to say that a sale of stock is reported all over the city before the brokers 
 who take part in it have had time to record it on their pads. The reporter 
 hears the offer, catches the word “sold” or sees the gesture which closes the 
 transaction, walks twenty feet across the Floor to the nearest pedestal and 
 taps out the report on the telegraphic key. Upstairs the operator at the 
 disc catches the message “by ear,” spells it out on the buttons, and before 
 the buying and selling members have gathered themselves together for the 
 next trade the ticker in every broker’s office in the Street has printed the 
 fact on the tape. 
 
 In busy times the ticker does fall behind the market, but on an ordinary 
 day it is not behind at all. The swiftness of the electric current and the 
 rapidity of the trained workers who bridge the gaps in the circuit keep the 
 ticker service well abreast in the market. The man who has given an order 
 to his broker to buy 500 Steel at 60, if he only stays near a ticker can 
 know when the market has reached his price, and his stock presumably been 
 bought, much sooner than, if he were buying a dozen eggs, the grocer could 
 have them wrapped up for him. 
 
 The Stock Exchange does its business in the open. The public knows 
 what has happened there just as quickly as the members on the Floor. 
 No trades are concealed; no news of trades delayed; no prices made or 
 broken without instant word going to every part of the land. Of course 
 this is not to say that the reasons for each sale, the forces behind it, the 
 meaning of each movement in price, of each “bulge” or “break,” are trans¬ 
 mitted to the public. They are not known even to the members themselves 
 except by inference and deduction and guesswork. The Stock Exchange no 
 more than any other organization of men can penetrate the individual mind 
 and heart and determine infallibly and instantaneously why the individual 
 performs a given act. How, then, can it tell the public why a certain thing 
 happens and what the happening portends? But it can tell the public 
 just what does happen, and it does so with astonishing suddenness. It is 
 hard to see how a more complete and instantaneous mechanism for spread¬ 
 ing broadcast the news of the course of business in a given field could be 
 devised. What the Stock Exchange does the country knows, and knows it 
 the next moment. 1 
 
 It may be added that the Exchange’s control of quotations is 
 used not merely to enable it to furnish a valuable service to its mem¬ 
 bers, but also as a source of considerable revenue and as a means of 
 controlling certain activities of individuals not members of the 
 Exchange. For though ticker privileges are sold to non-members, the 
 
 1 Adapted by permission from H. Howland, “ Gambling Joint or Market 
 Place,” Outlook , June 28, 1913, pp. 423-25. 
 
THE SECURITY MARKETS 
 
 T 35 
 
 Exchange retains the right to refuse quotation to bucket shops 1 
 and others whose use of the quotations is calculated to bring discredit 
 on the business of the Exchange. 
 
 The other chief means of securing information for the benefit of 
 members and their clients is found in the rules governing the listing 
 of securities. The Stock Exchange maintains a committee on stock 
 listing, whose business is to receive and consider applications for 
 placing securities on the list and make recommendations concerning 
 them to the governing committee, or in the case of certain high-grade 
 securities, to list them without reference to the governing committee. 
 The requirements for listing are extremely strict. The corporation 
 applying for the listing of its stock must file a statement showing, in 
 addition to the ordinary information concerning its charter, form of 
 capitalization, and field of business, complete details concerning its 
 financial structure and financial strength. This includes such detailed 
 information as: 
 
 A. Voting power of obligations of debt. 
 
 B. (i) Purpose of issue; (2) application of proceeds; (3) amount issued 
 for securities, contracts, property; description and disposition; (4) addi¬ 
 tional property to be acquired. 
 
 C. Tabulated list of constituent, subsidiary, owned, or controlled 
 companies showing (a) date of organization; ( b ) where incorporated; ( c ) 
 duration of charter; ( d ) business, and ( e ) capital stock issues (by classes), 
 par value, amount authorized, issued, owned by parent company. 
 
 D. (1) Mortgage, and (2) other indebtedness, ( a ) date, ( b ) maturity, 
 ( c ) interest rate, ( d ) redemption by sinking fund or otherwise, ( e ) amount 
 authorized, and (/) amount issued; (3) similar information regarding 
 mortgage and all indebtedness of constituent, subsidiary, owned, or 
 controlled companies. 
 
 Other liabilities in detail, description of property owned in fee, con¬ 
 trolled, or leased. 
 
 Policy as to depreciation. 
 
 Output or production for the preceding five years, dividends paid, 
 income account, balance sheet, and similar accountings for predecessor, 
 constituent, subsidiary, owned or controlled companies and corporations 
 recently consolidated. 2 
 
 The corporation must also agree not to dispose of its stock interest 
 in subsidiaries, except under existing authority or on direct authoriza- 
 
 1 A bucket shop is an organization posing as a commission house which executes 
 fictitious trades for customers, paying them their profits or pocket ing their losses 
 
 2 Adapted from Rules of the New York Stock Exchange , reprinted in J. E. 
 Meeker, The Work of the Stock Exchange, pp. 577 ff. 
 
1 3 6 
 
 RISK AND RISK BEARING 
 
 tion of stockholders, to publish at least once a year an income account 
 and balance sheet, to maintain a transfer and registry office in New 
 York City, to notify the Exchange of any change of capitalization, 
 to publish promptly any action in respect to interest on bonds, divi¬ 
 dends, or allotment of rights, and to have on hand at all times a 
 sufficient supply of certificates to meet the demands for transfer. 
 
 These provisions are intended to secure adequate publicity for 
 the business of the corporation, and to enable investors to form an 
 intelligent estimate in regard to their value. The provisions control¬ 
 ling the listing of new securities are much more adequate for this 
 purpose than are the provisions controlling corporations whose stocks 
 have been listed. Once the securities of a corporation have been 
 placed upon the list, the Exchange, as a matter of fact, exercises very 
 little supervision over the management of the business, so long as 
 investors are notified promptly of the declaration and passing of 
 dividends, issuance of rights, suspension of interest payments, and 
 similar necessary data. Even the requirement that an annual income 
 statement and balance sheet be published is not rigidly enforced, 
 though nearly all corporations whose securities are listed do, as a 
 matter of fact, publish this information. 
 
 Control of the Exchange is highly centralized .—The Stock Exchange 
 is controlled by a Governing Committee of forty members together 
 with the president and treasurer of the Exchange. This committee 
 has practically absolute power not only to lay down rules for trading 
 but to discipline members by fines, suspension, and expulsion. Sub¬ 
 ordinate to the Governing Committee are a number of special com¬ 
 mittees composed of members of the Governing Committee and 
 appointed by it to manage special departments of the work. For 
 example, the management of the Stock Exchange Building is in the 
 hands of the Committee on Arrangements, and the giving out of 
 quotations is controlled by the Committee on Commissions and 
 Quotations. 
 
 It has frequently been suggested by outside critics that the Stock 
 Exchange should be incorporated in order to bring it under a larger 
 degree of governmental control. This suggestion the Exchange has 
 steadily resisted. The Exchange authorities deny that the public 
 would gain from such incorporation any valuable powers of control 
 which it does not already possess. On the other hand, they fear 
 that incorporation would tie the hands of the Governing Committee 
 in matters of discipline, and make impossible prompt action in closing 
 
THE SECURITY MARKETS 
 
 137 
 
 the Exchange on occasions of public disturbance, in regulating prices 
 of cornered stocks, and in similar cases of emergency. The expe¬ 
 rience of the Chicago Board of Trade, which is incorporated, does not 
 indicate that incorporation would be likely to have any important 
 effect either for good or for evil. 
 
 The membership of the Exchange includes specialized groups. —As 
 was noted above, membership in the New York Stock Exchange is 
 limited to 1,100 members. The only way, therefore, that a new mem¬ 
 ber can be admitted is through a transfer of the membership of some¬ 
 one else. The “seats” are regularly bought and sold, fluctuating in 
 value with the volume of speculation. During the war boom, seats 
 in the New York Stock Exchange sold as high as $115,000. Purchas¬ 
 ing a seat, however, does not of itself entitle one to a membership, as 
 the Committee on Memberships scrutinizes every candidate’s qualifica¬ 
 tions with great care, and individuals whose record either for reliability 
 or for financial strength is unsatisfactory are quite often rejected. 
 
 The membership is made up chiefly of the following classes: (1) 
 partners in commission brokerage houses; (2) “two-dollar” brokers; 
 (3) “specialists”; (4) dealers in odd lots; (5) professional speculators; 
 and (6) inactive members. A survey of the work of these classes of 
 members will serve to bring out most of the essential features of the 
 organization and work of the Exchange. 
 
 1. The commission brokerage house buys and sells stocks and bonds 
 as the agent of outside investors and speculators. —It is always unincorpo¬ 
 rated, sometimes individually owned, more often a partnership. 
 A large brokerage concern usually has memberships in all the impor¬ 
 tant exchanges. Officers are maintained in leading cities all over 
 the country, and private wire connections established between them. 
 
 The chief asset of a commission house is its list of customers. 
 Its chief income is the commission it obtains for executing trades, 
 either upon the exchange floor or elsewhere. The commission for 
 executing trades is 15 cents per share for stock selling from $10 to $125 
 per share; 7} cents per share below that figure and 20 cents per share 
 above, and $1.50 per $1,000 for bonds. For this commission the broker 
 attends to all the details not only of executing the trade but of delivery, 
 payment, and transfer on the books of the issuing corporation, and 
 also furnishes its customers and the public generally with a large 
 amount of service, for which it is not directly paid. Many houses 
 maintain customers’ rooms in which quotations are posted on 
 blackboards as fast as they are received from the Exchange. Financial 
 
138 
 
 RISK AND RISK-BEARING 
 
 journals and manuals and other sources of information are kept 
 available, and advice is freely given on the customer’s investment or 
 speculative problems. In addition to this, the commission brokerage 
 house regularly undertakes the responsibility of financing its cus¬ 
 tomers’ purchases, exacting a “margin” of from 5 to 40 per cent of 
 the amount, and furnishing the rest of the capital itself or borrowing 
 it from banks. 
 
 Facilities are also offered for executing what is known as a “ short 
 sale .”—This is a sale of stock which the customer does not own but 
 which is borrowed for him by the broker for delivery, the loan being 
 repaid when the stock is bought at a later date. The financing and 
 executing of such transactions may be illustrated by the following 
 diagram: 
 
 A and D are speculators, and B and C their respective brokers. 
 A orders B to “sell short” for him 100 shares of Southern Pacific 
 stock, posting about $1,000 as margin. B sells the 100 shares at 
 $98 each to C, who represents D, a speculator desirous of purchasing 
 100 shares of Southern Pacific. D usually posts with C $1,000 as 
 margin. Delivery and payment must be made the next day. In 
 order to make delivery, B borrows 100 shares of Southern Pacific 
 from F, posting with F the full $9,800 as security, and delivers the stock 
 to C, collecting from him $9,800. C then posts the stock with E, a 
 bank, as collateral for a loan of say, $8,000, advancing the balance 
 out of his own funds. Usually B collects from F interest on the $9,800, 
 which is posted with him as collateral for the loan of the 100 shares of 
 stock. D pays interest to C on his unpaid balance of $8,800 and C, 
 of course, pays interest to E on the $8,000 which he has borrowed. 
 Usually C and F pay the call loan rate, while D pays a customary rate 
 which does not fluctuate as often as the call loan rate but averages 
 somewhat higher. In case a dividend is declared on the stock while 
 the short trade is open, both D and F are entitled to receive it. Hence 
 A must make good one dividend, the company, of course, paying the 
 other. 
 
THE SECURITY MARKETS 
 
 139 
 
 The advantage of the transaction to F is that he is enabled, through 
 loaning his stock, to borrow on it up to 100 per cent of its face value; 
 whereas through a bank he could probably not borrow more than 
 70 or 80 per cent. A may close out the transaction at any time by 
 ordering B to purchase stock in the open market and deliver to F 
 in repayment of the loan. D also may close out the trade at any 
 time by ordering C to sell the stock in the open market. In case F 
 desires the return of his stock before A wishes to purchase, it is B’s 
 business to borrow the stock elsewhere. In case the stock cannot be 
 borrowed, B must “ cover the sale,” i.e., buy the stock in for A’s 
 account. Most brokers will not execute orders for short sales except 
 m securities which have a large floating supply, so that the risk of being 
 compelled to “cover” in this way is small. In case of a scarcity of 
 stock for loaning purposes, the interest rate paid by the lender of 
 stock will go below the usual call rate. Sometimes the lender of 
 stock is enabled to get the use of the money for nothing, in which case 
 the stock is said to loan “flat” and occasionally a premium is paid for 
 use of the stock in addition to the waiver of interest. 1 
 
 In practice, of course, C does not negotiate a separate loan at the 
 bank for every margin trade his customers may make. What he 
 does is to borrow on the mass of securities in his possession as much 
 money as he needs to take care of his customer’s demands. Most 
 brokers carry their customers on smaller equities than do the banks, 
 so that the broker has to advance part of the funds on his own capital. 
 Some, however, pursue the opposite policy, requiring margins so large 
 that they can secure larger loans from the bank than they make to 
 their customers. The purpose of the margins is, of course, to protect 
 the brokers against adverse fluctuations in the price of the stock. 
 In the illustration above, if, while A is still short, the price of Southern 
 Pacific advances, B must have some protection in his obligation to 
 return the stock to F on demand. Even if he is not required to return 
 the stock he may be called upon to post additional money for F’s 
 protection. In case the advance in prices is large, A will be called 
 upon to post additional margin, and if he is unable or unwilling to do 
 so, the stock will be bought in the open market and delivered to F in 
 
 1 For instance, the following quotations were published on April 7, T921: 
 “Crucible, 1-16 per cent premium; American Sugar, B.R.T., D.&H., Maxwell, 
 Penna., flat; L.&N., 2; American Smelting, Anaconda, Baldwin, Bethlehem B., 
 General Motors new, Alcohol, M.P., Food Products, U.S. Rubber, U.S. Steel, 6; 
 Atchison, B.&O., C.P., C.&O., St. Paul, R.I., Erie, Marine common, Marine pre¬ 
 ferred, N.H., Centra). N.P., Reading, S.P., Studebaker, U.P., 5 per cent.” 
 
140 
 
 RISK AND RISK-BEARING 
 
 repayment of the loan, and the loss charged to A’s account. In case a 
 sudden change of market makes it impossible for the broker to sell 
 the stock at a price which protects him, or, in other words, in case the 
 loss is greater than the margin A has posted, B has a valid claim 
 against A for the additional loss. D’s margin protects C against a 
 decline in price just as A’s margin protects B against advance. 
 
 The volume of exchange trading is very great .—The way in which 
 such transactions as those described above make possible an enormous 
 volume of trade through the rapid turnover of a comparatively small 
 amount of stock has been described as follows: 
 
 The process is very simple, once you get it clear. We take a simple 
 case. Suppose A has 1,000 shares of Bethlehem Steel. He may be carry¬ 
 ing it for a client. Anyhow he has it—the actual stock. Let us suppose 
 that he is carrying it for a client, and has hypothecated it along with other 
 stocks for a loan at his bank. Now a speculator wishes to sell Bethlehem 
 Steel for a fall, that is, to sell it short. He has no stock, but he knows he 
 can borrow it. Men at the Bethlehem Steel post are bidding for it. One 
 who shall be C bids 150I for 1,000 shares, and B cries “Sold!” That goes 
 out on the ticker instantly—1,000 shares of Bethlehem Steel sold at 1503 
 and you might suppose that so much actual property had changed hands, 
 like real estate. But the seller, remember, had no Bethlehem Steel Stock to 
 sell. He may never have owned a share in his life. But all the same he 
 must deliver 1,000 shares to C. 
 
 After the close of the day’s trading there is a “loan crowd,” where all 
 active stocks are borrowed and loaned. B, the speculator, shouts: “I 
 want to borrow a thousand Bethlehem.” And now A appears. He has 
 1,000 shares of stock hypothecated at the bank, and he agrees to lend it to 
 B. They exchange memoranda. So now A gets his 1,000 shares of Bethle¬ 
 hem Steel back from the bank (either by paying the money he has borrowed 
 on them there or substituting other collateral in their place), and delivers 
 the stock to B in exchange for a certified check of $150,500. B delivers 
 this borrowed stock to C, to whom he sold it, and receives from C a check 
 of $150,500 in payment for it. 
 
 The actual stock is now in possession of C, who hypothecates it at his 
 bank. The next day another speculator, who shall be D, in like manner as 
 B, is moved to sell 1,000 shares of Bethlehem Steel stock for a fall. He 
 sells it to E, borrows it from C and delivers it to E. Now three people have 
 title to 1,000 shares of Bethlehem Steel stock, namely, (1) A who had it 
 first and loaned it to B, (2) C who bought it from B, and (3) E who bought 
 it from D. Actually only 1,000 shares of real stock have figured in these 
 transactions, but 2,000 more have been bought and paid for. This may go 
 on and on so long as nothing unexpected happens. 
 
THE SECURITY MARKETS 
 
 141 
 
 If the price falls the speculators who have sold it short and borrowed 
 it for delivery return it to those from whom *t was borrowed. If it falls, 
 for example, to 140^, B buys 1,000 shares at that price, for $140,500, 
 sends the stock to A from whom he borrowed it, and gets back his own 
 original $150,500. The difference is his profit. If the price rises, the short 
 sellers buy it in the same way and return it to those from whom they 
 borrowed it, but they do it in that case at a loss, because the stock they 
 buy is worth more than the stock they borrowed. 
 
 The unexpected does sometimes happen. A number of people may have 
 been lending the stock over and over to short sellers, intending all at once 
 to demand the return of it in a concerted manner. The speculators are 
 deceived by the willingness with which the owners lend it and deduce from 
 that that the supply is ample. But all at once the lenders call for the return 
 of the stock and the borrowers, unless they can find other owners who will 
 lend, are compelled to buy the stock in the open market at a loss. 
 
 So corners are contrived. Speculators are beguiled to sell what they 
 do not own, because they think it will fall and can be bought cheaper tomor¬ 
 row, and the stock with which to make their deliveries is loaned to them 
 by manipulators who may know all the time approximately how much real 
 stock there is in the floating supply. When the ratio of contracts to actual 
 stock is very high they call suddenly upon the borrowers to produce it. 
 As it cannot be produced, the borrowers have to settle, that is, they have to 
 buy at any price, and their bidding for it causes wild advances in the price. 
 
 In a stock on which speculative interest is centered there is, of course, 
 a great deal of mere “trading” by professional members of the Stock 
 Exchange who seldom receive or deliver stocks at all. They buy and 
 sell the same day, their purchases canceling their sales. One who buys 
 1,000 Bethlehem Steel at 10 o’clock and sells 1,000 shares at 3 o’clock is 
 “even.” The two transactions pair themselves off at the Clearing House 
 afterward. The trader merely sends a record of what he has done to the 
 Clearing House. He owes nobody any stock; nobody owes him any stock. 
 But there is a difference in money to be settled. He may have bought from 
 A 1,000 shares in the morning at 150^, and in the afternoon he may have sold 
 1,000 shares to Z at 151I. He has made a profit of $1,000; but he neither 
 receives stock from A nor delivers stock to Z. He merely attaches to his 
 Clearing House sheet a draft for $1,000. The Clearing House deals with 
 A and Z. A has sold 1,000 shares of stock at 150I for which he will receive 
 $150,500 in money. Z has bought 1,000 shares of the same stock at 151^, 
 for which he must pay $151,500. The difference is $1,000 and that is the 
 trader’s profit. A sold the stock to the trader and Z bought it from the 
 trader, but it is Z who receives it from A. The trader was in the middle, 
 never intending either to receive or deliver stock. The Clearing House 
 sends him $1,000 which is the difference between what A gets and Z pays 
 
142 
 
 RISK AND RISK-BEARING 
 
 for the i ,000 shares of stock. And by these processes mainly is it possible 
 for Stock Exchange “transactions” greatly to exceed the actual amount 
 of a given stock existing in Wall Street. 1 
 
 Large brokerage houses maintain an elaborate system of private 
 communication between their offices in leading cities. —These are called 
 “wire houses.” The following is an excellent description of this 
 service: 
 
 A large part of all the stock bought and sold in the Wall Street offices 
 of brokerage firms is of course for the account of operators who live in New 
 York. But in addition to this the large brokerage concerns have a remark¬ 
 ably expensive telegraph system whereby orders are gathered from far distant 
 points. The “wire map” of any one of a half-dozen or so of the large houses 
 looks like a complete railroad guide of the United States. One particular 
 firm reaches by private leased duplex wire from its main Wall Street office 
 to such cities as Baltimore, Washington, Charlotte, Charleston, Atlanta, 
 Savannah, Augusta, Jacksonville, New Orleans, Memphis, Chicago, Cleve¬ 
 land, Cincinnati, Omaha, Colorado Springs, Denver, Salt Lake City, Butte, 
 Spokane, San Francisco, Pasadena, Los Angeles, Coronado Beach, and 
 San Diego. It also has wire connections to Boston, Portland, Montreal, 
 Toronto, Detroit, Gary, Indianapolis, Louisville, St. Louis, Kansas City, 
 Milwaukee, St. Paul, and Winnipeg. This particular firm has six branches 
 in the state of California alone. These wires may connect with branch 
 offices or merely with correspondent firms. 
 
 The relative importance of this outside business may be judged from 
 the following figures. On two successive days in the summer of 1919, 
 75,000 and 60,000 shares respectively were handled by branch offices; 
 while 38,000 and 46,000 shares respectively were handled by the main 
 office in New York. The extent of this “outside” participation in New 
 York Stock Exchange speculation is, of course, very much increased in 
 times of active bull markets, such as prevailed in the early summer and 
 again in the autumn of 1919. 3 
 
 2. “ Two-dollar brokers” are exchange members who specialize in 
 the execution of trades for other members. —They are so called because 
 their commission at the time the name arose was $2 per 100 shares of 
 stock bought or sold. (The present figure is $2.50.) These brokers 
 are of two classes. Some of them form permanent connections with 
 brokerage houses, doing practically all of their floor work. Such a 
 connection is especially valuable to a small house whose exchange 
 
 1 Adapted by permission from “The Phenomena of Phantom Stocks,” New 
 York Times Annalist , August 2, 1915, p. 127. 
 
 'Adapted by permission from H. G. Moulton, The Financial Organization of 
 Society , pp. 290-91. (University of Chicago Press, 1921.) 
 
THE SECURITY MARKETS 
 
 143 
 
 member is the proprietor of the business or a senior partner, and whose 
 time is more valuable in the office than it would be on the floor. A 
 large house finds it, as a rule, more economical to have a partner who 
 does the floor work, but small houses often do not have enough floor 
 trading to occupy the entire time of a partner. Other two-dollar 
 brokers are employed by the floor members of brokerage houses to 
 assist them in rush periods, or at times when they have orders calling 
 for immediate attention in different parts of the floor at the same 
 time. This is particularly likely to be the case at the opening of the 
 market, when the trader’s book is filled with an accumulation of 
 overnight orders. 
 
 It may appear that there is an unduly wide spread between the 
 commission of $15, which the brokerage house charges its customers 
 for buying or selling 100 shares, and the $2.50, which it pays the 
 “two-dollar broker” to do the work for it. It must be remembered, 
 however, that the two-dollar broker has no responsibility to furnish 
 information to customers, maintains no selling organization, keeps no 
 books except his list of open orders and his record of work done, 
 borrows no money from banks or stocks from other brokers, makes 
 no deliveries, and, in general, has no business cares and responsibilities 
 after his rather short day’s work is done. On the other hand, the 
 accounting work alone of a large brokerage house is a task requiring 
 the employment of many clerks and bookkeepers, while the annual 
 cost of a private wire between two important trading centers may 
 run far into thousands of dollars. Expensive services in furnishing 
 information are usually provided. It is these outside services, rather 
 than the actual work of making a trade on the floor of an exchange, 
 for which the commission house receives its compensation. 
 
 3. The “ specialist ” makes a market for inactive stocks .—The 
 specialist is a trader and broker who devotes himself solely to the 
 execution of orders and stocks traded in at the same point on the 
 floor, sometimes indeed solely to the issues of a single corporation. 
 It is the business of the specialist to make a market at any time for 
 the security in which he specializes. This he does by quoting a “bid 
 and asked” price upon request. If few other dealers are interested 
 in the security in which he specializes and there is little speculative 
 interest in it, he may be able to keep the market for himself while 
 quoting a bid and asked price a considerable distance apart. If so, 
 he makes of course a correspondingly large profit by buying at the 
 bid and selling at the offered price. If the security becomes more 
 
144 
 
 RISK AND RISK-BEARING 
 
 active, he has more competition and must quote prices closer together 
 in order to make trades, thus reducing a profit on a single transaction 
 but presumably increasing the number of his trades. The “ specialist ” 
 also acts as a “two-dollar broker,” handling orders for other brokers 
 to buy and sell his special stocks. In this case he gets the $2.50 
 commission just as the regular two-dollar broker would get it. He is 
 of course not allowed to act both as a broker and as a dealer in the 
 same transaction, and would be punished by a heavy fine or suspension 
 if caught attempting to do so. 
 
 4. The odd lot dealer handles small orders .—Another very interest¬ 
 ing branch of stock exchange business, as it is carried on in New York, 
 is the work of the odd lot dealer. The standard unit for dealings on 
 the New York Stock Exchange is, as previously stated, 100 shares, 
 and only trades of that size, or of some multiple of 100 shares, are 
 reported on the ticker or closed out through the clearing house. 
 There is however a very large volume of business in less than 100 
 share lots—some estimates of it run as high as 20 per cent of the total 
 trade. Almost any brokerage house will accept orders for as few as 
 25 shares for margin accounts and smaller lots for cash sale or purchase, 
 and some houses handle as few as 10 shares in a single order on margin 
 account. In executing these trades, resort is nearly always had by 
 the broker to representatives of a few large houses which specialize 
 in the odd lot business. These houses buy and sell on their own 
 account, making their income out of profits on the trade, not out of 
 commissions. The customer, of course, pays the usual commission, 
 but this goes to the house which represents him, not to the odd lot 
 house. The most frequent way in which such orders are executed is 
 to hold them until the next trade in the round lot market, immediately 
 after which the odd lot man will sell at one-eighth or one-quarter 
 point 1 above, or buy one-eighth or one-fourth below the price recorded. 
 This gives him a profit of one-quarter or one-half point if he is able 
 to make both a purchase and a sale before the “round lot” price 
 changes. 
 
 Another method which avoids the delay incident to waiting for a 
 sale is for the odd lot house to buy at the bid price and sell at the 
 offered price (or one-eighth away in the case of inactive stocks). In 
 this case the odd lot dealer makes his profit out of the spread between 
 the bid and the asked price, just as does the specialist. 
 
 1 A “p o i n t” is one dollar per share in stock quotations, or ten dollars per 
 thousand dollars face value in bond quotations. 
 
THE SECURITY MARKETS 
 
 145 
 
 In order to make his deliveries, the odd lot man is frequently 
 obliged to buy or borrow 100 share lots and split them up into frac¬ 
 tional lots, remaining “long” of the unused balance if he buys, or 
 “short” of the amount sold if he borrows' This leaves him, of course, 
 exposed to the risk of market fluctuations, but he is able to keep this 
 risk at a minimum by buying part of his stocks and borrowing part 
 of them, so that in case of a market change he will make about as 
 much on the stocks in the one group as he loses on the stocks in the 
 other. 
 
 The following is a description of the work of the odd lot dealer: 
 
 The stocks traded in on the Exchange are divided by the “Odd Lot” 
 dealer, into two classes, which are known as “eighth stocks” and “quarter 
 stocks.” An “odd lot” order in an “eighth stock” is executed at one-eighth 
 point from the next “full lot” sale, or if the client so desires, at the bid or 
 offered price. Orders in “quarter stocks” are executed at one quarter 
 point from the next full lot sale, or one-eighth point from the bid or offer. 
 A large majority of the stocks are “eighth stocks.” The “quarter stocks” 
 are either inactive or the price fluctuations in them are at such wide figures 
 that trading on so narrow a margin for profit as one-eighth of one percent 
 would be impracticable to the odd lot dealer, and would not permit him 
 to give the free market in every stock on the list whether active or inactive 
 that now exists for the trader in odd lots. 
 
 The firms which deal exclusively in odd lots are represented by as mani¬ 
 as twenty-five or more members on the New York Stock Exchange. Each 
 one of these representatives is located in his particular place or station on 
 the Exchange floor and confines his activities solely to the execution of the 
 odd lot orders in the group of stocks assigned to him. 
 
 The individual desiring to buy or sell an odd lot gives an order at the 
 office of a Stock Exchange house or to one of its branch offices or out-of-town 
 correspondents with whom he has an account or wishes to open one. The 
 New York Office immediately upon receipt telephones the order to its clerk 
 on the floor of the Stock Exchange who writes it on an order slip and hands 
 it to a Stock Exchange employee in charge of the pneumatic tubes at his 
 booth. It is then sent through a tube to the tube station at the post at 
 which the particular stock is traded in, where it is removed from the carrier 
 by another Stock Exchange employee and by him handed to the odd lot 
 dealer or placed on the odd lot dealer’s special clip at his post. If it is a 
 limited order, the odd lot dealer enters it in his book; if it is a market 
 order he executes it, basing the price on the first sale of a full lot that takes 
 place after he receives the order. He then hands the report of the execution 
 of the order to the tube employee who sends it through another tube back 
 to the original tube station; here it is handed to the telephone clerk who 
 telephones it to the office. 
 
146 
 
 RISK AND RISK-BEARING 
 
 Market orders : An odd lot market order is an order to buy or sell a 
 stated number of shares from 1 to 99 at f (or |) away from the price of the 
 next sale of a full lot taking place after receipt of the order by the odd lot 
 dealer. Market orders received before the opening of the market are 
 executed at | (or £) from the opening price. It sometimes happens, how¬ 
 ever, especially when important news about a stock has come out over night 
 that there will be a wide, or as it is sometimes called “a split opening,” 
 when sales at different parts of the crowd occur simultaneously at different 
 prices. For example: U.S Steel might have an excited opening, sales of 
 ten thousand shares taking place immediately upon the ringing of the open¬ 
 ing gong at from 80 to 81 and the ticker would report “U.S. Steel 10,000, 
 80 to 81.” A reasonable opening price between these prices would have to 
 be decided on. In this case it would very likely be that the odd lot dealer 
 would buy at 8of or sell at 8of. 
 
 Limited orders: An odd lot limited order is an order to buy or sell a 
 stated number of shares from 1 to 99 at a stated price. For example: An 
 order is given “Buy 10 Reading at 69.” That this order may be executed 
 Reading must sell at 68| or less. If the first sale after receipt of this limited 
 order permits of its execution, the limit is ignored and the order considered 
 a market order. Should the first sale be 68j the order would be executed 
 at 68f. A limit is also ignored on a limited order if the opening sale any 
 morning permits of its execution while the order is in force. A limited order 
 must be executed at its limit, however, when the next sale after it is received 
 does not permit of its execution. For example. An order is given to “ Buy 
 10 Reading at 69.” If the first sale after receipt of the order is 695 and the 
 next sale 685 the order is executed at 69. In this case the odd lot trader 
 secures exactly the price he would have secured had this order been for 
 100 shares, because his broker would have been bidding 69 and the 100 
 shares would have been sold to him at 69 on his bid before the stock could 
 sell at 685. 
 
 Stop orders: A stop order is an order to buy or sell a stated number of 
 shares at the market after a fixed price is reached. An odd lot stop order 
 is executed at ^ (or \) from the first sale of a full lot which makes the stop 
 order operative. For example u Sell 10 Reading 69 Stop” If Reading 
 sells at 695 and then at 69 the order is executed at 685 but if the sale after 
 695 is 685 then the stop order is executed at 68f. 
 
 Orders to buy or sell at the close: An order may be given to buy or sell 
 an odd lot “at the close.” The execution of these orders is always based 
 on the closing bid and offer and not on the last sale of the day. It would 
 be impracticable for the odd lot dealer to trade on the last sale, as the last 
 sale might occur as early as 2:30 p.m. and this sale, for example, might have 
 been at 69 and the close 68-685 or 695-70. In justice to all concerned 
 therefore an order reading “At the close” must mean, at the closing bid 
 or offer (or § away). 
 
THE SECURITY MARKETS 
 
 147 
 
 These methods for conducting trading in Odd Lots, have been in general 
 use on the New York Stock Exchange for the past forty years. 1 
 
 5. Floor traders speculate on their own account. —Professional 
 speculators are not always members of the Exchange, but many of 
 them do find it advantageous to purchase memberships either in 
 order to make their own trades on the floor of the Exchange or in 
 order to secure the advantage of the lower rate of commission which 
 is charged by members executing trades for one another. Those who 
 trade for themselves are usually what are known as “scalpers,” i.e., 
 speculators who trade for small profits—an eighth to a half “point” 
 on a trade, and close out their trades quickly if the price goes against 
 them. In this sort of speculation, of course, the trader is governed 
 not by considerations of the investment value of the securities in 
 which he trades but by his judgment of the conditions which affect 
 the market of the immediate future. Consideration will be given 
 to these “technical conditions,” as they are called, in chapter ix. 
 
 6. Inactive members are numerous. —These comprise the office 
 members of certain brokerage houses, who seldom appear on the 
 floor, a few large professional operators who own memberships for 
 the sake of the reduction in commissions which it gives them, and a 
 great many representatives of prominent investment institutions, 
 who make little direct use of their memberships but desire to have 
 some voice in the management of the exchange or find some advertis¬ 
 ing value in their connection with it. 
 
 The “ Curb ” Market specializes in newer stocks. —Other exchanges 
 in the United States need little description, as they are all much smaller 
 than the New York Stock Exchange, and present no points of differ¬ 
 ence which are of interest. Until recently a noteworthy exception 
 to this statement was found in the New York Curb Market, the great 
 market place for unlisted securities. This was an informal gathering 
 of brokers who met in the open air on Broad Street, in New York 
 City, and carried on an active trade, largely in mining stocks and the 
 stocks of new corporations. Orders were transmitted by signals from 
 adjacent windows, and quotations were recorded only by newspaper 
 reporters who collected them from various brokerage houses specializ¬ 
 ing in the Curb trade. 
 
 At first the Curb trade was entirely disorganized, anyone being 
 free to trade or refuse to trade with anyone he pleased. An organiza- 
 
 1 Adapted by permission from a pamphlet issued by Carlisle, Mellick, and Com¬ 
 pany, New York. 
 
148 
 
 RISK AND RISK-BEARING 
 
 tion was formed however for the purpose of introducing some system 
 and responsibility. This organization grew more and more powerful 
 till in 1921 it emerged as a full-grown stock exchange, housed in a 
 splendid building, with ticker service, listing rules, and with the 
 opportunity of trading on the floor restricted to members. A small 
 remnant of the old group remained in Broad Street as the “outside 
 Curb,” but this market is at present of slight importance. 
 
 The “inside” or regular Curb is made up chiefly of partners of 
 members of New York Stock Exchange firms and constitutes an 
 important feature of our market machinery. In theory its listing 
 requirements are quite as rigid as those of the New York Stock 
 Exchange, but the regulations apparently are not enforced in the same 
 spirit, as a considerable trade is reported in securities of corporations 
 which refuse to publish income statements or other information deemed 
 essential by the older organization. Indeed it is difficult to see the 
 advantage of maintaining the two organizations were it not for this 
 sort of specialization in the class of securities traded in. The Curb 
 serves as a seasoning place where a market can be maintained by 
 stock exchange members without even the qualified indorsement 
 of the securities which is implied in listing them on the larger 
 Exchange. 
 
 The Consolidated Stock Exchange is a rival New York organization .— 
 It deals chiefly in the same securities that are traded on the New York 
 Exchange. It has an entirely separate membership, consisting chiefly, 
 though not entirely, of smaller commission houses and private floor 
 traders. The unit of trading is ten shares, and a much larger propor¬ 
 tion of the trade is professional “scalping” than is the case in the 
 “Big Exchange.” For the most part the prices tend to follow the 
 quotations on the New York Exchange. During the past year (1921- 
 22) the Consolidated Stock Exchange has suffered a considerable loss 
 of reputation on account of a number of failures in its membership. 
 It does not appear, however that there is any inherent weakness in 
 the organization which accounts for the higher percentage of failures 
 among the Consolidated as compared with the New York Stock 
 Exchange membership. 
 
 Other American stock exchanges are much smaller than the New 
 York Exchange. —The American stock exchanges outside New York 
 City are chiefly of local importance. In most of them the securities 
 of local public utilities and industrials are apt to be absorbed by the 
 
THE SECURITY MARKETS 
 
 149 
 
 New York Stock Exchange as soon as they become of national 
 interest. 1 
 
 There is also a considerable amount of specialization by industries, 
 which is only partly accounted for by location. Thus, the Boston 
 Exchange is the great market for copper stocks, though a dozen of 
 the leaders are active in New York; automobile stocks are heavily 
 traded in Detroit; gold-mining stocks in San Francisco and Denver; 
 and public utilities in Philadelphia. 
 
 In general, the methods used in the smaller exchanges are less 
 formal, and the requirements both for membership and for listing 
 securities less exacting than is the case in the New York Stock 
 Exchange. The relative importance of the outside exchanges and 
 the New York Exchange may be judged from the fact that the New 
 York Exchange has sometimes handled more stock in a single day 
 than the Chicago Exchange handled in the entire year. 
 
 There is a large trade in securities outside the exchanges .—Many 
 stocks of well-known corporations are not listed on any exchange, 
 and many stocks which are listed rarely appear in the published 
 quotation lists, for the reason that no trades are executed in them. 
 This indicates a lack of public interest in the security, but does not 
 prove anything with regard to its merits. Often the inactivity is 
 due to the fact that nearly all the issue is closely held by interests 
 affiliated with the management, or by investors who are not active 
 speculators and cannot be induced to dispose of their holdings except 
 by bidding up the price to an unreasonable level. On the other hand, 
 the lack of interest may be due to the fact that the corporation in 
 question has been so thoroughly discredited that no one cares to buy 
 its stock. Again, it may be because the corporation has done no 
 public financing, and no broker has ever taken the trouble to work 
 up an interest in its securities, so that few people’s attention is called 
 to their investment or speculative possibilities. 
 
 Whenever a stock or bond becomes inactive, the bid and asked 
 prices draw apart, so that it becomes difficult to buy without running 
 up the price and equally difficult to sell without breaking it. In 
 such cases the exchange method of dealing is not advantageous. 
 Exchange trading really is based on the presumption that, whatever 
 
 1 This is apparently less likely to happen in the case of public utilities. Peoples 
 Gas of Chicago, Pacific Gas and Electric of San Francisco, and Columbia Gas and 
 Electric of Cincinnati are the only outside local utilities which are at all active in 
 the New York market. 
 
RISK AND RISK-BEARING 
 
 150 
 
 the price may be, a slight decline will bring in new buying from 
 brokers who are present and immediately aware of the change, and 
 that a slight rise will bring forth selling. Its foundation principle is 
 continuity. If only one or two brokers are interested in a security 
 at any reasonable price, it is obvious that public bids and offers on 
 the exchange do not constitute an efficient method of establishing 
 sales at a price corresponding to the known facts about the security. 
 Some device is needed for hunting up a second party to accept a 
 given bid or offer. In such cases the most important marketing 
 agency is the so called “over-the-counter” market. 1 
 
 Over-the-counter trading means chiefly trading by telephone and 
 telegraph. Houses handling this kind of business usually cater more 
 to the investment than to the speculative trade, and for this reason 
 bonds are handled more than stocks. 
 
 The trader’s equipment consists of a set of telephones in the quiet¬ 
 est room available, some financial manuals, a card index of securities 
 showing the latest bids and offers, a battery of clerical assistants, a 
 quick wit, and a reputation for fair dealing. When the house receives 
 an order for a bond or share of stock which it does not itself have for 
 sale, inquiries are put out. Sometimes a certain house is known to 
 specialize in securities of the particular corporation in question. If 
 the security was originally underwritten, the house of first purchase 
 will usually “maintain the market” by standing ready to buy or sell 
 at a narrow spread of bid and offered price, and will have on file lists 
 of present holders who are the most likely prospects for either sales 
 or purchases. A house may specialize in the securities of a corpora¬ 
 tion for which it has done no underwriting, however, particularly if 
 it handles the securities of affiliated interests. If no house is known 
 to specialize in the securities of the particular corporation, it is often 
 possible for the trader to make a deal through a house which specializes 
 in the securities of the whole industry in question. 2 Again, as noted 
 above, trade in certain classes of stocks and bonds is centralized in 
 certain cities, and an order for such securities will most likely be 
 telegraphed at once to some house in that city. In the absence of a 
 specialized center, inquiries will be scattered more or less broadcast,' 
 and, in case of an order of large size, rapidly find their way around the 
 United States, Canada, and Europe, each trader passing on the inquiry 
 
 1 In Chicago the over-the-counter market is called the “curb.” 
 
 3 See for examples the advertising columns of the Wall Street Journal and of 
 the New York Times Annalist. 
 
THE SECURITY MARKETS 
 
 'Si 
 
 to someone else. The inquiry sometimes comes back to the original 
 inquirer from various directions. This wandering and redoubling 
 may give the appearance of a much more active interest than really 
 exists. Sometimes resort is had to advertising, a few houses regularly 
 publishing lists of securities which they desire to buy or sell, sometimes 
 with, and sometimes without, quotations. In the case of an inactive 
 security, it is not unusual for a considerable difference to appear in 
 simultaneous bids and offers published by competing houses. 
 
 Independent brokers also make a business of making the rounds 
 of the larger houses in New York, getting lists of securities wanted, and 
 bringing the trader in touch with others who can supply his needs. 
 Some of these brokers take one side of the trade themselves, and may 
 make a considerable margin by buying in one office at the offering 
 price and selling in another at the bid price. To an increasing extent, 
 however, the business is done by regularly organized “street broker¬ 
 age” houses, which charge commissions for bringing buyers and 
 sellers together. It is of course illegal to take both a commission 
 and a profit on the same trade. 
 
 To a large extent the brokerage work of a large investment house 
 is done for no commission or a nominal one, to retain the good will of 
 customers with whom new issues may be placed. Often, indeed, 
 the placing of a new issue requires that assistance be given the customer 
 to get rid of his present holdings in order to invest the proceeds in the 
 new issue. The underwriter’s profit on the new issues makes it worth 
 while to do a great deal of this brokerage work as an accommodation 
 for customers, in order to keep the market for new securities alive. 
 
 II. THE MARKET FOR NEW SECURITIES 
 
 The marketing of new issues of corporation bonds and stocks is a 
 business of entirely different character from the business of bringing 
 together buyers and sellers of securities already outstanding. In the 
 latter case, no one is greatly concerned in facilitating the trade except 
 two investors, one seeking to buy and the other to sell. If the issuing 
 corporation has any interest in the trade it is indirect, as the quotations 
 for its securities may affect its credit at the banks, or influence the 
 market for other securities it may have to offer in the future. Conse¬ 
 quently, the compensation of the broker or other middleman dealing 
 in old securities must come in one way or another out of the difference 
 between the prices at which one investor is willing to sell and another 
 is willing to buy at the same time. This margin, in the case of securi- 
 
152 
 
 RISK AND RISK-BEARING 
 
 ties of established merit, is usually rather narrow, so that the middle¬ 
 man cannot afford to go into the market and use the arts of salesman¬ 
 ship to drum up purchasers. His function approaches that of a real 
 middleman, that is, a connecting link between two individuals who 
 have a real interest in getting in touch with one another. 
 
 On the other hand, corporations in need of capital are willing, or 
 can be forced, to pay for capital amounts largely in excess of what the 
 average investor can secure for his relatively small units of capital 
 without the aid of the middleman. The margin between the most the 
 public will pay and the least the corporation can afford to take, rather 
 than fail to market its securities, is a large one, hence the compensa¬ 
 tion of the banker who effects the sale can be made much larger than 
 is possible in brokerage in old securities. Moreover, new securities 
 usually require some active effort to interest investors in their merits, 
 in part because they lack the reputation which comes from a satis¬ 
 factory record of interest or dividend payments, and in part simply 
 because they are unfamiliar and if not advertised would be likely to 
 remain unnoticed. This makes the services of specialized selling 
 agents necessary. 
 
 The selling of new securities comprises several quite different kinds 
 of marketing. —High-grade securities are seldom sold without pro¬ 
 fessional aid, except where stock is sold through the issuance of 
 “rights” to subscribe at a low price to holders of stock already out¬ 
 standing, and even in this case the guaranty of a financial institu¬ 
 tion is sometimes secured before the issue is offered. Low-grade 
 securities, on the other hand, are frequently marketed direct by the 
 issuers, less often through the agency of a bank, broker, or bond-dealer . 1 
 
 The chief institution concerned in the marketing of new securities 
 of a conservative type is the investment bank, commonly known as 
 the bond house. Typically, this is a highly specialized institution, 
 though of recent years a great deal of the business has been taken over 
 by bond departments of large city banks, and there is also some 
 tendency to combine the business with brokerage in miscellaneous 
 stocks. 
 
 1 By high-grade securities are meant the prior lien bond of solvent corporations 
 with a fair earning record extending over a period of some years and not engaged 
 in a highly speculative line of business, the junior bonds and preferred stocks of the 
 stronger members of this group, and the common stocks of a few of the very 
 strongest. It should not be overlooked that this classification has reference only 
 to new securities. Old securities present such a regular gradation of degrees of 
 risk from the safest to the most speculative that a classification into “high grade” 
 and “low grade” has little or no usefulness. 
 
THE SECURITY MARKETS 
 
 153 
 
 Investment houses are of three principal types: first, the large 
 houses which deal directly with corporations, taking over whole 
 issues or arranging syndicates to divide the responsibility; second, 
 the distributing houses, which do little or no large purchasing but 
 accept allotments from houses of first purchase and distribute them 
 to their customers; third, houses organized in affiliation with indi¬ 
 vidual corporations (usually in the public utility field) to aid in the 
 distribution of their securities . 1 
 
 Analysis of the merits of a proposed issue of corporation securities 
 and determination of the price at which it should be offered to the 
 public, if it is deemed to be worth floating at all, is highly expert 
 work. It includes an analysis of the corporation’s record of earnings 
 and of its balance sheet, an appraisal of the property, usually by a 
 firm of engineers, an audit of the books by an independent firm of 
 public accountants, a survey of the state of the industry in which the 
 firm is engaged, and a study of the outlook for the security market. 
 This work, however, has to be done only by the house of first purchase. 
 The distributing houses content themselves, as a rule, with the results 
 of the investigation made by the purchasing house and apply for as 
 many bonds as they think they can dispose of, or, perhaps more often, 
 accept the quota which is allotted them. The retail price is fixed by 
 the original purchasers, or by the management of the syndicate if it 
 is a joint undertaking, and no house is allowed to sell its quota below 
 this figure. The weaker distributing houses are dependent on the 
 good will of the larger houses to secure their quotas, and can hardly 
 refuse to accept the responsibility for the share which is given them . 2 
 
 The houses which distribute securities direct to investors number 
 several thousand in the United States alone. The process of distribut¬ 
 ing an issue has been described by one writer as follows: 
 
 When an issue of securities is ready for distribution, it is necessary to 
 attract the attention of potential investors. This is customarily done by 
 
 1 For example, the Utilities Securities Corporation’s chief business is the mak¬ 
 ing and finding of a market for the securities of a group of ijiidwestern public utili¬ 
 ties controlled by Samuel Insull; the Electric Bond and Share Company distributes 
 securities of corporations affiliated with the General Electric Company; Henry A. 
 Doherty and Company distributes the numerous issues of the Cities Service Com¬ 
 pany and its subsidiaries. 
 
 2 Cases are not unknown where distributing houses have accepted quotas of 
 undesirable issues rather than risk the loss of good will of the house responsible for 
 the securities’ distribution, but insisted on the listing of the securities on a stock 
 exchange so they might have a chance to get rid of their quotas through an imper¬ 
 sonal market and not have to load up their own customers with them. 
 
*54 
 
 RISK AND RISK-BEARING 
 
 means of a public announcement, which formally calls attention to the 
 amount of the issue, the terms, and the date by which subscriptions must 
 be in. In many cases a great deal of general advertising has been quietly 
 done before the public announcement is made; indeed, the securities may 
 all have been subscribed for in advance, in which case the public announce¬ 
 ment might be regarded as superfluous, except that it affords an opportunity 
 to call attention to the significant fact that the bonds have already been 
 disposed of, thereby adding to the prestige of the house or syndicate. The 
 public announcement is aimed at investors en masse , and it is effective in 
 proportion to the attractiveness of the particular issue and the condition of 
 the investment market. 
 
 The subscribers include, as already noted, the houses which have 
 participated in the syndicate, other bond houses, dealers and brokers, and 
 a number of closely associated financial institutions. One writer has listed 
 the following among these associated institutions: 
 
 “i. An insurance company and its directors, who, if rich men, will 
 probably buy for their own account some portion of a bond issue that their 
 company has taken. 
 
 “2. A firm of bankers or a bank in a smaller city that supplies a local 
 investment demand. 
 
 “3. A European group or syndicate that acts as a secondary distributor 
 or buys securities against which it issues its own debentures, as in the case 
 of the Scotch trust companies and the investment associations of Holland. 
 
 “4. Individual trustees or lawyers charged with the investment of 
 large estates, who are generally willing to anticipate their requirements if 
 anything especially choice is for sale. 
 
 “5. Trust companies and their correlated banks, whose purchases may 
 be either for the trust funds of the former or an investment for the deposits 
 of both. 
 
 “6. Savings banks, which, taken as a class, are the largest institutional 
 buyers of the classes of bonds to which they are restricted by the laws of 
 the various states. 
 
 “7. The list of the various subsidiary groups among which the distribu¬ 
 tor of bonds finds his best market might be extended almost indefinitely, but 
 those described will give a reasonably clear idea of what may be called the 
 headwaters of the investment stream that must be kept continually flowing 
 into the bond market.” 1 
 
 The second part of the selling program is the more difficult—that of 
 convincing individual investors by direct and personal appeal of the sound¬ 
 ness and attractiveness of the issue in question. If the bond market is 
 apathetic or crowded with issues—if, as the phrase goes, there are many 
 undigested securities floating around—the selling of the entire issue may 
 
 1 Theodore II. Price, Outlook, CVI (1913), 598. 
 
THE SECURITY MARKETS 
 
 155 
 
 prove a very difficult and long-drawn-out affair. It involves the use of 
 advertising literature sent through the mails, and to an ever-increasing 
 extent it requires expert salesmanship. In former days when the issues of 
 securities were few and when the announcement of a new offering was always 
 an event of importance, advertising literature made an effective appeal; 
 but under present conditions, with a large number of bond houses and with 
 thousands of different issues, the mails are to some extent losing their 
 effectiveness. Much of this advertising literature is consigned to the waste- 
 paper basket by the busy man of affairs without so much as a glance at 
 the offer. Personal appeal through salesmen is increasingly necessary to 
 bring results. 1 
 
 “ Low-grade ” securities are usually marketed by the issuers .—The 
 organization for selling bonds and stocks, which has just been de¬ 
 scribed, is only available for the service of concerns which have a fairly 
 well-established reputation, a strong record of earnings, or in the 
 absence of these a very unusual prospect for the future. An invest¬ 
 ment banker can only do business profitably by making repeated 
 sales to the same buyers. Hence, his good will is his most valuable 
 asset, and he cannot jeopardize it by undertaking to float speculative 
 securities, even in cases where the prospect of success is such as to 
 make the speculation a very attractive one. The reputation of an 
 investment banker is injured by a few flotations which result in loss 
 to investors more than it is helped by numerous cases where the ven¬ 
 ture turns out better than was anticipated. Hence, the rule of “ safety 
 first” has come to be accepted as axiomatic in investment banking 
 quite as much as in commercial banking. The not infrequent cases 
 where securities floated through the stronger investment houses do 
 turn out badly are to be accounted for rather by errors in judgment 
 than by any disposition to take speculative chances. 
 
 The result of this situation is that concerns which, on account of 
 their youth or the hazardous character of the business in which 
 they are engaged, cannot meet the standards of the investment bank, 
 find it much more difficult to supply their capital needs. Securities 
 of these concerns are lumped together in financial literature under the 
 caption of “low-grade securities.” The term is somewhat unfortu¬ 
 nate, as it carries with it the implication that all securities outside 
 the “high-grade” class are inferior in merit. The class does include 
 many securities which are issued in defiance of the dictates of sound 
 judgment, and some which are downright fraudulent, but it also 
 
 1 Adapted by permission from H. G. Moulton, The Financial Organization of 
 Society, pp. 234, 237-39. (University of Chicago Press, 1921.) 
 
RISK AND RISK-BEARING 
 
 156 
 
 includes many excellent speculative and semispeculative opportunities, 
 and also many thoroughly sound issues which are too small to receive 
 attention from an underwriting house. 
 
 New stocks and bonds, which cannot find a market through the 
 investment banker are usually sold by the issuing corporation, some¬ 
 times by newspaper advertising, sometimes by circularizing selected 
 lists of names, sometimes by contracts with concerns which are organ¬ 
 ized to sell low-grade securities at exorbitant commission rates. The 
 methods used in the marketing of highly speculative securities are as 
 a rule very different from those employed by the conservative invest¬ 
 ment banker. Flamboyant advertising, exaggerated statements, com¬ 
 parisons with successful enterprises of more or less similar character, 
 and other methods of inducing people to take snap judgment, have 
 been used so frequently both by promoters of fraudulent schemes, and 
 by sincere but mistaken promoters, that the whole business of selling 
 by direct solicitation has fallen somewhat into disrepute, and perfectly 
 legitimate enterprises are frequently handicapped in getting capital for 
 this reason. The difficulty is that direct solicitation either by advertis¬ 
 ing or by correspondence with miscellaneous individuals whose names 
 fall into the possession of promoters, is so expensive that any enterprise 
 financed in this way starts out heavily handicapped. If, as is not 
 infrequently the case, 50 per cent of every investor’s money goes to 
 pay the expense of discovering him and selling him a security, the 
 enterprise must earn 20 per cent on the capital actually used, in order 
 to pay 10 per cent on the capital raised. Hence, only propositions 
 which have some chance of making abnormally high profits are worth 
 financing in this way, and enterprises which have a chance of making 
 abnormally high profits nearly always involve a correspondingly high 
 degree of risk. 
 
CHAPTER IX 
 
 STOCK SPECULATION AS BUSINESS 
 
 ENTERPRISE 
 
 With this much information concerning the market machinery 
 for trading in securities, we are now ready to examine the methods by 
 which investors and speculators make use of these markets. In the 
 present chapter, we are concerned with the business of speculation, 
 that is, trading in stocks and bonds, chiefly stocks, for the sake of profit 
 from price fluctuations. Two tasks, therefore, present themselves, 
 first, a survey of certain technical practices which are associated with 
 speculative trading, and second, a consideration of the methods used 
 in attempting to forecast the course of the market as a basis for such 
 operations. 
 
 Orders may be placed for execution in either of three ways: at the 
 market , at a limit , or on stop-loss order. —A market order is simply an 
 order to buy or sell a definite number of shares of stock (or a certain 
 quantity of bonds) at the best price obtainable. In the case of an 
 active security, it may be assumed that a market order will be executed 
 at a price not far from the last quotation, but in the case of an inactive 
 security a “market” order of any considerable size may have to be 
 executed at a price far above the last price, if a purchase, or far below 
 it, if a sale. Market orders have the advantage of certainty of execu¬ 
 tion, but are too dangerous to find extensive use outside the list of 
 securities in which there is a brisk speculative market. 
 
 A limited order is an order to buy or sell at a certain price, or 
 better. In the case of an order to buy, for instance, at 70, if the order 
 can be filled at 69 the customer is entitled to secure the stock at that 
 price, just as though the order had been placed “at the market.” 
 A buying order with a limit above the current price is in effect a market 
 order, with a protective provision to secure the buyer against the risk 
 that his order may happen to find the market bare of offerings and 
 cause an unexpected advance. A buying order with a limit below 
 the current price, on the other hand, can only be executed in the event 
 of a decline. Such an order is known as a resting order. Sometimes 
 it is limited in force to the day on which placed, or to a specified 
 period; sometimes it is of indefinite duration. Orders of the latter 
 
 157 
 
RISK AND RISK-BEARING 
 
 153 
 
 class may be carried on the books of the broker for weeks before an 
 opportunity presents itself for their execution. A scale order is a 
 series of resting orders for execution at specified prices, below the 
 market in the case of buying orders, above in the case of selling orders. 
 
 A stop-loss order is in a way the reverse of a resting order to buy 
 or sell. An order to buy on stop, for instance, is an order to buy 
 “at the market” as soon as a trade is made at a certain price above the 
 present market. Such orders are used for several purposes. Their 
 most frequent pupose is to protect speculators from excessive losses on 
 single transactions. If, for instance, A buys stock at 60, putting up 
 a margin of ten “points,” a stop-loss selling order at 57 would insure 
 that his stock would be sold as soon as the market declined to that 
 point, thus reducing the risk of a greater loss. It should be noted 
 however that the stop-loss order does not furnish a guaranty that the 
 loss will not exceed that contemplated, for after a sale is made at 57 
 there may be no bid for more stock above, say 55, and, the broker 
 must sell for whatever he can get. As a matter of fact, every margin 
 transaction involves a real stop-loss order, for the broker will have to 
 sell to protect himself before the margin is exhausted; what the stop- 
 loss order does is to place the selling point closer to the market, thus 
 increasing the probability that the account will be sold out, but 
 decreasing the probable loss from such action. 
 
 Occasionally stop-loss orders are used when there are no open 
 trades to be protected, on the theory that if the market advances to 
 a certain point it will advance further. For instance, in an active 
 market a trader reaches the conclusion that if the quotation for a 
 certain security reaches a round number, say 100 (or perhaps reaches 
 the highest point it has previously reached during the year), a number 
 of buying stop-loss orders from short sellers will be uncovered, and 
 a further advance will result. He will therefore place a stop-loss order 
 at 100 with a limit of ioo|, and a resting order to sell at ioof, hoping 
 to shave a profit out of the flurry that will occur if 100 is reached. 1 
 
 A third use of the stop-loss order is connected with the operation 
 known as pyramiding , which is the practice of using accumulated 
 profits as margin to protect further trades. Suppose B sells short 
 100 shares of Baldwin Locomotive at 125, placing with his broker 
 $1,500 as margin. In the course of a few days, Baldwin declines to 
 120. The trader now has twenty points’ protection, while his broker 
 
 1 All operations aiming at small profits from quick fluctuations are popularly 
 known as “scalping” operations. 
 
I 
 
 STOCK SPECULATION AS BUSINESS ENTERPRISE 159 
 
 requires only fifteen. The extra $500 is sufficient to enable him to 
 sell short an additional 25 shares and have sixteen points’ protec¬ 
 tion on the whole “line” of 125 shares. He does so, and the market 
 continues to decline till a price of 115 is reached. The profit from this 
 further decline is $625, enough to margin 35 or 40 shares additional. 
 It is obvious that so long as the market continues to move in a down¬ 
 ward direction the size of the order and the rate of profit can be made 
 by this method to increase in geometrical ratio, and if no mistakes are 
 made concerning the course of prices an enormous profit can be made 
 with very small initial capital. A stop-loss order is not essential to 
 such an operation, but is frequently used both to control the pyramid¬ 
 ing process and to protect the profits. For instance, in the illustration 
 given, when the market reached 117 the trader might put in a stop- 
 loss order to sell 40 shares at 115, and another to buy 125 at ii8|. 
 The selling order would provide for the further development of the 
 pyramid, in case prices continued downward, while the buying order 
 would probably close out the trade at some profit, in case of a reversal 
 of the trend. 
 
 The stop-loss order for protection is an utterly illogical device and 
 its persistent use is one of the surest roads to financial ruin. What it 
 amounts to is saying that a certain security, which we do not care to 
 buy at the present price, we intend to purchase when it has advanced 
 to a figure from one to five points higher. If a security is not an 
 attractive purchase at a given level, it is never rendered more attractive 
 by an advance, whether of small or large proportions, in its price. 
 It is true that in certain situations the stop-loss order is a useful 
 protection, but the careful trader does not put himself in such situa¬ 
 tions. Invariably the necessity for the use of the stop order goes 
 back to one fundamental reason, overtrading. If one’s trades are 
 so large in proportion to his capital that an adverse fluctuation of a 
 few points forces him to close out or reduce his line, the trades are 
 too large. Trades made on account of exhaustion of margin, or on 
 account of fear of that contingency, are practically always contrary 
 to the trader’s judgment, and man rarely profits by putting himself 
 in a position where his action is dictated by fear instead of by judg¬ 
 ment. Stop-loss trades are fear trades. 
 
 The only case where an exception to this condemnation need be 
 made is in the case of the use of the stop order to develop a pyramid, 
 and even here its use is generally an indication of overtrading. If, 
 however, our trader, in the illustration cited above, had “inside 
 
I 
 
 160 RISK AND RISK-BEARING 
 
 information,” or for any reason was practically certain that Baldwin 
 Locomotive was about to decline in price to a certain point, and felt 
 sure also that there would be no large fluctuations upward before the 
 decline was completed, the use of the stop-loss order to build a pyramid 
 downward offered him the chance of making the maximum profit out 
 of his limited capital. Such situations are very rare; in most cases 
 even though the trader were right in his opinion of the trend of the 
 market, the use of the pyramid would insure that a strong rally would 
 “wipe him out” before the operation was completed. 
 
 Before turning to the technique of forecasting market movements, 
 attention must be given also to certain maxims by which speculators 
 sometimes attempt to determine a profitable line of individual action. 
 “Cut your losses and let your profits run,” is a very common adage 
 of the financial district, for which there is very little basis in sound 
 reason. If the maxim means anything definite, it must mean that 
 the same price is a desirable price at which to sell if one bought a 
 little above it, and an undesirable one at which to sell if one bought 
 a great deal lower. “No one ever lost any money by taking his 
 profits,” say other sages of the market. Even fairly high-grade invest¬ 
 ment houses and financial journals sometimes advise clients to sell 
 if they have a profit, but to hold on if they have a loss. This is just 
 the reverse of the other maxim, and is equally irrational. The fact is 
 of course that the price at which a security was bought is totally 
 irrelevant to the question whether it should be sold. If the chances 
 seem to favor an advance, and no more profitable use of funds is in 
 sight, presumably securities should be held; if they are expected to 
 decline, it is irrational to hold on simply because selling involves taking 
 a loss, or because it does not. 
 
 “Averaging down” is another fallacious method of speculating, 
 very similar in principle to those just discussed. If, for instance, 
 C has bought fifty shares of stock at 90 and the price later declines 
 to 80, he buys fifty additional shares at that price in order to reduce 
 his average cost to 85 and improve his chances of getting out without 
 a loss. Of course, the second trade may be a good one, but in decid¬ 
 ing whether it is so or not, the price at which the first lot was bought 
 is of no significance. 
 
 Holding stock merely because it was bought at a higher price 
 instead of selling out when one foresees a decline, and selling to “ take 
 profits” in spite of indications that the market is going higher, are 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 161 
 
 expressions of the same fallacy, the notion that the past history of 
 one’s own individual account has a different significance in determin¬ 
 ing the line of one’s future conduct from the significance it has in the 
 determination of anyone else’s. Every decision to enter on a new 
 speculation, or stick with an old one, should rest on a judgment of 
 the future; the past is of no significance except as an index of the 
 future, and, except as a part of the whole history of the market, 
 one’s own particular record of losses or gains is totally irrelevant. 
 
 The exception to this generalization is the same that was suggested 
 in connection with the stop-loss order, that is, the case of the man 
 who overreaches himself by trying to handle trades in excess of what 
 his capital justifies. The man who overtrades must cut his losses 
 short to avoid the embarrassment of margin calls, but by putting 
 himself in such a straitened position he has forfeited the privilege of 
 following his best judgment. 
 
 Let us turn now to the consideration of the methods used by 
 speculators in attempting to forecast the major and minor swings of 
 prices. Attempts to make money out of purchase or sale of securities 
 may be classified as follows: ( a ) speculative trading in securities, 
 aiming at quick profits; ( b ) speculative trading aiming at long-swing 
 profits; ( c ) investment operations aiming at high yield on investment; 
 (d) investment operations aiming primarily at safety. 
 
 Trading in stocks for quick profits comprises the bulk of what is 
 commonly known as stock speculation. —The methods of analysis and 
 operations used by persons engaged in this kind of speculation may 
 be outlined as follows: ( a ) trading on the technical position; (b) 
 trading on the news; (c) trading on “inside information,” “tips,” 
 etc.; (d) manipulation. 
 
 By the technical position is meant the sum total of conditions 
 affecting the movement of prices which have their origin in the opera¬ 
 tions of the traders themselves. Scientific study of the technical 
 position is usually equivalent to a study of the factors which determine 
 the movement of prices in the immediate future, as distinguished from 
 those which determine the trend over a period of weeks or months. 
 That this distinction is an important one may be seen from the fact 
 that in a strong advancing market extending over several months, 
 the prices of active stocks will decline on 30 or 40 per cent of the trading 
 days. The main elements which constitute the technical position are: 
 
 1. The present and prospective state of the loan market , especially 
 fur call loans. This includes both the interest rate and the attitude 
 
162 
 
 RISK AND RISK-BEARING 
 
 of bankers toward speculative collateral, affecting the proportion of 
 market value of stocks which can be borrowed upon them. The 
 speculative markets are absolutely dependent on the banks for funds. 
 Margin buyers pay interest, short sellers pay none; hence an advance 
 in money rates strengthens the bears and weakens the bulls. Con¬ 
 versely, an advance in the market increases the demands on the banks, 
 partly because the same stocks are now good collateral for larger 
 loans and partly because advancing prices generally stimulate an 
 increase in speculative interest. 
 
 For these reasons the call-loan rate is very generally regarded as 
 a valuable index of the strength of the market, a rise in the rate 
 tending to force liquidation and therefore forecasting a decline in 
 prices. 
 
 The importance of this factor is very much overestimated, how¬ 
 ever. It takes only a very small fluctuation in the price of a security 
 to offset the interest cost of several weeks’ waiting, and even a doubling 
 of the call-loan rate would rarely make the difference between profit 
 and loss on any except very long-time speculations. Anything which 
 is generally believed to affect prices will have some effect on them 
 simply because the effect is anticipated, and the call-loan rate is 
 so emphasized by financial writers that it can hardly fail to have 
 some sentimental effect, but its practical importance is slight. 1 
 
 2. The amount of the floating supply of speculative securities , i.e., 
 stocks in the hands of brokers, most of which are likely to come on 
 the market as a result of comparatively slight changes in price. This 
 floating supply, it will be noted, determines whether the stock can 
 safely be sold short. A small floating supply makes the position of 
 the short seller precarious; many stocks cannot be borrowed for short 
 sales at all. 2 
 
 3. The proportion of the long stock which is weakly held, i.e., held 
 on small margins or held by people who are interested in taking quick 
 profits and cutting losses short, as compared with the proportion of 
 stock which is known to be held for purposes of control or by investors 
 who are not at all likely to sell or lend the stock. 
 
 1 Mr. L. D. Thompson has shown {The Relation of Call Money Rates to Slock 
 Market Speculation, a thesis submitted in candidacy for the degree of Master of 
 Arts at the University of Chicago, 1922) that there is no significant correlation 
 between call rates and the volume of trading on the New York Stock Exchange, and 
 his data seem to indicate also a lack of correlation between call rates and prices 
 though the latter question is in need of further investigation. 
 
 * See p. 138. 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 163 
 
 4. The size of the 11 short interest ” (number of outstanding loans of 
 stock to short sellers). 
 
 5. Location of stop-loss orders and resting orders. 
 
 6. The state of speculative sentiment on the part of the public, the 
 amount of free capital controlled by the section of the public who 
 display an interest in the market. 
 
 Judging the technical position is not easy. —Of these six elements 
 only the first is readily ascertainable. The data most commonly 
 employed in the effort to judge the others are: 
 
 1. Loan rates for stocks . 1 When the loan rate is low, or a stock 
 loans “flat,” or at a premium, the presumption is that there is a big 
 short interest in that particular security. This may plausibly indicate 
 that there is a preponderance of expert judgment to the effect that the 
 price is too high and is likely in the long run to fall. Its immediate 
 significance, however, is just the opposite, for it indicates that there 
 is a big group of prospective buyers made up of those who have already 
 sold short. They will have to buy at any price if their margins are 
 endangered by an advance, and will probably buy to obtain their 
 profits if there is a decline. Hence, the technical position is judged 
 to be “strong.” Too much confidence should not be placed in this 
 reasoning, however, for the floating supply may be increased at any 
 time by the sale of loan of stock which has been held outside the 
 “Street.” (For further discussion of this point see pp. 166-67.) 
 
 2. Public interest , as manifested by the size of the crowds before 
 the brokers’ blackboards, and the volume of orders on their books. 
 Increasing interest on the part of the people is likely to presage 
 increased buying power, as the public always comes in after a dull 
 market as a group of buyers rather than short sellers. Such an 
 increase in public buying, however, may be the signal for a wave of 
 delayed selling by professional speculators, pools, or insiders in the 
 management of corporations who have waited for just such an oppor¬ 
 tunity to unload their holdings. 
 
 3. Volume of transactions , as shown by the ticker tape. 
 
 4. Continuity of quotations and variation of the volume of trade 
 from day to day. 
 
 5. Charts , calendar schemes , and other mechanical forecasting devices. 
 
 These last three methods, which comprise the favorite field of the 
 
 modern alchemist, may be discussed together. Of schemes to forecast 
 
 1 See p. 130. 
 
164 
 
 RISK AND RISK-BEARING 
 
 the action of market by studying the record of prices and volume of 
 sales as it appears on the ticker tape or in the daily papers, there is 
 no end. Few features of modern business have received more minute 
 study than has been devoted to the attempt to work out a mechanical 
 method of judging from the present and past condition of the market 
 what its future is going to be. “Tape readers” study the fluctuations 
 of prices from hour to hour, record the volume, and attempt to fore¬ 
 cast the immediate future, trading for profits of an eighth to a half 
 point. Chart artists trace the movement of prices of selected groups 
 of stocks and attempt to draw conclusions from the shape of the curve. 
 “Calendar traders” scrutinize the stock-exchange quotations for 
 evidence of seasonal tendencies, and express their conclusions by such 
 phrases as the “January rise,” the “spring rise,” etc. Most of this 
 sort of study is obviously wasted effort. The generalizations are 
 usually based upon the experience of a comparatively short period, 
 five or seven years in the case of the calendar trader and six or eight 
 coincidences in the case of the chart plan. Even if such coincidences 
 are not accidents, but due to some continuing cause, it does not 
 follow that this unknown force will continue to produce the same 
 effect. If no other force comes in to change the future, the very 
 fact that a regularity is great enough to be observed by numerous 
 traders constitutes a force disturbing the sequence of price movements 
 in the future. If, for instance, there is a tendency for several years 
 in succession for stocks to rise in January, 1 perhaps on account of 
 dividend disbursements reinvested around January 1, the more 
 regularly the phenomenon appears, the more certainly will there be 
 a bunching of purchases just ahead of the date when the rise is due in 
 order to sell on the rise; and these operations may cause the rise to 
 appear earlier and to be followed by an earlier decline. It would be 
 rash indeed for anyone to say that none of these mechanical methods 
 has any value, for no one has tested them all, and the more valuable 
 any method proves itself to be the less likely are its discoverers to give 
 it publicity. So far as can be judged, however, from a survey of the 
 rather extensive literature of stock speculation, there are few less 
 promising ways of making an income than attempts to “beat the 
 tape” by a study of the tape itself. 
 
 It does not follow, however, that a study of the data revealed by 
 the tape is of no significance whatever in forecasting the course of 
 
 1 The careful studies published by the Harvard Committee on Economic 
 Research in the Review of Economic Statistics indicate that there is no seasonal 
 fluctuation in the prices either of industrial stocks or of high-grade bonds. 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 165 
 
 prices. There are apparently certain relationships between the 
 volume of trading and the course of the typical stock-exchange 
 cycle which are useful as a supplement to other methods of analysis. 
 The following quotations summarize all that, in the author’s opinion, 
 can safely be said with regard to this phenemenon: 
 
 How much attention, if any, should the “investor for profit” pay to 
 the stock market from day to day or from week to week ? Has he anything 
 to gain from watching current fluctuations and volumes, or studying the 
 general behavior of the market ? 
 
 We may answer at once that he should pay relatively little attention 
 to these things. Earnings and values, growth of population and of business, 
 dividends and money rates, political conditions and the accumulation of 
 capital in the banks, are of far more importance and significance to the 
 investor than any indications he can draw from the temporary and often 
 erratic fluctuations of prices. 
 
 Yet this question of the action of the market should not be entirely 
 ignored. It is a well-known fact that some professional speculators are 
 able, by carefully watching the technical indications derived from a study 
 of volumes and prices, to make more money during the year than they lose. 
 
 Reduced to its lowest terms, the action of the market includes only 
 three basic factors: (1) price; (2) time; (3) volume; that is, the number 
 of shares bought and sold at a certain price or during a certain time. 
 
 Each of these three factors may be recorded or used in different ways, 
 and the three, or any two of them, may be combined according to different 
 plans. 
 
 First, no important conclusions can be obtained from any one of the 
 three factors, taken alone. It is the varyihg relations between two or three 
 of them that serve to give the market a sort of character of its own. 
 
 Second, the element of time must always be included. Thousands of 
 students have wasted a great deal of more or less valuable brain-power in 
 trying to draw conclusions from a combination of prices and volumes, 
 without reckoning in the lapse of time. In my opinion, it can’t be done. 
 
 Third, a study of time and volume without prices would be meaning¬ 
 less, as the investor cannot buy or sell except at some price. 
 
 Common sense tells us that the lowest prices are likely to be made when 
 most people are trying to sell, and the highest prices when the greatest 
 number are anxious to buy. We shall expect, then, that the volume of 
 sales will be relatively large at the top and the bottom, and this conclusion 
 is borne out by history. 
 
 A heavy trade in stocks is pretty sure to be accompanied by relatively 
 wide fluctuations in prices—the whole market gets bigger, in every way. 
 So we find that at these turning points the range of prices for the day, as 
 shown by the length of the lines on the graphic connecting the average 
 high with the average low, will be relatively wide. 
 
i66 
 
 RISK AND RISK-BEARING 
 
 After a period of heavy selling pressure, buyers are not likely to rush 
 in the moment the selling ceases. They fear a renewal of the liquidation, 
 and will only begin to buy gradually, as the market becomes quieter and 
 more settled. Consequently a period of activity—that is, big volumes and 
 wide daily ranges—at low prices, is usually followed by a time of dullness 
 without any very great change in the general level. 
 
 The same principle, of course, applies after great activity at high prices; 
 but the period of activity may be longer and the period of dullness shorter 
 than at the bottom, because speculation is naturally broader at high prices 
 and the public participation in the market more general. 
 
 Probably the best indication of the trend of the market, that is easily 
 available to everybody, is found in the comparison of the total volume of 
 trade on days when the market moves sharply upward, and the volume on 
 declines. In a bull market, buyers come in on the advances. In a bear 
 market, they refuse to do so. In a bear market, holders are urgent to sell 
 on declining prices. In a bull market, they hold on stubbornly. 
 
 The result is that, in a bull market, the volume of trade is likely to 
 increase on the advances, while in a bear market it will probably become 
 heavier on declines. But this principle can only be interpreted and applied 
 to the market by long study and careful observation. The novice finds 
 many stumbling blocks. 
 
 One of them is that he is almost sure to lay too great weight on small 
 movements, caused only by professional operations. Professional traders 
 make prices temporarily, but they have very little influence on the general 
 trend of prices over a considerable period. They are merely trying to follow 
 this trend, not to make it. The attitude of investors creates the trend, and 
 no useful indications as to its direction can be gained from fluctuations 
 caused only by professional speculators. 1 
 
 The difficulties involved in attempts to predict the market’s 
 course on the basis of its own action are summarized by an experienced 
 trader as follows: 
 
 It might be supposed that the borrowing demand for stock would serve 
 as an indication of the extent of the short interest, but as a matter of fact 
 it is of little value in that direction. In the first place, the borrowing may 
 be by a short interest of an “investment” character, which cannot be 
 driven to cover and therefore does not create an “oversold” market in the 
 ordinary sense of that word. 
 
 Second, the stocks borrowed may be to temporarily take the place of 
 long stocks sold by previous holders whose certificates have not yet arrived 
 in New York from abroad or from other cities, or even for holders who have 
 delayed getting their certificates out of their vaults and delivering them. 
 
 1 Taken by permission from G. C. Selden, hivesting for Profit, 137-48. (Maga¬ 
 zine of Wall Street, 1913.) 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 167 
 
 A large interest may sometimes prefer to have its liquidating sales appear 
 to be short sales until it has disposed of its entire line, thus avoiding any 
 premature filling up of the Street with certificates, which might help to 
 depress prices. 
 
 How then are we to find out the amount of the short interest ? Some 
 line on the situation can be obtained by talking with active brokers. True, 
 the broker can only express his opinion, formed from such opportunities 
 for observation as he may have. For that reason, his words cannot be 
 accepted as gospel. In fact, it will often happen that one broker thinks 
 the market is oversold while another sees no special evidence of any extended 
 short interest. Nevertheless the broker has a much better opportunity 
 of getting this information than the outside investor, and his opinion should 
 be duly considered. 
 
 Coming to the position of big operators, this is as a rule very difficult 
 to ascertain and the average outside speculator can rarely allow himself 
 to be much influenced by it. Most of the gossip floating around the Street 
 as to what Morgan, Kuhn-Loeb, or the City Bank is doing in the market 
 is worse than valueless. 
 
 The task of finding out what big interests are doing in the market is 
 not absolutely impossible, but it is almost as difficult as learning to judge 
 the market correctly yourself. For that reason your main reliance must 
 always be on yourself, and such reports are always to be regarded 
 suspiciously. 
 
 Sincere reports from the floor as to the position and sentiments of the 
 majority of the traders are not usually very difficult to get from your 
 broker, but I am obliged to admit that I have never got much benefit from 
 them. Floor traders rarely agree in their views and as their opinions are 
 usually formed from the surface indications which flicker back and forth 
 before their eyes, their sentiments are likely to change with a suddenness 
 and completeness which are confusing to the outsider. They willingly 
 report what they see, but I doubt very much whether the outsider can make 
 much profitable use of their reports. 
 
 The presence of stop orders above or below the current plane of 
 prices will, if they are in any considerable volume, have a decided effect on 
 the trader’s position. The first question in this connection is: How are 
 we to discover whether such stop orders are present or not ? 
 
 The reports on this subject which are from time to time heard floating 
 around the Street, or are ’phoned by customers’ men to their more active 
 following, are hardly ever to be taken at their face value. This is chiefly 
 because actual information about stop orders is, as a rule, unobtainable. 
 Reports on the subject are pretty sure to be guess work. 
 
 Of course the most important stop orders are not put on the floor. In 
 fact they usually do not exist anywhere except in the mind of the operator. 
 
i68 
 
 RISK AND RISK-BEARING 
 
 He has, let us say, a big line of Steel common. He makes up his mind that 
 if Steel declines to 62 he will close out his line, as that much decline would 
 indicate to him that his judgment of the situation has been wrong. 
 
 Such a determination on the part of the operator is exactly equivalent 
 to a stop order on his holdings of Steel at 62; but there is no record of that 
 determination anywhere, and no possible way of getting information about 
 it in advance. The operator does not tell his broker to put a stop at 62, 
 because he very well knows that such a course would invite attack. If 
 through any “leak”—and it is very difficult for any brokerage house, no 
 matter how honorable, to stop all possible leaks—the fact became known 
 to the floor traders that a big line of Steel would be stopped out at 62, they 
 would all be expecting the price to decline to 62, and would therefore 
 hesitate to buy even if they did not take the short side. The small trader, 
 of course, need not hesitate to put in his stop in advance. He is merely a 
 fly on the wheel, and his position will have no perceptible effect on the 
 market. 
 
 You always have to remember that when you feel a certain way about 
 the market, a lot of other people are feeling just the same way. What you 
 have to do is to be a little bit cleverer than the others—for example, to 
 buy when the stop orders are executed around 150. Then you can safely 
 enough put in your own stop at perhaps 149 after the market has turned 
 upward. But it takes you a number of years to get to be cleverer than 
 others—cleverer than the market, in other words—and in the meantime 
 you are very likely to put your stop in the wrong place. 
 
 In a general way we can get some idea of the situation by noting whether 
 transactions increase or decrease on the declines. Short sales may, it is 
 true, produce a moderate and temporary increase in business on declines, 
 but any important or persistent increase may always safely be set down as 
 evidencing sales by actual owners of the certificates. In order to do more 
 business at lower prices, traders and speculators must very soon get hold of 
 more stock which may be bought and sold. If instead of finding more 
 stocks in the floating supply after a decline they find fewer stocks, transac¬ 
 tions will quickly shrink and a trapped short interest will soon have to buy 
 back its sales at higher prices than where they were put out. 
 
 Suppose prices decline rapidly on a big volume of trade for perhaps two 
 weeks, with relatively wide fluctuations in the leading speculative stocks 
 from day to day. Then from near bottom prices we have a sharp rally 
 for several days, caused by covering of shorts. After that the market 
 grows dull and drifts slowly downward for two or three weeks, with transac¬ 
 tions much smaller than on the previous decline and with a narrower range 
 of daily fluctuations. This is a plain case, and it generally occurs in sub¬ 
 stantially the way above outlined several times in every year. It shows 
 three steps, which always occur when the market strikes bottom and turns 
 upward: 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 169 
 
 (1) Liquidation by investors and traders who have become discouraged, 
 either by the unfavorable outworking of the whole situation or by specific 
 bear news. 
 
 (2) Partial cessation of such liquidation, quickly followed by covering 
 of shorts which had been put out during the decline, causing a rally. 
 
 (3) A period of rest, accompanied by a small amount of left-over 
 liquidation and by scalping short sales, the latter practically all by pro¬ 
 fessionals and semi-professionals. 
 
 After this process the market is ready to respond to favorable news when 
 it comes, and will decline but little on further bear news, unless it is of a 
 very sensational character. 
 
 What has really occurred is that the floating supply of stocks, which had 
 been increased by liquidation, has little by little been absorbed. Some 
 investors were buying on a scale during the first decline. Others bought 
 when they thought the market has turned. Still others were busy picking 
 up stocks during the third period above described, so that every evidence 
 of temporary weakness resulted in scattering buying orders. 1 
 
 Trading on the news involves great risks .—The second great method 
 of speculating for the short swing is trading on the news. There is no 
 place in the world where so much attention is paid to the gathering, 
 dispensing, and study of the current news as in the speculative invest¬ 
 ment markets. Outside of the news of sports, the want ads, the 
 divorces, and the crimes there is little in the daily newspaper which 
 does not have a bearing on the incomes of businesses, big and little, 
 and hence upon the value of securities. But the newspaper is too 
 slow and too little specialized to meet the demands of the speculative 
 public, so an elaborate system of specialized information service has 
 been developed. Of this apparatus, the most important parts are 
 the news ticker, the Bulletin Service, the market letters, and the 
 reviews furnished by the professional financial service bureaus. Of 
 these, the quickest is the news ticker or broad-tape service, a collection 
 of bits of general political and economic news, corporation reports and 
 brokers’ gossip, which is sent out over leased telegraph wires and 
 printed simultaneously in every important brokerage office in the 
 country. 
 
 Slightly slower than the ticker, but fuller, is the hourly or half- 
 hourly Bulletin Service published in eastern cities. Some brokerage 
 houses issue daily market letters which purport to explain the action 
 of the day’s market and make cautious predictions of the nearby 
 
 • 1 Adapted by permission from Browne, Practical Points on Stock Trading, 
 35-49, 55-64. (Magazine of Wall Street, 1918.) 
 
170 
 
 RISK AND RISK-BEARING 
 
 future; others issue more pretentious weekly reviews which discuss 
 the general economic situation and also summarize the known facts 
 concerning the situation of individual companies. 
 
 Trading on the general news is simpler than trading on the tech¬ 
 nical position, and looks, at first glance, to be a more sensible pro¬ 
 cedure. “Values are subject to constant change,” runs the reasoning 
 back of this method of procedure. “The changes all have causes, 
 and these causes must in large part appear in the news. Trading on 
 the news after everyone has it obviously promises no profits; the 
 important thing is time. Our business is to anticipate other men’s 
 decisions to buy or sell, and to do this we must get the news before 
 they do.” This reasoning is sound enough, yet there is no reason to 
 believe that people who make a practice of buying Bulletin Services 
 or frequenting brokers’ offices to keep in touch with the latest informa¬ 
 tion actually make money by so doing. A fourfold difficulty obstructs 
 all attempts to make money in this way. In the first place, the impor¬ 
 tant news, the items that will cause a real change in the level of stock 
 prices, such as supreme-court decisions or declarations of war, arc 
 known to a great many people before they appear even on the broad 
 tape, and are pretty accurately anticipated by a great many more, 
 so that even the most studious frequenter of the broker’s room is apt 
 to be too late. In the second place, speed is gained in these services 
 at the sacrifice of accuracy. Like the daily press, the news services 
 abound in unverified rumors, some of which are probably put out for 
 the deliberate purpose of influencing the market, but many merely to 
 fill space. In the third place, on nine out of ten days there is no news 
 of sufficient importance to justify anybody in changing his market 
 position, and in the absence of really significant news the tape and 
 the bulletins are filled up wflth actual information which is indeed more 
 or less relevant to the general financial situation but is so slight in its 
 significance and so great in its mass that it creates only confusion. 
 Finally, the Wall Street news services are themselves read by so many 
 people that any given individual finds it difficult to profit greatly by 
 being one of those who get the news through them. Prices adjust 
 themselves to the known elements of a situation with astonishing 
 rapidity, and there is no commoner error than trying to make a profit 
 by trading on news which is already fully discounted before one’s 
 order comes to the floor. 
 
 The following comment, by the editor of a prominent financial 
 journal, summarizes the situation well: 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 171 
 
 So far as the news is concerned, there are two kinds: known and 
 unknown. Known news is what we find on news slips, news tickers, news¬ 
 papers and the usual run of market letters. Known news is what has hap¬ 
 pened and has been told. It becomes public property the moment it is 
 printed in Wall Street. News known to everybody is, except in rare cases, 
 of little use to anybody. Yet the great public thirsts for news, talks news 
 and trades on news. Market letters of brokerage houses are practically 
 all based on an analysis of known stock market factors; also newspaper 
 financial articles and “reviews and outlooks.” 
 
 One need spend but a few months in Wall Street to find that the move¬ 
 ments of the market 1 cannot consistently be reconciled to the news, statistics, 
 earnings, outlook or such other considerations as largely influence the general 
 public. Almost every day we see the market advance on bad news or break 
 in spite of favorable developments. It is impossible to analyze the effect 
 of a certain situation upon the minds of a million people who are interested 
 in the market, either as investors or as speculators. Wall Street is a great 
 “hopper,” into which all day long there pours an unceasing stream of news, 
 statistics, decisions, railroad and industrial reports, Government estimates, 
 court rulings, corporation announcements, and last, but not least, rumors 
 and tips. 
 
 All this news and all these facts and rumors and tips which are poured 
 into the “financial hopper” have a certain influence on the minds of traders 
 and investors, causing them (directly or indirectly) to buy or sell. 
 
 We frequently notice squibs in the papers to the effect that “ the advance 
 in Reading was due to the company’s favorable monthly report,” or some 
 expression of that kind. One can readily see how impossible it would be 
 for the reporter who writes this paragraph to ascertain just why those who 
 bought and sold during the day, did so. In order to make such a statement 
 with any degree of accuracy it would be necessary to communicate with each 
 buyer and seller for the day, extract from him the reason why he made the 
 trade and strike a balance. These buyers and sellers may be scattered all 
 over the earth, dealing in one, ten, fifty or one thousand share lots. It is, 
 therefore, absurd to place any reliance on statements that this or that was 
 the cause of the advance or the decline. This not only emphasizes the 
 necessity of taking newspaper reports with a grain of salt, but proves that 
 no one actually knows what produces these small advances and declines, 
 although there are a great many people who guess about it. 3 
 
 Trading on “inside information” is very common .—The third 
 method of short-time speculation is trading on “inside information,” 
 
 1 The reference is to short swings, not to the major changes which require months 
 or years for their completion (ed.). 
 
 2 Adapted by permission from Richard D. Wyckoff, “Why the Action of the 
 Market Is a Better Guide than the News or the Fundamentals,” Magazine oj Wall 
 Street , March 19, 1921, pp. 709-10. 
 
172 
 
 RISK AND RISK-BEARING 
 
 that is, information not yet available to the general public. The only 
 generalization which can be made, with reference to the value of this 
 sort of material, is that it all depends on the source from which the 
 information comes. The vast majority of the so-called tips which 
 float around the customers’ rooms of the brokerage offices are worth¬ 
 less. Especially is this true of the information in regard to the doings 
 of prominent operators, a popular basis of trading among small-fry 
 speculators. On the other hand, advance information of the condi¬ 
 tion of corporation reports, and of changes in the dividend policy of 
 important corporations, is nearly always available to a sufficient 
 number of people, so that its market influence is shown from one to 
 three or four days ahead of the public announcement. Boards of 
 directors have often been severely criticized on account of stock-market 
 movements, which indicate that they have themselves operated on 
 the knowledge of their own actions to the detriment of other stock¬ 
 holders, 1 or have improperly given advantages to a favored few. The 
 directors are not always at fault, however. There are many other 
 chances for leaks. Employees of public accountants’ offices often 
 know the essential features of a corporation’s annual statement before 
 the officers of the corporation know them. Stenographers and tele¬ 
 phone operators must be taken into the confidence of the management. 
 Tips from such sources as these may exercise an influence in the market 
 for which the directors are blamed. However, there is no reason to 
 doubt that many corporation directors do consider it legitimate for 
 them to trade in the securities of their own corporations on the strength 
 of their advance information. To quote Mr. Wyckoff again: 
 
 Unknown news consists of important facts in possession of a few insiders. 
 It is the possession of these facts which distinguishes the insider from the 
 public. The insider works with an incalculable advantage. Reports of 
 earnings, probability of reduced or increased dividends, etc., must be known 
 to some one person or a few, before public announcement can be made. 
 This may take place a few minutes, hours, days or weeks later, according 
 to market conditions and the position of the insiders. Meantime those 
 who trade on the news which is known are simply playing into the insider’s 
 hands. 
 
 The insider does what probably you would do if you were in his place. 
 During the interval between his receiving and announcing the news, he 
 telephones his broker and gives his order. This takes but a moment. If 
 he is a big enough factor, some manipulation may accompany his buying 
 
 1 The Rock Island receivership was a comparatively recent case in point. 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 173 
 
 or selling; but whether his operations are large or small, there is usually 
 a coterie of associates who act with him or upon his information. 
 
 Each of the persons composing this group has his own broker, and each 
 broker his own clientele. It is customary for a broker who sees inside 
 orders coming through, to advise certain of his clients in accordance there¬ 
 with, without necessarily disclosing the actual source. For example, the 
 broker will say, “Now Jones, I want you to buy some of this stock. I can’t 
 tell.you what I know, but there is excellent buying going on, and if you will 
 take on a little, I believe you will make some money.” Thus unknown 
 news becomes the power behind a movement which may attain large pro¬ 
 portions before public announcement is made—when the unknown news 
 becomes known news. 
 
 However desirable this unknown news or “inside information” may be, 
 getting it from its-original sources is beyond the reach of the average trader. 
 And even if he had “underground” connections with every important source 
 of information in the Street, there would be no certainty that he could always 
 profit thereby. Insiders are often completely surprised and suffer heavy 
 losses on account of an adverse trend of the market, some other and more 
 effective news, an accident or the operations of opposing speculative pools 
 and large individual traders. One clique may possess a bit of knowledge 
 which, in their opinion, will produce a certain market effect; another 
 group may command greater resources, swing larger lots, diffuse more 
 effective “information.” Group One may, therefore, find its efforts futile. 
 
 Then we must consider the “sentiment” of the Street, which is fre¬ 
 quently more powerful than any group of operators. In former years, 
 manipulatory able to swing fifty or a hundred thousand shares could practi¬ 
 cally dominate the market; but in these days of hundred million dollar 
 issues and billion dollar capitalizations, everybody is stronger than anybody. 
 At such times “inside information” is likely to ruin one who follows it in 
 the face of overwhelming buying or selling by the public. In other words, 
 insiders are not invariably correct. It is an old saying that “inside informa¬ 
 tion ” will break anyone. 1 
 
 “ Manipulation ” is difficult to detect .—The fourth method of 
 speculation for the short turn is manipulation, by which we mean all 
 operations aiming at a profit from a change in the market which the 
 operator himself causes, either by the sheer weight of his own opera¬ 
 tions or by coloring the news, or often by a combination of both 
 methods. Manipulation is only possible through large-scale opera¬ 
 tions, and the number of people who can engage in it is comparatively 
 small, though, by pooling their capital and intrusting the management 
 of their campaign to a single manager, a group of individuals can 
 
 l Loc. cit. 
 
174 
 
 RISK AND RISK-BEARING 
 
 influence the market as much as a single operator owning much larger 
 capital. Such pool operations are probably very common, but au¬ 
 thentic information concerning their activities seldom reaches the pub¬ 
 lic. The following reading describes typical manipulation methods: 
 
 There may be said to be three principal forms of manipulation, apart 
 from those that were formerly conducted through what are known as 
 “wash sales” and fictitious transactions, which have largely been abandoned, 
 and others which it will not be necessary to discuss. 
 
 1. The most common and most vicious form is effected by what are in 
 substance bogus purchases and sales to create a false appearance of activity 
 for the purpose of unloading the stock on the public at high prices. The 
 same person or group gives buying orders to one set of brokers and selling 
 orders to another but the selling orders exceed in volume the buying orders 
 until the stock is marketed. The apparent purchases and sales may and 
 often do exceed the actual purchases by the public ten or twenty over. In 
 order to actually unload one hundred shares on the public the manipulator 
 may have to apparently deal in thousands of shares. So long as commissions 
 are paid on these sham transactions on both sides of the bargain the Exchange 
 has regarded them as entirely legitimate, even though the real nature of 
 the dealing is apparent from their volume and from general report and can 
 readily be verified from the books of the brokers, to which the Exchange 
 has free access at all times. 
 
 2. A series of transactions conducted for the purpose of acquiring or 
 selling a large block of the stock of a given corporation not for investment 
 but with the intent of realizing an immediate profit, brought about by 
 purchases and sales that are calculated to affect the price in the way best 
 adapted to accomplish the end in view. If the purpose be to accumulate 
 stock so as to sell at a substantially higher level, the plan involves selling 
 part of the accumulations as the stock rises so as to depress the price and 
 then make larger purchases. If the intention is to sell the opposite course 
 is adopted. The ultimate object is to buy stock that you do not want or to 
 sell stock that you do want with the view of affecting the price. 
 
 3. Where a new security is to be introduced, instead of advertising its 
 merits by the publication of a prospectus or by open solicitation, the security 
 is here again given a false appearance of activity to attract dealings. After 
 the public has been led to buy on the assumption that it is acquiring a 
 security with an active market that is readily saleable, those who were 
 interested in creating this impression and who have probably disposed of 
 the stock they had to sell find it unnecessary to continue the heavy expense 
 of paying out commissions on what are in effect fictitious transactions, and 
 the buyers’ apparently active market gradually and sometimes suddenly 
 fades away. 1 
 
 ‘Taken by permission from Samuel Untermyer, “Speculation on the Stock 
 Exchange,” Supplement to American Economic Review , March, 1915, pp. 47-4S. 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 175 
 
 Concerning the profitableness of this type of speculation, no 
 authoritative statement can be made, as the facts about success¬ 
 ful attempts at manipulation are never made public, and those con¬ 
 cerning unsuccessful ones only rarely. The risks involved are obvi¬ 
 ously large, but whether the profits compensate for the risks undergone 
 we do not know. 
 
 Even the trader who is correct in the majority of his forecasts is likely 
 to lose more than he makes. —If all trades made by a given individual 
 are of the same size, and he follows a uniform rule as to the size of 
 the profits or losses for which he will wait before closing out trades, 
 the odds against him are small. Making trades purely at random, 
 the average number of profitable trades, ignoring commissions and 
 similar expenses, would be 50 per cent of the total number of trades, 
 and in the long run the net loss should therefore equal the total amount 
 of commissions and expenses. The average trader would probably get 
 about the same result by following the news and exercising his 
 judgment. 
 
 If the trades are of the “scalping” type the commission is a very 
 heavy percentage of the profit aimed at, and a very large excess of 
 successes over failures must be attained in order to avoid speedy ruin; 
 if the trader holds out for five- or ten-point gains or losses, on the 
 other hand, a slight preponderance of successes will more than offset 
 the commissions and other expenses. 
 
 The overwhelming difficulty is that it is almost impossible to avoid 
 methods of trading which make the average loss greater than the aver¬ 
 age gain, so that the trader may be right six or seven times out of 
 ten and still be forced to quit a loser. The reason for this is the incor¬ 
 rigible tendency to expand the scale of operations after a success and 
 to contract it after a loss. Most speculators are supplied with small 
 capital in proportion to the volume of their customary trades—if this 
 were not true the privilege of trading on margin would be of little 
 value, except to the short seller. Suppose a speculator begins trading 
 with a capital of $2,000, and to be conservative decides to buy on a 
 twenty-point margin stocks which his broker would be willing to carry 
 on ten points. He buys 100 shares of Southern Pacific stock, which 
 he sells at a five-point profit, clearing about $465. He repeats the 
 operation, making five and a half points, and has now increased his 
 capital to nearly $3,000, and can trade in 150-share lots quite as safely 
 as he could trade in 100-share lots at first. Either by “pyramiding” 
 or by collecting his profits and reinvesting them he can, so long as all 
 
176 
 
 RISK AND RISK-BEARING 
 
 goes well, rapidly increase the scale of his operations and correspond¬ 
 ingly increase the rate at which his profits pile up. If all his forecasts 
 are correct, there is no way in which a small capital can be built up 
 into a large one so quickly. But if part of his trades result in losses, 
 as they certainly will, the losses will be sure to come at the times 
 that the trades are largest. On the other hand, if the first few trades 
 result in losses and it becomes necessary to curtail the scale of opera¬ 
 tions, then on the smaller scale of operations a larger number of success¬ 
 ful trades must be made in order to recover what has been lost. If 
 the trades are originally so large that the trader is in fear of being 
 sold out on a decline, or if stop-loss orders are used, the probability 
 of making bigger average losses than profits is accentuated. In the 
 author’s opinion, this adjustment of the size of the trade to the volume 
 of accumulated profits or losses is by far the most important cause 
 of the excessive proportion of losers among speculators. The only 
 real defense against it, aside from avoidance of the market, is to keep 
 the trades so small in proportion to the capital actually used or avail¬ 
 able that the gain or loss from an accidental succession of good or bad 
 forecasts will have no appreciable influence on the scale of operations 
 which can safely be undertaken. 
 
 The probabilities of success in short-swing speculation in stocks are 
 small. —In summary of our conclusions on this topic, it may be said that 
 speculation in stocks, with a view to profiting by fluctuations in prices, 
 affords one of the best examples of what the economist calls entrepre¬ 
 neurship, i.e., the quest of pure profit, an income made possible by 
 the presence of uncertainty. The profit of the successful enterpriser in 
 this, as in other forms of risk-bearing, depends on the presence of one 
 of three situations— knowledge of the outlook superior to that of others 
 who are rival seekers for profit from the same source, ability to control 
 the factors on which the outcome of the venture depends, or sheer 
 superiority of luck. A few major operators may have some degree 
 of control over the movements of the whole market, and a consider¬ 
 able number of business men have some control over the prices of the 
 securities of the corporations with which they are connected; the rest 
 of the speculative fraternity must depend on knowledge or on luck. 
 Of these, again, a few have access to “inside infomation” which 
 enables them to trade with the odds in their favor, while the majority 
 must rely on their superior sagacity in interpreting the news which 
 they share with thousands of others. Under these circumstances the 
 amount of luck involved in the outcome of a particular venture is 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 177 
 
 necessarily enormous, and the popular confusion of speculation with 
 gambling has a large degree of justification. 
 
 Speculation for “long-swing” profits involves fewer unavoidable 
 uncertainties than does speculation for the “short-swing ”—The opera¬ 
 tions of the speculator who tries for large profits on a slow turnover 
 are of an entirely different character from the type of speculation which 
 has been discussed in the preceding pages. Changes of 40 or 50 per 
 cent in the value of the higher-priced and safer securities, and of 
 several hundred per cent in the lower-priced and more speculative 
 issues, often take place within the course of a year or two, and traders 
 who successfully forecast these changes may make correspondingly 
 large profits without the futile and nerve-wrecking experience of watch¬ 
 ing for indications of the minor and quite inexplicable fluctuations 
 which occur from day to day. It is true, of course, as in every other 
 form of speculation, that it is impossible to profit except by superior 
 luck or skill, that there is always a losing as well as a winning side, 
 and that of a large number of trades the losses must always exceed 
 the gains by the amount of the commissions, taxes, and other expenses, 
 so that there can be no such thing as a permanent science of specula¬ 
 tion. As fast as such a science became generally known it would 
 become obsolete. In the present stage of development of the business, 
 however, it appears probable that the fundamental facts, which are 
 indeed accessible to all those who put their money into the market, 
 are studied with care by a sufficiently small proportion of them so 
 that there is a fair chance that those who do base their opera¬ 
 tions on something approaching the character of a scientific study 
 will profit at the expense of those who do not. In so far as this is 
 true, it is undoubtedly the operator for the long swing who has the 
 advantage. 
 
 Analysis of the long-range outlook for security prices takes two 
 forms, namely, the study of the outlook for individual firms and the 
 study of the trend of the market for large groups of security prices. 
 Those who practice the first type of speculation talk and think in 
 terms of balance sheets, income statements, unfilled orders, changes in 
 personnel, and similar evidence of the prosperity and prospects of 
 individual firms. These are the bargain-hunters of Wall Street. 
 Their special objective is to find securities of relatively inconspicuous 
 corporations which have passed through a period of improvement 
 whose effect on the value of the securities has been overlooked, so 
 that the securities may be bought below their true value, or, vice 
 
173 
 
 RISK AND RISK-BEARTNG 
 
 versa, to find securities of corporations which have a good reputation 
 based on past performance but are going backward, so that the securi¬ 
 ties are selling at a price too high to be justified by the present outlook. 
 Such traders have no interest in safe bonds or stable stocks once the 
 public has become convinced of their safety and stability. 
 
 The methods of analysis employed by the bargain-hunting type 
 of speculator are in general identical with those employed by capital¬ 
 ists who are looking for a permanent investment for income. Espe¬ 
 cially is the investor who is trying to secure yields above the market 
 rate for safe investments similar in his objectives and methods to 
 the bargain hunting type of speculator, for the security which con¬ 
 tinues to yield an abnormally high return is nearly sure to advance 
 in price. 
 
 Investors for income, even those who are disposed to take specula¬ 
 tive chances for the sake of the high yield, characteristically pay for 
 their stocks in full and take them out of the market, while the indi¬ 
 vidual who is planning to close out his trade on a market fluctuation 
 is very likely to buy on a conservative margin. Moreover, the long- 
 swing speculator is ready to take short side, in case the securities of 
 a given corporation are overvalued, while the investors’ bargains have 
 to be found in cases where the securities are undervalued. This differ¬ 
 ence in methods of operation, however, does not involve any important 
 difference in the method of arriving at conclusions concerning the 
 strength of the corporations or the soundness of their issues. 
 
 Discussion of the methods used in analyzing the position of indi¬ 
 vidual firms and the strength of particular securities with a view to 
 profiting by changes in their prices is therefore deferred to chap¬ 
 ter x, where attention is given to the whole problem of investment 
 analysis. 
 
 The other type of long-swing speculation looks not at the record 
 of the individual corporation but at the future of the market as a 
 whole. Followers of this method talk and think in terms of the 
 general level of prices, the effect of changes in the interest rate on 
 the price of bonds, the amount of bank reserves, the volume of pig- 
 iron production, and similar “fundamentals.” For the purpose of 
 this group of speculators, the most desirable stocks are those of 
 corporations whose prospects are the best known and least subject to 
 change from agencies peculiar to the corporation itself. In practice 
 this generally means the safer securities, not so much because the 
 
STOCK SPECULATION AS BUSINESS ENTERPRISE 
 
 179 
 
 trader is averse to taking risks as because these conservative securities 
 are most likely to run “true to form” in accordance with the outlook 
 for business activity and for the money market. 
 
 This type of speculation depends entirely on the principles dis¬ 
 cussed in chapter vi, hence needs no elaborate discussion here. The 
 most important barometers are those discussed in connection with the 
 money market. The long-swing speculator who depends on this 
 type of forecasting keeps out of the market, except as a conservative 
 investor, for perhaps four-fifths of the time, returning to it only when 
 he believes that there are clear indications of an early change in the 
 trend. His plan is to buy high-grade preferred stocks and the very 
 best common stocks early in a period of liquidation, shift to more 
 speculative securities late in a depression and again shift to short¬ 
 term notes, or if he is less conservative, take the short side of the specu¬ 
 lative market, at the height of a boom. Diversification is imperative 
 in this method of operation, as any one security is likely to fail to 
 follow the trend. 
 
 The greatest difficulty in the way of this plan, aside from the 
 extremely great difficulty in resisting the strong tide of optimism or 
 pessimism which sets against an operator of this type, is the fact, to 
 which reference was made in chapter vi, that the swings of the stock 
 market are more numerous than those of the cycle of general business, 
 and that there are no known formulas for forecasting the intermediate 
 swings. Such a decline as that of 1917 is likely to catch the student 
 of the cycle unprepared. 
 
 The two methods of long-swing speculation are often combined .— 
 Analysis of securities and analysis of the trend of the stock market 
 are distinct but not conflicting methods, and those who practice the 
 latter, as a rule, practice the former also. That is, they attempt first 
 to determine when to enter the market either as buyers or as sellers, 
 then decide what to buy or sell by study of corporation reports and 
 the outlook for specific industries. Such bargain-hunting methods 
 presumably offer the largest chance of profit, but involve more risk 
 than is involved in the simpler method of sticking to the stocks of the 
 best-known corporations and depending on diversification for safety 
 and on choice of times to buy and sell as a source of profit. The weak¬ 
 ness of the combination method is that an error in either the analysis 
 of the security or the analysis of the market will involve the operator 
 in loss. 
 
i8o 
 
 RISK AND RISK-BEARING 
 
 QUESTIONS 
 
 1. A bought ioo shares of stock on January 4 at 91 and sold on 
 February 10 at 94. Figuring commissions at $25.00, taxes at $4.00 and 
 interest at 5 per cent, what was his profit? How would the profit be 
 affected by a change of the interest rate on 90 per cent of the amount to 
 10 per cent ? 
 
 2. Examine the reports of the stock exchange trading in the press and 
 list ( a) the explanations offered for market changes; ( b ) the probable 
 sources of information in regard to these reasons. 
 
 3. Summarize the indications available to you regarding the future 
 course of stock prices. Estimate probable amount of error in your forecast. 
 
I 
 
 CHAPTER X 
 
 THE ANALYSIS OF SECURITIES 
 
 As was noted in chapter vii, the investment of capital in businesses 
 of others, or in government securities, presents one of the purest cases 
 of an economic activity in which risk is the paramount consideration 
 in determining the course of action. This is as true of the most 
 conservative buyer of government bonds as it is of the most reckless 
 stock-market operator. In each case, the problem is exactly the same; 
 it is that of judging the probability of a favorable or an unfavorable 
 outcome, and balancing the risk of loss against the return to be secured 
 in the event of a favorable outcome, in order to determine which of 
 two or more alternative employments of capital is the more attractive. 
 The difference in the decisions of these two extreme types of conserva¬ 
 tive and reckless buyers and of the innumerable intermediate types, 
 reduces itself to ( a ) a difference of knowledge of the relevant facts; 
 (b) a difference of judgment concerning the conclusions to be drawn 
 from those facts; (c) a difference of attitude toward the bearing of risk. 
 
 The formulation of an investment policy with regard to a particular 
 security involves consideration of factors which may be analyzed as 
 follows: 
 
 I. Income factors 
 
 a) The rate of income yielded 
 
 1. Direct yield 
 
 2. Yield to maturity 
 
 b ) Prospective increases in the rate of return 
 
 1. Changes in dividend rates; issuance of “rights”; liquidation of 
 arrears, etc. 
 
 2. Prospective increases in market values 
 
 3. Gains through calling of securities at premium above purchase 
 price 
 
 c) Taxation 
 
 II. Factors of risk 
 
 a) Security of principal 
 
 b ) Certainty of income 
 
 c ) Marketability 
 
 d) Diversification 
 
 III. Indirect factors: control; prestige; access to desired information; 
 
 social and moral objections to certain types of investment 
 
 181 
 
182 
 
 RISK AND RISK-BEARING 
 
 The indirect factors are usually unimportant. —We may therefore 
 dispose of the third group of considerations at once and pass to those 
 which normally determine the decision. The cases where the direc¬ 
 tion of investment is determined by collateral considerations of a 
 social, moral, political, or business nature are relatively few, are highly 
 diverse in character, and are of so personal a character that hardly 
 any important general statements can be made about them. In 
 theory, a type of investment which is avoided by numerous investors 
 on account of social and moral considerations must pay a higher rate 
 of return to secure its capital, and therefore should be unusually attrac¬ 
 tive to those who are not disturbed by its unpopular aspects, but 
 this factor is of no practical importance, so far as the investment 
 market is concerned. It does have some influence in determining 
 the rate of return for personal services and the profits of personally 
 conducted businesses, but the investment market is too large and 
 impersonal for prestige or social disapprobation to exert a visible 
 influence upon it. 
 
 The yields afforded by safe securities admit of exact comparison .— 
 The technique of methods of figuring direct and maturity yields, effects 
 of taxation on yield, and similar items with regard to securities 
 regarded as safe needs no discussion here. These are questions of 
 mathematics, not of business judgment, and are fully treated in the 
 general literature of investment as well as in that of mathematics. 1 
 
 The essence of the problem of relating price to yield, where risk 
 is disregarded, is a comparison between the present and the future 
 value of a stated sum of money. The market value of a safe security 
 is the sum of the present worths of all the amounts to be received— 
 principal, interest, dividends, rights, premiums, etc., discounted at the 
 market rate of interest, and conversely the yield is the rate of interest 
 at which the market price compounded will amount to the various 
 sums payable under the instrument by the time they are due and paid. 
 In the case of securities which pay normal rates of interest at ordinary 
 intervals, the investor is relieved of the labor of calculation through 
 the use of bond tables, while for irregular payments formulas are 
 available which make the calculation purely mechanical. 2 
 
 1 See, for example, Lagerquist, Investment Analysis; Chamberlain, Principles 
 of Bond, Investment; Jordan, Investments; Skinner, Mathematics of Investment. 
 
 2 The use of these tables and formulas involves certain elements of error, none 
 of which, however, are of great practical importance. The inaccuracies include 
 the following: (a) Loss of interest on interest accrued at the time of investment: The 
 
THE ANALYSIS OF SECURITIES 
 
 183 
 
 Tax exemptions, so far as they are known when investments are 
 made, involve a simple modification of the mathematical results of 
 calculations of yield. They would be of no practical importance if 
 they affected all investments alike, since the problem is always one 
 of a choice between alternative employments of capital, but if these 
 are differently affected by taxation the difference may be of very 
 great importance. This is particularly likely to be true if, as at present 
 in the United States, the same security or income is taxed differently 
 in the hands of different holders. Thus to an individual who pays 
 surtax at a high rate on his income, a fully tax-exempt bond bearing 
 5 per cent interest is more attractive than a 6 per cent security with¬ 
 out the exemption, while the small investor would suffer a loss if he 
 selected the higher-priced security. * 1 
 
 purchase price of bonds usually includes a pro rata share of the next instalment of 
 interest; on this amount the investor loses interest until it is repaid at the next 
 interest date. This results in a lowering of the actual yield, unless the securities 
 are purchased on interest dates. The discrepancy is greatest if purchases are made 
 at a time midway between interest dates, (b) Decimal approximation: The bond 
 tables ordinarily used give interest yields accurate to the second decimal place. 
 The maximum error which can result from this is $5.00 per $100,000 of principal 
 in figuring interest for one year. Tables are available, however, which give results 
 accurate to the cent for sums up to $1,000,000. (c) Rate of interest earned by 
 
 reinvestment of amortization funds: Bond tables are constructed on the assumption 
 that the payments to amortize the premium or discount are invested at the same 
 rate as the yield on the security itself; this assumption is likely to be inaccurate. 
 (d) Time of reinvestment: This error is similar to the one just mentioned. The 
 tables assume that all payments in amortization of premium or discount are rein¬ 
 vested instantaneously; this is often impracticable, (e) Interest interval: The 
 assumption of thi tables is that the amortization payments will earn interest pay¬ 
 able semiannually; if interest is collected quarterly or annually a slight error 
 results. (Cf. Chamberlain, op. cit., pp. 412-22.) 
 
 1 In this connection, it may not be out of place to refer to the widespread 
 fallacy that tax exemptions create a scarcity of capital for enterprises which can¬ 
 not issue similarly tax-exempt securities, a fallacy which has recently appeared in 
 highly respectable financial literature. Tax exemptions make a security less 
 attractive to some investors and more attractive to others, but the financing 
 of public enterprises through tax-exempt securities makes no larger drain on the 
 capital resources of the country than would the financing of the same enterprises 
 through securities subject to taxation. The tendency of tax exemption is to , 
 bring about a concentration of the securities so favored in fewer hands than 
 would otherwise be the case, but unless it is believed that the public enterprises 
 for which they are issued would not be financed at all without the exemptions 
 it cannot be said that they operate to reduce the amount available for other en¬ 
 terprises, or to increase the rate other enterprises must pay for their capital. 
 This statement is subject to a slight modification on account of the greater 
 selling cost involved in securing capital from the small investors to whom taxable 
 securities are most valuable. 
 
184 
 
 RISK AND RISK-BEARING 
 
 Prospective changes in income, which are placed among the factors 
 of income in our outline, may belong either here or in the category of 
 risk factors, in accordance with the degree of certainty of their attain¬ 
 ment. Future changes in dividend rates or in bond interest rates, 
 the payment of accrued interest or instalments of principal, and other 
 changes in nominal returns, if they are certain, are taken account of 
 in figuring the yield or price at the time an investment is made, just 
 as are the regular rate of interest and the amortization of the discount 
 or premium on bonds. These payments involve no element of 
 income to the investor, except the accrual of discount which was 
 contemplated in the original price. On the other hand, prospective 
 changes in income, whether increases or decreases, which are not* 
 regarded as certain, enter into the investor’s decisions as part of the 
 factor of risk. Premiums on redemption, profits on resale, gains at 
 maturity, and other irregular items, both certain and uncertain, come 
 into the calculation in exactly the same way as do the ordinary pay¬ 
 ments of dividends or interest. In each case, an income in the nature 
 of interest arises from a discounting of the payments anticipated as 
 certain, while economic profit or loss arises from the items not fore¬ 
 known and hence not fully discounted in the market price at the 
 time of purchase. The only difference is that the irregular items are 
 less likely to be foreknown. 
 
 Let us consider next the factors of risk. Security of principal and 
 stability of income are very closely related. In theory, in many types 
 of security, the safety of the principal depends on the value of property 
 specifically or impliedly pledged for the purpose, while income is more 
 directly dependent upon the earning power of the issuing organization. 
 Practically, however, the distinction is rarely important. The value 
 of property depends upon its income-producing power, and in default 
 of earnings or other income out of which to meet interest payments, 
 asset values crumble away. In choosing between ample property 
 values and ample earnings, the latter should always be given 
 preference. 
 
 When the safety of principal and income in any investment is so 
 great as to be a matter of general agreement, the yield is nearly sure 
 to be low, but there are cases where by careful study and good judg¬ 
 ment an income can be secured in excess of that usually obtainable 
 on securities of similar strength. This is the chief object of invest¬ 
 ment analysis. Success in identifying such opportunities affords 
 opportunity not only for profit in the form of an income yield in 
 
THE ANALYSIS OF SECURITIES 
 
 1^5 
 
 excess of interest and replacement funds, but, also for profit from 
 increase of market values, for securities rarely remain distinctly 
 undervalued for long periods of time. 
 
 Marketability is the facility with which a security can be bought 
 or sold. Since it is nearly always possible, however, to buy or sell 
 a security of known income-producing quality at some price, the 
 concept of marketability has been extended to mean the facility with 
 which the security in question can be bought or sold at a reasonable 
 price. The best test of reasonableness in price is the “spread” or 
 difference between what the investor can probably get if he tries to 
 secure a quick sale and the price he would have to pay to obtain 
 additional securities of the same type. Marketability is largely a 
 question of the size of the holdings. For the small investor, there 
 are innumerable high-grade securities of attractive yield which have 
 a “close” market for the small units in which he is interested, but 
 there are very few securities which can be bought or sold in very large 
 quantities without forcing the price materially upward or downward. 
 Quotations for listed securities, and for those unlisted securities in 
 which there is sufficient trade to maintain a quotable market, are the 
 prices at which small lots—usually one hundred shares in stocks and 
 $1,000 in bonds—are changing hands, and may be entirely misleading 
 if used as indices of the marketability of large lots. Quotations for 
 new securities which are in process of distribution are particularly 
 deceptive, because such securities are regularly supported by standing 
 bids from the distributing houses at the issue price. This gives the 
 market the appearance of being very close and active. Investors who 
 buy bonds in reliance on these quotations as an assurance of their 
 ability to recover their capital at will are likely to find at a later time 
 that the quoted market has disappeared and that the only outlet for 
 the securities is through the distributing house. Such houses usually 
 do protect their customers by making a market over their own coun¬ 
 ters, so that their issues are much more marketable than those of 
 corporations which do their own financing or those marketed by 
 irresponsible and transient underwriters. 
 
 Marketability is of importance for the investor who is attentive 
 to the security market and wishes to shift his funds from one invest¬ 
 ment to another as the relative desirability of different issues changes. 
 It is also of importance in case all or part of the invested funds are 
 likely to be needed for personal support or for strengthening the 
 finances of a private business. Marketability, as was noted above, 1 
 
 1 See p. 123. 
 
RISK AND RISK-BEARING 
 
 186 
 
 is a device to give the investor protection against the risk of being 
 unable to recover his funds when he wants them, without creating 
 for the borrower a corresponding risk of being called on to repay them 
 at an inconvenient time. For most investors, it is highly desirable 
 to have some funds in marketable securities, but a waste of money to 
 pay for this advantage for all one’s funds. Sometimes the cost is 
 negligible, however. The two principal devices for securing market¬ 
 ability are, first, the exchanges, and, second, the practice of invest¬ 
 ment banks of maintaining a market for securities which they have 
 floated. So well developed are these and other marketing agencies 
 that the mere fact of a high degree of safety, coupled with attractive 
 income yield, is now usually sufficient to insure marketability in the 
 case of so many of the investments that no one need pay a high price 
 to secure the necessary liquidity in his funds. The two types of 
 investment where this is least likely to be true are small real estate 
 mortgages and the securities of little-known corporations which have 
 been sold without the intervention of an investment banker. In 
 these cases, it may readily be true that the risk, as estimated by those 
 best informed, is very small, while at the same time the market is so 
 restricted by the difficulty of obtaining this information that the 
 security will lose much of its attractiveness for those who wish to keep 
 their funds mobile. In such cases, the income return is likely to be 
 high as compared to the risk of final loss, and the security correspond¬ 
 ingly attractive to those who know the facts and do not require 
 marketability in their investments. 
 
 The analysis of securities, to determine the degree of risk attendant 
 upon their purchase, presents a problem of considerable difficulty, and 
 one which differs greatly in character with respect to different types 
 of security. So many legal, personal, and technical elements in the 
 solution are inaccessible to the individual private investor that he is * 
 compelled to rely in large part, no matter how careful his own analysis, 
 upon the findings of experts. Nevertheless, a knowledge of the ele¬ 
 ments of the method to be employed is necessary, if for no other purpose 
 than to assist in the choice of counsel. The case is not dissimilar 
 to the case for training in law as an aid to the business man. A lay¬ 
 man’s training in law cannot serve as a substitute for the services of a 
 good lawyer, but it may be very useful as a means of aiding him to 
 decide when the lawyer’s services are really needed, and as a guide 
 in distinguishing the trustworthy adviser from the charlatan. It is 
 true in the investment field, even more than in the furnishing of legal 
 
THE ANALYSIS OF SECURITIES 
 
 187 
 
 advice, that high respectability and pretentious claims of expertness 
 and disinterestedness cannot be taken at face value. A little learning 
 is a dangerous thing, but it is quite sufficient to unmask the emptiness 
 of the claims of a large proportion of bond salesmen to a standing as 
 expert advisers. 
 
 For discussion of methods of analysis, the bulk of investment 
 securities may be classified as follows: (a) United States government 
 and municipal bonds; ( b ) foreign government bonds; (c) railroad 
 bonds and stocks; (d) public utility bonds and stocks; (e) industrial 
 bonds and stocks. 
 
 Concerning the obligations of the United States government, 
 those of most of the states, of the federal land banks, and of many of 
 the municipalities of the country, the question of safety is hardly 
 worth discussion. Conditions under which they would be defaulted 
 or become unmarketable are quite thinkable, but they are conditions 
 so remote that we have no means of forecasting their approach, and 
 no way of selecting alternative employments of capital which are 
 free from the same elements of risk. The fluctuations in the value of 
 these securities depend on variations in the interest rate at which the 
 payments are capitalized, not on factors of risk at all. The choice 
 among these investments rests chiefly on considerations of taxation. 
 Some are completely exempt from all taxes, others have exemptions 
 restricted either to holders of limited quantities or to residents in 
 states in which they are issued. These exemptions make them so 
 much more valuable than securities not so exempt, to a small group 
 of holders, that others frequently cannot buy them at a price where 
 they are as attractive as are safe securities without the exemption 
 feature. 
 
 In the case of most bonds of political subdivisions of the American 
 states, the factor of safety is very high, but more caution is necessary 
 in purchasing them than is the case with the issues of the United States 
 and of the states themselves. The questions which arise in connec¬ 
 tion with them relate themselves, first, to validity; second, to legal 
 limitations on the power to incur additional debt; third, to financial 
 strength compared with the outstanding debt; and fourth, to character 
 of the community. 
 
 The legal questions which arise in connection with municipal bond 
 issues are so technical as to make it very difficult and expensive for 
 the individual investor to satisfy himself in regard to them; hence, 
 except in the case of small issues which are issued locally, recourse is 
 
RISK AND RISK-BEARING 
 
 188 
 
 had to the intervention of an investment house which buys and dis¬ 
 tributes the issue, giving its customers the benefit of opinion of its 
 legal counsel. This method enables all of the issue to be sold to 
 scattered investors on the faith of one investigation, and, except in 
 the case of the largest buyers, it is the only method which is at all 
 practicable. To a certain extent, the same method is applicable to 
 other phases of the investigation. The financial middleman takes 
 the responsibility of collecting the data relative to financial resources, 
 existing debt, limitations on further debt, purposes of the issue, etc., 
 and assembles them in a convenient prospectus for the information 
 of the investor. It is possible, however, for the investor to check up 
 on some of these details, and probably rather better worth while that 
 he should do so than is the case with the questions of legality and 
 validity. So far as outright misstatement is concerned, the prospectus 
 of a reliable investment house is presumed to be trustworthy, for the 
 ethics of the business set a high standard of accuracy, but there is 
 more likelihood of omission of significant qualifying detail than is the 
 case with the opinion of counsel concerning legal requirements sur¬ 
 rounding the issue. For example, it is not infrequently the case that 
 the amount of debt per capita or per dollar of assessed valuation of a 
 given political district is stated without reference to the fact that the 
 same population or property is included within the bounds of over¬ 
 lapping or coextensive units which have independent debts, or author¬ 
 ity to contract them. 
 
 Foreign government bonds have only recently come to occupy a 
 large share of the attention of the American investing public. Under 
 pre-war conditions, the securities of the leading nations of the world 
 shared the distinction of rating as riskless securities. The effect of 
 the war has been to destroy the credit of certain nations whose securi¬ 
 ties formerly enjoyed this high rating, and to inject an appreciable 
 amount of uncertainty into the status of others whose credit is still 
 high. It has also had the effect of shaking confidence in the absolute 
 soundness of the bonds of countries which were not adversely affected 
 by the war, by emphasizing the uncertainty of the political structure 
 of modern civilization which underlies the value of the whole body of 
 evidences of public debt of most countries whose securities enter the 
 investment market. 
 
 In all probability, there is no considerable group of securities 
 in existence whose record of payment of the interest and principal 
 of their bonded debt is as likely to be unbroken, which yet yield 
 
THE ANALYSIS OF SECURITIES 
 
 189 
 
 as high a return as the obligations of the neutral and former 
 allied nations of Western Europe. Analysis in accordance with the 
 usual methods of comparison of indebtedness, financial resources, and 
 record of performance of obligations in the past, entitles them to the 
 very high rating which they are accorded by professional financial 
 rating bodies. Yet the market’s rating is unfavorable, and the reluc¬ 
 tance of investors to register, in actual purchases, the high rating which 
 paper analysis affords, is not difficult to understand. The major risk 
 in the investment of capital in the securities of the nations of Western 
 Europe is the hazard of another great war, and this hazard is entirely 
 incapable of mathematical estimate either as to the probability of its 
 incidence or as to its probable effect upon the foreign bonds of the 
 countries engaged in it. It seems highly probable that the course of 
 events over the next decade or two will be such as to strengthen the 
 credit rating of all the leading powers; and if so, the yields of their 
 foreign debt at this time will seem a few years hence to have been 
 incredibly high. It does not on the other hand seem impossible 
 that international war, or internal disturbance, may reduce the obli¬ 
 gations of other powers to the status of the bonds of Germany and 
 Russia; the proper bond yield to discount this possibility is a matter 
 of conjecture rather than of investment science. 
 
 In the analysis of corporate securities, the same contrast appears 
 which we noted in the analysis of municipal issues, between the items 
 which the individual investor can learn and discount for himself and 
 the items in regard to which he is dependent on the specialized assist¬ 
 ance of the investment banker or other financial specialist. There is 
 this important difference, however, that, in the case of the industrial 
 issues, the legal questions are relatively of less importance, and the 
 general economic and financial factors which are accessible to the 
 investor for use in forming an independent judgment are more numer¬ 
 ous and more important, so that detailed examination of the problems 
 which confront him is more likely to be of practical value. This is 
 the more important because the services of the financial middleman 
 are available chiefly in connection with new issues, while many of the 
 issues concerning which the investor has an interest, are old issues 
 which are no longer being pushed systematically by any financial 
 organization. 
 
 The following outline suggests the most important items which 
 should be taken into account in estimating the investment position 
 of the securities of industrial corporations: 
 
190 
 
 RISK AND RISK-BEARING 
 
 ELEMENTS OF STRENGTH IN INDUSTRIAL SECURITIES 
 
 I. Position of the industry 
 
 a ) Secular trend: Is the business likely to increase or decrease in 
 importance ? 
 
 b) Cyclical position: How is this line of business affected by the 
 coming and going of prosperity ? 
 
 II. Position of the individual firm 
 
 a) Position in the industry 
 
 1. Strength of competition, present and prospective 
 
 2. Record of growth; evidence of progressive policy 
 
 3. Reputation of firm in the industry 
 
 b) Financial position 
 
 1. Current position 
 
 2. Financial history 
 
 3. Banking and underwriting connections 
 
 c ) Personnel 
 
 III. Position of the individual securities 
 
 a) Priority of lien; adequacy of security; protective provisions 
 
 b) Market history 
 
 c ) Technical factors: floating supply, market interest, manipulative 
 activity, etc. 
 
 The position of the industry is usually susceptible of more adequate 
 analysis than is the position of the individual firm. Industries rise 
 and decay as do individual firms. The most profitable investments 
 have been those which have been made at an earlier stage in the history 
 of a new and successful invention. It does not follow however that 
 a policy of seeking such opportunities is a profitable policy. For 
 every case where fortunes have been made by buying the securities of 
 corporations formed to develop new industries, dozens of ventures, 
 which at the outset appeared equally promising, have swallowed the 
 capital of their projectors without adequate return. The history of 
 the telephone, the telegraph, and the condensed-milk industry is 
 constantly kept fresh in the minds of investors by promoters of new 
 concerns, while the financial failure of liquid air quickly fades from 
 memory, Even where new industries have been successful in the end, 
 it is frequently true that the original investors have failed of a reward, 
 or that the major returns have gone to those who came to the rescue 
 of the enterprise when it had passed its initial difficulties but exhausted 
 its capital in so doing. 1 
 
 1 Cf. Conyngton, Financing an Enterprise, chaps, xii, xiii. 
 
THE ANALYSIS OF SECURITIES 
 
 191 
 
 On the other hand, the fact that an industry has a long and impres¬ 
 sive record of profitable operations is not sufficient to make it a desir¬ 
 able field for the investment of additional capital, or even for the 
 purchase of securities representing investment already made. The 
 price at which such securities are obtainable is usually controlled, 
 among other things, by the past record of the industry, and if the 
 industry has passed its zenith, investments in it are likely to be over¬ 
 valued. This is true not only of cases where the market for its output 
 is actually dwindling but also of the less obvious cases where the rate 
 of growth is falling or is generally overestimated, so that an overbuilt 
 condition threatens. 1 
 
 If the growth of an industry has been determined in part by the 
 development of a consumers’ fad, as was the case with the bicycle 
 industry in the middle nineties and the radio industry in 1922, there 
 is no accurate method of forecasting its development. Collapses, 
 due to the appearance of a superior technique of production or the 
 invention of substitute products of superior efficiency or lower cost, 
 are also impossible to foresee. They are among the inherent risks of 
 industry, which can readily be seen to be greater in some industries 
 than in others, but cannot be eliminated by research. 
 
 The decline in profitableness which results from an overbuilt 
 condition, however, can frequently be foreseen. Statistics of con¬ 
 sumption of basic commodities for the leading countries are available, 
 and the producing capacity of most industries is also a matter of 
 approximate knowledge. During a time of prosperity, whether the 
 general prosperity which marks the culmination of an upward swing 
 of the business cycle or a boom in a specific industry caused by war 
 orders, by a consumers’ craze, or by the development of new markets 
 for the product, there is always great danger that an overinvestment 
 will take place. The result of such a contingency is not merely to 
 waste the capital of those investors who come in last or choose the 
 least favorable conditions for their investment; it is often to create 
 a condition of overcompetition which makes it difficult for any concern 
 in the industry to make satisfactory returns on its capital. 
 
 In general, investments in the securities of corporations which 
 have monopolistic advantages are the safest, and those in industries 
 where competition is keen are the riskiest. Competition has decided 
 advantages from the standpoint of protection of the public interest, 
 but monopoly has correspondingly great advantages from the stand- 
 
 £ Cf. J. M. Clark, quoted above, pp. 79-81. 
 
192 
 
 RISK AND RISK-BEARING 
 
 point of investors. This applies not only to those concerns which are 
 protected by patents or franchises or by control of limited natural 
 resources. Indeed, it is often the case that such corporations are 
 singled out as the subjects of attack by legislators and by the agencies 
 which shape public opinion to such an extent as greatly to lessen the 
 strength of their position. If this is not the case, the price to be paid 
 for their securities is likely to discount the strength of their position 
 so that the investor secures a safe investment, but one which yields 
 a correspondingly low return. Almost as high a degree of safety, with¬ 
 out so much danger of attack, and often without the necessity of pay¬ 
 ing so high a price for it, is obtainable through investment in securities 
 of concerns which, without possessing actual monopoly power, yet 
 have attained such a position of leadership, either through early 
 start, unusually competent management, high reputation of product, 
 or successful advertising, as to render them relatively free from the 
 effects of competition. The advantage which such concerns enjoy is 
 particularly apparent in periods of liquidation and depresssion. At 
 such times, competition in most lines is abnormally keen, so that even 
 those concerns which secure a satisfactory volume of orders find it 
 impossible to make a good margin of profit, but the concerns which 
 are fortunate enough to have a position of monopoly or semi-monopoly, 
 though they suffer a decline in the volume of orders received, are able 
 to keep prices at a level which insures a satisfactory profit on the busi¬ 
 ness actually done. 
 
 Industries differ widely in the extent to which their volume of 
 business and their profit margins are affected by the business cycle. 
 It is not necessarily true that an industry in which there are violent 
 fluctuations of prosperity and depression is for that reason either more 
 or less profitable than a steadier industry, but it is necessary to take 
 careful account of this factor in appraising the financial record of the 
 individual concern for two reasons. In the first place, the securities 
 of corporations engaged in lines where the fluctuation is great are to a 
 considerable extent valued upon the basis of the immediate outlook, 
 rather than upon the average of good and bad times which determines 
 their real income-producing power. Hence they are very likely to 
 be overvalued in good times and undervalued in bad times, and the 
 investors’ decisions should be made with this factor in mind. In the 
 second place, many industrial corporations and not a few underwriting 
 concerns are not overscrupulous about choosing financial data in 
 such a way as to make the best possible showing for the concern. 
 
THE ANALYSIS OF SECURITIES 
 
 193 
 
 Hence, prospectuses which advertise securities on the basis of the aver¬ 
 age earnings for the preceding three or five years, or the balance 
 sheet at a given time, should be scrutinized with care to see whether 
 they represent the showing during an abnormally favorable period 
 of the business cycle. 
 
 The extent to which a given industry is subject to the influence 
 of cyclical movements depends chiefly on the character of the product. 
 Consumption goods are affected quite differently from producers’ 
 goods. Among consumers’ goods, the demand for luxuries fluctuates 
 more than that for necessities, but even so-called necessities show 
 plainly the effect of changes in income which result from prosperity 
 and depression. More important is the classification into goods which 
 make up a significant part of the budget and those which are trifling 
 in importance from the standpoint of the amount spent by any one 
 user. Matches, for instance, show much less evidence of the cycle 
 in their market than does meat, though a proportionate reduction in 
 the consumption of matches would probably involve much less real 
 sacrifice for the community. 
 
 Producers’ goods fluctuate in demand with the demand for the 
 product, but this fluctuation is greatly accentuated in certain lines by 
 the producers’ practice of specializing in the manufacture of parts and 
 supplies for the use of other manufacturers who produce themselves 
 enough to supply part of their needs. In case, for instance, a manu¬ 
 facturer of automobiles is equipped to produce a certain part in 
 sufficient quantity to supply his needs when his plant is running at 
 half-capacity, a decline in his business from 100 per cent to 75 per 
 cent of capacity will result in a reduction of about 50 per cent in his 
 purchases, assuming that he does not produce or purchase for stock, 
 and a 50 per cent reduction in the volume of his orders will take him 
 out of the market as a buyer entirely. 
 
 Still more important, in many cases, is the question of perisha¬ 
 bility of product. If it is possible to store up a product for future use 
 or sale at times when scarcity or rising prices are expected, the fluctua¬ 
 tions in actual consumption will be greatly exaggerated in the market 
 demand for the product. For example, the demand for bread shows 
 little effect of the cycle, but that for flour shows it very clearly. 
 
 Another important point is the readiness with which prices of the 
 commodity or service sold reflect changes in market conditions. Lines 
 in which selling prices are fixed by law or custom have a cycle of pros¬ 
 perity inverse to that of most businesses, their costs going up in times of 
 
194 
 
 RISK AND RISK-BEARING 
 
 prosperity more than their incomes, and vice versa. Gold-mining and 
 the manufacture of artificial gas are illustrations. This point is of 
 importance not only in connection with the securities of corporations 
 engaged in these industries but also in judging the position of industries 
 which sell them equipment and supplies. Manufacturers of electrical 
 equipment are relieved of part of the effect of the business cycle by 
 the fact that their sales to public utilities are likely to increase at times 
 when their sales to industrial concerns are at a minimum. 
 
 Analysis of the financial position of industrial corporations always 
 involves a large margin of error. —Whereas the facts concerning the 
 present condition and outlook for whole industries are in large part 
 common knowledge so far as they are available to anyone, the facts 
 concerning the position of individual corporations are highly confiden¬ 
 tial, and are imparted to the investing public only in so far as the 
 management deems it good policy to do so. Many large and appar¬ 
 ently prosperous concerns publish no information concerning their 
 finances, and this in no way reflects upon their standing. Concerns 
 which desire to secure funds from a wide range of investors, however, 
 through the sale either of stock or of bonds, are practically compelled 
 to give out a certain amount of information, and some firms consider 
 it good policy to publish financial statements even though they are 
 under no immediate pressure to do so. Of these reports, by far the 
 most important, so far as investment analysis is concerned, are the 
 balance sheet and the income statement. These are worthy of careful 
 study by the prospective investor, first, because the elements of 
 strength or weakness do not all lie on the surface of a perfectly 
 unbiased report, and, second, because reports are often colored to suit 
 the purposes of the management, and evidence of this coloring may 
 sometimes be detected, particularly if a series of statements for succes¬ 
 sive years is available for purposes of comparison. 1 
 
 The following questions suggest some of the factors which the 
 careful investor, or the speculator operating for the long swing, will 
 take into consideration in analyzing the reports of industrial 
 corporations: 
 
 1 It must not bo overlooked that the bias is not always in the direction of 
 making the corporation appear more prosperous than it really is. For purposes 
 connected with market manipulation, or for the sake of the effect upon competi¬ 
 tion, in recent years also on account of income taxation, it is frequently desirable 
 to make the prosperity appear less than it actually is. 
 
THE ANALYSIS OF SECURITIES 
 
 195 
 
 A. QUESTIONS ON THE BALANCE SHEET 
 
 1. At what time was the balance sheet drawn? For instance, does 
 it reflect a peculiar seasonal situation ? Does it reflect the actual 
 position or that which will obtain after a proposed issue of new securi¬ 
 ties? The practice of issuing balance sheets “adjusted to show the 
 effect of the present financing,” which was popular in connection with 
 the distress flotations of 1920-21, operates frequently to cover up a very 
 weak current position. By subtracting the amount of the new issue 
 from the fixed liabilities and adding a similar amount to the current 
 liabilities, or subtracting it from the cash, an approximation of the 
 current position can be obtained. 1 
 
 2. How are the fixed assets valued? This information is not 
 always obtainable, but can generally be secured in connection with 
 new issues. In analyzing statements of corporations which are not 
 in the market to sell securities, some idea of the valuation method can 
 sometimes be gotten by comparing the valuation of fixed assets with 
 that of other corporations engaged in a similar line of business, or 
 checking through a series of statements to see whether the growth has 
 corresponded to the growth of other items. Sudden increases in 
 value assigned to fixed assets frequently indicate a desire to cover up 
 the depletion of surplus through business losses. 
 
 3. Are depreciation reserves adequate , and are the depreciation allow¬ 
 ances consistent ? Manipulation of the depreciation reserve is a 
 favorite method of producing misleading results in the calculation of 
 net income. In many cases, however, it is impossible to tell accurately 
 whether this has been done, because the only figures given are for 
 depreciated value of assets. 
 
 4. Are the figures for good-will reasonable? This item is of less 
 importance than it is frequently judged to be. There is a strong 
 prejudice in favor of a “clean” balance sheet with no intangible 
 assets, but if the good-will item is shown separately so that it is possible 
 to see what the tangible assets amount to, the inclusion of a large 
 item of good-will offset by a correspondingly large item of sur- 
 
 1 For example, a prospectus of a bond issue, gotten out by a reputable bond 
 house early in 1920, emphasized by the use of black-faced type the current ratio 
 of 18:1, obtained by applying part of the prospective net return from the bond 
 issue against current liabilities and adding the remainder to the cash. The actual 
 ratio was apparently about 1:1. In this case, it happened that the sale of the 
 bond issue was never completed. 
 
196 
 
 RISK AND RISK-REARING 
 
 plus, is an item neither of strength nor of weakness. If there is 
 a large good-will item and the surplus is not sufficient to offset it, 
 the stock is shown to represent wholly or partially a capitalization 
 of actual or anticipated earning power and not an actual investment. 
 In the case of a going concern, even this does not of itself indicate a 
 weak position. The earnings are the significant item. In the case 
 of a new company with no record of earnings, a large item of good-will, 
 offset by stock issues, indicates that the stock has no present value, 
 and the risks of the enterprise will fall on the prior lien securities, 
 which will nevertheless have only a limited claim to the earnings. 
 
 5. Are the figures in the investment account satisfactory? The 
 investment item is frequently difficult of interpretation. If small, it 
 may be disregarded, but in the case of a holding company it is impor¬ 
 tant to know on what basis the securities of subsidiaries are valued. 
 Sometimes advances to subsidiaries which are uncollectible are carried 
 as investments, and sometimes the item represents fictitious book 
 values of subsidiaries, securities which have no market, and whose 
 value to the parent company bears little relation to the figure at which 
 they are carried into the balance sheet. Information concerning this 
 item is not readily obtainable; in case it is not to be had, large figures 
 for investment should be given little weight in evaluating the strength 
 of the company. 
 
 6. What is the ratio of quick assets to current liabilities? This 
 item is more important in analyses made for use in passing on applica¬ 
 tions for short-time credit than it is in investment analysis. Two to 
 one has been widely accepted as a normal minimum ratio, though the 
 significance of a variation from this ratio is quite different at different 
 times of the year and at different stages of the cycle. Wide variations 
 from this ratio are not necessarily indicative of abnormally weak or 
 strong positions, but there should be some satisfactory explanation 
 for them. 
 
 7. Is the inventory account satisfactory? Excessive inventories are 
 a source of weakness in times of falling prices and of strength in times 
 of rising prices. It is this fact that makes the current ratio (ratio of 
 quick assets to current liabilities) of such different significance at 
 different stages of the cycle. The item has very different meaning, 
 moreover, in the case of corporations which hold inventories for sale 
 from its significance where the inventories are used up in furnishing 
 services whose value does not fluctuate with changing values of the 
 inventory. 1 
 
 1 See p. 193. 
 
THE ANALYSIS OF SECURITIES 
 
 197 
 
 8. Is the net working capital adequate? Corporations which show 
 a narrow margin of working capital above absolute requirements in 
 times of prosperity are apt to be the first to collapse in times of 
 adversity. 
 
 9. Does new financing appear to he imminent ? This question is 
 closely related to the preceding one. It is usually poor policy to buy 
 the stock of a corporation just prior to the annoui cement of new 
 financing, particularly in times of liquidation and depression, unless 
 the credit of the corporation is very good indeed. 
 
 10. What is the character of the surplus ? Does it seem to represent 
 profits available for distribution, profits permanently reinvested, 
 premium from stock sales, or capitalization of hopes through inflation 
 of the good-will or fixed asset items ? Some corporations habitually 
 transfer surplus permanently reinvested to the capital account through 
 stock dividends; others allow it to remain in the surplus account. 
 From the standpoint of the preferred stockholders and the bond¬ 
 holders, the former policy is preferable as it makes it impossible to 
 distribute the accumulated surplus to stock-holders through cash 
 dividends. 
 
 B. QUESTIONS ON THE INCOME STATEMENT 
 
 i. Is the income ample to cover the requirements? These include 
 interest, dividends, sinking funds, amortization of discount, etc., on 
 the security under consideration, together with all prior claims. In 
 most lines of business, the income in a normal year should cover inter¬ 
 est requirements on a given bond three or four times to entitle it to a 
 conservative rating. Preferred stocks require a higher margin of 
 safety to entitle them to an equally good rating, as they are likely to 
 have their lien impaired by the issuance of bonds with a prior lien. 
 Even when this is apparently rendered impossible by stipulation in 
 the indenture covering the preferred stock, there is always the prob¬ 
 ability that bank loans and trade indebtedness will accumulate, and 
 these claims always come ahead of the claims of the stock. When 
 this has taken place, if the corporation has difficulty in meeting 
 maturing claims, the preferred stockholders are likely to be asked to 
 sanction a bond issue to refund the indebtedness, and they can gain 
 no advantage by refusing. Moreover, in case of reorganization, it is 
 customary to treat preferred stock in much the same way as common, 
 no matter how amply its priority has been protected by stipulations 
 which appear to make it almost the equivalent of a bond. 
 
198 
 
 RISK AND RISK-BEARING 
 
 Common stocks should earn twice the dividend, if the dividend 
 is capitalized in the selling price at anything like the going rate for safe 
 investments. There is much more variability in the ratings of com¬ 
 mon stocks, however, for the price discounts all probable future 
 increases of earnings, and this factor may justify a price far in excess 
 of what the present earnings or dividends would support. 
 
 2. Have inventory losses been carried into the income statement? 
 During the recent period of falling prices, many corporations charged 
 their inventory and other extraordinary losses direct to surplus or 
 to reserves set up previously, while others charged them to current 
 income. Either method is defensible, but in comparing the showing 
 made by different corporations it is important that a difference of 
 policy in this regard be not overlooked. 
 
 3. Have earnings been manipulated by abnormal charges to reserves? 
 Reserves are of two classes: first, the reserves for depreciation, bad 
 debts, and similar items, which represent an actual correction of the 
 book value of asset items, and, second, proprietary reserves, such as 
 “Reserve for Contingencies,” “Reserve for Inventory Shrinkage/’ 
 “Dividend Reserve,” which are merely ear-marked surpluses. By 
 making charges to the first class of reserves unduly small, the earnings 
 may be padded to conceal the effects of bad management or mis¬ 
 fortune; by making them excessive, or by making charges to the 
 second class of reserves against earnings, instead of against surplus, 
 the earnings can be made to appear smaller than they really are. 
 Examination of the reserve accounts will often make such manipula¬ 
 tion evident. 
 
 C. QUESTIONS ON THE FINANCIAL HISTORY 
 
 1. Has the growth of gross and net earnings kept pace with the growth 
 of the industry ? 
 
 2. Has the working capital been increasing with the growth of the 
 business? An increase of surplus or of capital accompanied by a 
 decrease of working capital means that earnings have been made in 
 the form of increased quantity or higher valuation of fixed assets. 
 Such absorption of earnings in plant is not necessarily unfavorable, 
 especially in a rapidly growing business, but it may mean that a 
 showing of profits is being made through charges to betterment of 
 what are really repairs, or through excessive valuation of fixed assets. 
 It is much easier to verify the bona fide character of earnings accumu¬ 
 lated in quick assets than of those which appear in plant gains. More- 
 
THE ANALYSIS OF SECURITIES 
 
 199 
 
 over, even if the gains so shown are actual, there is indication of danger 
 that the business is expanding too rapidly for safety. 
 
 3. Has the dividend policy been liberal or conservative? From the 
 standpoint of bondholders and preferred stockholders, a policy of 
 dispensing dividends freely to common stockholders is objectionable; 
 from the standpoint of the buyer of common stock, the answer is not 
 so simple. Excessive liberality indicates a weakness, but the question 
 what constitutes excessive liberality depends on such circumstances 
 as the variability of the earnings, the necessity of maintaining large 
 reserves against inventory and credit losses, the amount of borrowed 
 capital used, concerning which no brief general statement is likely to 
 be of value. 
 
 D. QUESTIONS ON CORPORATE POLICY AND PERSONNEL 
 
 1. What is the character of the banking connections ? Naturally, the 
 fact that a corporation’s securities are underwritten by the leaders in 
 the business of handling securities of the type in question is a favorable 
 point. The absence of such connections, however, does not condemn 
 a security; it merely makes it necessary to seek a reason for their 
 absence. Some excellent issues are brought out without the aid of 
 underwriters, because they are too small to be attractive to high-grade 
 houses; others, because the concerns issuing them feel strong enough 
 to dispense with the investment bankers’ support. 
 
 2. Does the management seek publicity for its financial successes? 
 As a rule, it is an unfavorable sign if the management seems anxious 
 to secure publicity for its large profits. Very profitable enterprises 
 are more likely to wish to avoid undue publicity because of its effect 
 in stirring up competition and also because it increases public 
 pressure for lower prices for their products. However, there are very 
 successful firms which pursue a policy opposite to that of the majority, 
 making use of their financial success as a means of attracting attention 
 to the merits of their products. When the management is unusually 
 willing to have its profits advertised, it creates the suspicion that a 
 market is being maintained on which insiders may sell out their 
 holdings but such suspicion is not always justified. 
 
 3. Have dividends been increased recently more than earnings seem 
 to justify ? Or have extra cash dividends and stock dividends been 
 granted? The bearing of this question, from the standpoint of the 
 bondholder and the preferred stockholder, has been indicated in con¬ 
 nection with other questions. The receipt of dividends is of course 
 
200 
 
 RISK AND RISK-BEARING 
 
 ihe only thing that gives value to stocks, so that increases, if there is a 
 probability of their being permanent, are favorable. Very large 
 distributions, however, are likely to be interpreted as being more favor¬ 
 able than they really are. During a period of rapid expansion, when 
 large profits are being earned and the volume of business is increasing, 
 corporation managers are reluctant to disburse unusually large 
 amounts to stockholders for the reason that the funds are at that time 
 especially valuable to the business. It is at the end of a period of 
 high prosperity that accumulated earnings can best be distributed, and 
 extra dividends are therefore an index of past, rather than of prospec¬ 
 tive, prosperity. 
 
 Moreover, there are indications that stock dividends, extra divi¬ 
 dends, and increases of cash dividends have sometimes been used as a 
 cover for the distribution of stock by insiders to the general public. 
 The experience of 1907, 1911, 1917, and the early part of 1920, upon 
 all of which occasions unusual increases in dividends were accompanied 
 for many months by declining stock prices, indicates that the good 
 news of dividend increases was regarded by large holders as an oppor¬ 
 tunity to dispose of their stocks. 
 
 Railway and public utility securities present an entirely different 
 problem. —In the first place, the capitalization of railways and utilities 
 is usually more complex than is the financial structure of industrial 
 companies. One principal reason for this is that there is less variation 
 in the net earnings of railways and utilities. It is therefore possible 
 to issue underlying bonds which offer a very high degree of safety, 
 since there is slight possibility of such great decline of earnings as 
 will imperil them, while at the same time part of the necessary capital 
 must be secured through the offer of speculative inducements because 
 there is no assurance of sufficient income to pay a return on the entire 
 capital. Moreover, in the case of the railroads, there are usually his¬ 
 torical reasons for the existence of numerous bonds secured by liens 
 on specific parts of the property, and also for numerous strata of 
 bonds superimposed upon the same property. Without attempting 
 to work out a detailed method of analysis of railway and utility securi¬ 
 ties, the following points of difference from the industrials may be 
 noted: 
 
 1. The property account is of even less importance in railway and 
 utility statements than it is in industrial statements. —The bulk of the 
 property is not salable for any other purpose than that for which it is 
 being used, and the separate parts of the property have much less 
 
THE ANALYSIS OF SECURITIES 
 
 201 
 
 value as separate units than they do as a single property. The 
 security of the investor depends almost entirely on the continued 
 earning power of the corporation. 
 
 2. The current assets and current liabilities are of much less impor¬ 
 tance than in industrial statements .—The inventories are not held for 
 sale; the accounts receivable are small; and it is rarely the case that 
 sufficient capital is obtained through bank loans to make the problem 
 of meeting maturities of short-time obligations a serious one. 
 
 3. Conversely , the proportion of fixed charges to net income is much 
 more important than it is in most industrial corporations .—The cost of 
 capital is always an important item, and if too large a proportion is 
 obtained through securities bearing a fixed charge, some sort of re¬ 
 organization to scale down those charges becomes necessary. Fixed 
 charges usually play a less important part in industrial failure and 
 reorganization. 
 
 4. Relations with public authorities are of greater importance in 
 the case of railways and public utilities than in the case of industrials .— 
 Typically, the rates charged by utilities are fixed.by some public 
 authority or are subject to review, and the demand which they serve 
 is so inelastic that their income is, to a large extent, determined by 
 the rates they are allowed to charge. Hence changes in the attitude 
 of legislatures, courts, and of the public are of primary importance. 
 
 5. Railway reports are more uniform and easier of interpretation 
 than industrial reports; public utility reports less so .—The uniform 
 system of accounting prescribed by the Interstate Commerce Com¬ 
 mission makes it possible to secure prompt and intelligible information 
 concerning the finances of the railways. The only serious discrepancy 
 between one such report and another arises from the item of mainte¬ 
 nance. Formerly, there was wide difference of policy between different 
 roads as to what should be considered as expense and what charged 
 as betterment. Uniformity in this regard has been secured in recent 
 years, but there is still a considerable margin of uncertainty in the 
 figures for maintenance and consequently in the net earnings, on 
 account of the extent to which maintenance can be deferred or 
 hastened. 
 
 Public-utility reports are less uniform, and are frequently very 
 difficult of interpretation because of the lack of adequate information 
 concerning the amounts allowed for depreciation, particularly in the 
 accounts of subsidiary companies of large holding companies. The 
 same ambiguity occurs in the reports of industrial corporations, but 
 
202 
 
 RISK AND RISK-BEARING 
 
 it is of more importance in the case of the utilities on account of the 
 very large amount of fixed capital employed. 
 
 Finally, it remains to consider the factor which is most important 
 of all, but most difficult of access for the small investor—the character 
 of the management. Upon the ability and character of the men to 
 whom the management of his capital is intrusted, the investor must 
 rely for honest and capable service. This factor, however, cannot be 
 learned from the perusal of annual reports. Some information con¬ 
 cerning the personality and past performance of prominent industrial 
 leaders may be gleaned from the financial press, but the reader is 
 usually uncertain as to the extent to which the information so obtained 
 is inspired by the leader himself, or by those who have a personal inter¬ 
 est in promoting his reputation. Something can be learned by 
 inquiry through bankers, bond salesmen, and brokers, but much time 
 and experience is necessary to sift the wheat from the chaff in current 
 gossip concerning men prominent in the world of finance. 
 
 The best index to the character and capacity of an industrial 
 leader is the record of the corporations he has led. The man who has 
 been for years connected with the management of corporations whose 
 record of growth, progressive policy, fair treatment of investors, and 
 financial stability is good, comes to command the confidence of the 
 business community, and his name lends prestige to weaker or newer 
 businesses with which he may later associate himself. Inferences 
 drawn from the reputation of men who are associated with the manage¬ 
 ment of otherwise doubtful enterprises are by no means infallible, but 
 in most cases no better guide is available. 1 
 
 Diversification is a very effective method of reducing risk , so effective, 
 indeed, that it may well be said to be the foundation principle of 
 investment. No analysis of financial statements and market history 
 is adequate to insure safety, unless the investor is content with the 
 return obtainable from the highest grade of government bonds. As 
 soon as an effort is made to secure a larger return on one’s capital than 
 that obtainable through savings bank deposits and purchases of liberty 
 bonds and w r ar savings stamps, the factor of risk appears: risk that 
 the investor’s analysis may fail through negligence or misunderstand¬ 
 ing on his part; risk that financial reports may be deliberately mis- 
 
 1 In relying upon this sort of information, however, care must be taken to avoid 
 placing confidence in the reputation of men who are only nominally associated with 
 the management, or who, though once active, have ceased to play a dominant 
 r61e in the corporation’s affairs. 
 
THE ANALYSIS OF SECURITIES 
 
 203 
 
 leading; risk that quite unpredictable misfortune may overtake 
 borrowers whose position appears to be the strongest. 
 
 Against all these dangers, diversification offers the largest measure 
 of protection. The wider the range of investments the less is the 
 probability that all or the larger portion will turn out to be weaker than 
 they appear to be. This is simply the application of the law of large 
 numbers; the elimination of risks through combination. 1 
 
 To obtain the maximum benefit of distribution, it is necessary not 
 merely that the number of separate securities or separate borrowers 
 represented shall be large; it is equally important that they shall 
 represent enterprises exposed, as far as possible, to different hazards. 
 If possible, the diversification should be wide enough so that the 
 failure of any one obligor, or of any group exposed to similar hazards, 
 will not create serious embarrassment. A properly diversified list will 
 contain representatives of all the leading classes of investment securi¬ 
 ties; and within each group will contain representatives of as diverse 
 geographical, industrial, and commercial conditions as is reasonably 
 possible. The inclusion of representatives of all the different standard 
 types of security is necessary in order to secure protection against 
 the effects of a decline of the investment standing of some one entire 
 group, such as happened in the case of the public utilities and also in 
 the case of European government securities during the Great War. 
 Geographical diversification insures protection against the effects of 
 crop failure and reduces the effect of the business cycle. Diversifica¬ 
 tion of industries represented also reduces the effect of cyclical changes 
 and of the collapse of individual industries. Bonds are in general 
 more conservative investments than stocks, but a sprinkling of indus¬ 
 trial stocks serves as an offset to the losses incurred by investors in 
 times of rapidly rising prices, for dividends on industrial stocks are 
 likely to increase at such times, while bond interest remains stationary 
 in nominal amount and declines in real purchasing power. 2 
 
 In grouping the securities of railroads or industrial corporations, 
 an additional element of safety can be secured by balancing the 
 securities of strong competitors against one another, so that a serious 
 decline in the income of one, if caused by competition, is likely to be 
 offset by a gain on the part of the other,. 
 
 1 See chap. ii. 
 
 2 The experience of many colleges and other endowed institutions during 
 recent years has emphasized the desirability of balancing the customary heavy 
 investments in fixed income securities with a proportion of securities whose income- 
 producing capacity will be likely to increase with the level of prices. 
 
204 
 
 RISK AND RISK-BEARING 
 
 If investments are selected in such a way as to secure actual inde¬ 
 pendence of risks, the probability of total loss becomes negligibly 
 small with a very short list, but proper diversification is not attained 
 till the number of independent risks is large enough so that any 
 probable accidental combination of unfortunate developments in 
 different fields will not create serious embarrassment. For example, 
 if a fund is divided between four securities, and the probability of 
 default on any one of them is figured at one chance in twenty, there is 
 only one chance in 160,000 that all will fail, assuming that the causes 
 of failure are fully independent, but the probability that one or 
 another will fail is about three in sixteen. If the investor is dependent 
 upon the income of the fund to meet pressing needs, good policy would 
 not sanction his running so great a risk of losing one-fourth of his 
 principal. Either the fund must be distributed more widely or safer 
 securities must be chosen. This illustration points to the reason 
 why well-to-do investors often purchase higher-yielding securities 
 than are recommended for small buyers. The larger lists permit a 
 wider diversification, so that the failure of any one member of the 
 group does not eat up all the income from the rest. Of course the 
 probability that there will be some losses also increases with the 
 number of items included in one’s purchases, but the longer the list 
 the closer the actual loss is likely to run to the amount which is antici¬ 
 pated and discounted in the purchase price. As was noted in chapter 
 vi, investors who do not command a sufficient amount of capital to 
 secure diversification in their own investments can obtain it indirectly 
 through the mediation of savings banks and other financial institu¬ 
 tions. The recent development of the “baby bond” and of stocks of 
 low par value has made it possible for the small investor to choose 
 from an attractive list of offerings and obtain much more satisfactory 
 diversification than was the case a few years ago. The trouble and 
 cost of investigating the soundness of securities is as great for the buyer 
 of $100 worth as for the buyer of $5,000 worth, however, so that the 
 large investor can afford to spread his investments somewhat more 
 widely than can the small buyer 0 
 
CHAPTER XI 
 
 SPECULATION IN COMMODITIES 
 
 In a survey of the methods used in speculation in commodities, 
 our attention is directed at the outset to a distinction similar to the 
 one we observed in our study of the security markets, between the 
 listed and the unlisted securities. This is the distinction between 
 commodities which are traded in through organized exchanges and 
 those which have no such market. In both cases the organized 
 market is not essential to speculation and there is, in fact, a con¬ 
 siderable speculative interest outside the field which they cover, but 
 the speculator’s tasks of executing trades, obtaining information, and 
 financing his operations are greatly simplified by the exchange organi¬ 
 zation. Because of the concentration of speculative interest in them, 
 our attention will be directed primarily to the characteristic features 
 of the organized commodity markets and the methods used in operat¬ 
 ing through them. 
 
 In its external features and in many of its methods of operation, 
 the typical commodity exchange is very similar to the stock-exchange 
 organization which was described in a preceding chapter. A com¬ 
 modity exchange is an organization of brokers, dealers, and specu¬ 
 lators, formed for the purpose of facilitating the business of buying cer¬ 
 tain staple commodities and, incidentally, to promote the common 
 interests of its members through publicity, legislative, informational, 
 and such other services as it may be practicable for it to render. 
 The organization of the exchanges, the method of executing trades, 
 the ticker system, and most of the rules and practices are very similar 
 to those which have been described in connection with stock-exchange 
 trading. 
 
 The most distinctive feature of the trade, through the speculative 
 produce exchanges in the United States, is the futures contract . The 
 peculiarities of this contract explain most of the differences between 
 grain or cotton speculation and stock speculation. A futures contract 
 may be defined as a contract for the sale of a stipulated amount of a 
 specified grade of some commodity at a fixed price at a future date. 
 Typically, it contains the following special features: First, the specific 
 provisions of the contract are determined by the rules of the exchange 
 
 205 
 
200 
 
 RISK AND RISK-BEARING 
 
 the actual bargain being made in a highly informal way. The rules 
 and practices of the exchange are implied in each bargain, in the 
 absence of a specification to the contrary. Second, the futures con¬ 
 tract is a basis contract, which means that the commodity delivered 
 under it may be either of the “contract grade” or of some other grade 
 which may be delivered at the seller’s option at a price above or below 
 the contract price. The method of determining the differential 
 varies in different exchanges. Third, the seller is given the option 
 of making delivery at any date between specified limits; in this 
 country at any date within a specified calendar month. Fourth, the 
 enforcement of the contract is insured by a provision that a specified 
 amount known as a margin shall be deposited with some third party 
 by each of the contracting parties. These deposits are intended 
 to protect the seller against a refusal of the buyer to make good his 
 contract in case of a fall in prices, and, conversely, to protect the 
 buyer against a default on the seller’s part in case of a rise. Fifth, 
 delivery is effected by delivery of warehouse receipts for the com¬ 
 modity, which must be stored in a specific place—usually in approved 
 warehouses in the city in which the exchange is situated. 
 
 While a futures market is not essential to commodity speculation 
 and has other uses besides promoting speculation, such a market is 
 extremely convenient for the speculator’s purposes. Its great 
 advantage is that until delivery date arrives, the buyer does not have 
 to pay for the goods which he has bought, nor does the seller have to 
 own them. This tremendously simplifies the financing of commodity 
 speculation. The speculator who in October buys wheat for May 
 delivery need not worry about paying for it until May comes, and if 
 he sells before that time can have the grain delivered direct to his 
 buyer by the person from whom he bought, so that he does not have 
 to advance any capital except for margin purposes. On the other 
 hand, the speculator who believes that wheat is likely to fall in price 
 can sell in the fall for May delivery and need not purchase the wheat 
 to fulfil his contract until the last day of May. Whenever he buys 
 he can have settlement made direct between his buyer and his seller, 
 without any responsibility except to keep his margins good and 
 settle his losses. 1 
 
 1 Commodity speculation can also be carried on through the use of warehouse 
 receipts for commodities in storage, in much the same way that stock speculation 
 is carried on through the transfer of certificates, the warehouse receipts being 
 loaned for short sales and the buyers paying cash for them. This method was 
 used before the general development of the futures market. Under this system 
 
SPECULATION IN COMMODITIES 
 
 207 
 
 The following are the futures markets in the United States, as 
 listed by the Federal Trade Commission: 
 
 Trading in Cereal Futures—Grains Traded in on Each Exchange 
 
 in the United States 
 
 Chicago. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 Rye 
 
 Barley 
 
 Minneapolis. 
 
 Wheat 
 
 
 Oats 
 
 Rye 
 
 Barley 
 
 Duluth. 
 
 Wheat 
 
 
 
 Rye 
 
 Milwaukee. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 Omaha. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 
 Kansas City. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 
 St. Louis. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 4 
 
 Toledo. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 
 Baltimore. 
 
 
 Corn 
 
 
 
 
 San Francisco. 
 
 
 
 Oats 
 
 
 
 Chicago Open Board.. 
 
 Wheat 
 
 Corn 
 
 Oats 
 
 
 
 There is also at Duluth a futures market for the special variety of wheat 
 known as durum. There is similarly a market for kaffir corn (including 
 milo maize and feterita) at Kansas City. In addition to the food grains, 
 flax futures are traded in at Duluth. Toledo has futures markets for the 
 several important kinds of hayseed—clover, alsike, and timothy. The 
 New York Produce Exchange has a futures market in cottonseed oil. At 
 New York, also, and at New Orleans are important markets in cotton 
 futures. Butter and eggs, prior to the entrance of the United States into 
 the World War, were traded in through a call for futures on the New York 
 Mercantile Exchange, the New York Butter and Eggs Exchange, and the 
 Chicago Butter and Egg Board. Provision futures (pork products) are 
 traded in at Chicago'. * 1 
 
 To this list may be added the futures market in coffee and sugar 
 maintained by the New York Coffee Exchange, and the recently 
 established market for cottonseed oil on the Chicago Board of Trade. 
 Leading futures markets of other countries include a very active 
 cotton market in Liverpool, silk and rice markets in Tokyo, and large 
 wheat markets in Winnipeg, Rosario, Buenos Aires, and Liverpool. 
 A great many other commodities have at one time or another had 
 futures markets of more or less importance. 
 
 The qualifications of a commodity which adapt it to future 
 trading are: first and most important, that it shall be susceptible of 
 
 the speculative buyer has to meet the cost of storage, insurance, interest, and other 
 carrying costs, and commissions are higher than in the futures market, hence the 
 method has gone out of use except for commodities not traded in through the 
 exchanges. 
 
 1 Report of the Federal Trade Commission on the Grain Trade, V, 31. 
 
208 
 
 RISK AND RISK-BEARING 
 
 accurate classification into a fairly small number of grades, so that 
 buyers may have a definite idea of what they are likely to have 
 delivered to them; second, that there shall be a large enough interest 
 in the commodity so that would-be buyers can be fairly sure of finding 
 sellers at any time, without bidding up the price out of reason, and 
 vice versa, that sellers shall be able to find buyers at reasonable 
 concessions in price; and third, that the supply of the commodity 
 physically available shall under all ordinary conditions be quite 
 large. This last qualification is necessary, in order to protect sellers 
 against the danger of finding the entire available supply bought up 
 and held off the market when they try to obtain the goods to fulfil 
 their contracts. 
 
 To illustrate the customs and methods of future trading, the 
 wheat market on the Chicago Board of Trade will be described in 
 some detail. The Chicago Board of Trade is an incorporated body 
 of about i,600 members. As noted above, it provides facilities for 
 trading in five grains, in cottonseed oil, and in pork provisions. The 
 speculative trade in rye, barley, and cottonseed oil, however, is quite 
 negligible in volume, and oats, short ribs, and pork also comprise 
 only a small part of the trading. Wheat and corn make up the bulk 
 of the grain trade, and lard is the speculative leader in the provisions 
 group. 
 
 The management of the Board of Trade is sufficiently similar to 
 that of the New York Stock Exchange, described above, to make a 
 detailed description unnecessary. In theory, the membership is 
 not closed, a contrast to the organization of the New York Stock 
 Exchange, which it will be remembered, is limited to 1,100 members. 
 In practice, however, no new memberships are created. The market 
 price of a seat is usually in the neighborhood of $7,000 to $8,000 
 while the fee for entry through the creation of a new membership is 
 $25,000. Hence the “open” character of the membership is more a 
 theory than a practice. 
 
 The standard futures contract of the Chicago Board of Trade 
 provides for trading in units of 5,000 bushels of grain, although 1,000- 
 bushel lots of wheat are handled through a special arrangement. 
 Contracts are made orally just as is the case in the stock market. 
 The small number of commodities compared with the great number of 
 stocks handled in the Stock Exchange makes the organization of trad¬ 
 ing somewhat simpler. In place of the posts which designate the spots 
 for trading in the different securities in the stock exchange, we find 
 
SPECULATION IN COMMODITIES 
 
 209 
 
 on the floor of the Chicago Board of Trade three pits: one for wheat, 
 one for corn and oats, and one for provisions. Trades are made by 
 oral bids and offers, and confirmations are exchanged at the close of 
 the day’s business. The wheat contract calls for the delivery of 
 Number Two red winter wheat at the seller’s option on any date in 
 the month specified. Various other grades are deliverable at the 
 seller’s option at premiums or discounts. As these differentials are 
 fixed in the rules and are changed quite infrequently, one would 
 expect that they would frequently get out of line with the actual 
 differences in the market values of the various grades. No serious 
 dissatisfaction appears to exist with the working of this rule, how¬ 
 ever. May, July, September, and December are the only deliveries 
 for which any considerable number of contracts are sold. 
 
 Members carry accounts either as principals or as agents for 
 outside traders. After a trade has been made, the seller and the 
 buyer are both required to post 10 per cent of the amount of the 
 transaction with one of certain designated banks, as security for the 
 fulfilment of the contract. In case the price of wheat changes mate¬ 
 rially before the delivery date, the deposit must be adjusted. If, for 
 instance, the market price of a certain contract advances five cents 
 per bushel, all members -who have that contract bought from others 
 may withdraw five cents of their posted margins, and may demand 
 that the sellers post additional margin to that amount. The practice 
 in regard to calling for these margins depends upon the confidence 
 which the traders have in one another’s responsibility. ’ These 
 margins posted by the members with banks must not be confused 
 with the margins which the broker requires from his customer, when 
 dealing as an agent for an outside party. The broker is entitled to 
 call a margin from his customer regardless of whether he is himself 
 required to post a margin or not. There is no rule regarding the 
 size of the margin which may be required from customers. The 
 actual practice varies with the activity of the market, the amount 
 of confidence the broker has in his customer’s financial responsibility, 
 the value of the account to the broker, and the readiness with which 
 the customer can be reached in an emergency in order to call on him 
 for additional security. 
 
 The fulfilment of all contracts is made by the delivery of ware¬ 
 house receipts for grain stored in “regular” warehouses, that is, 
 warehouses which have been authorized by the directors of the 
 exchange to handle grain for delivery on contracts. In practice, a 
 
210 
 
 RISK AND RISK-BEARING 
 
 great majority of the trades do not involve an actual delivery of grain 
 directly between the parties, although any buyer or seller can obtain 
 delivery if he desires. This is true not because the contracts are 
 fictitious, but because in most cases the grain is resold before it is 
 delivered to the original purchaser. The methods employed in 
 handling these transactions have been the subject of a considerable 
 amount of uninformed criticism, and an understanding of them is 
 fundamental to an understanding of the whole system of future 
 trading; hence, they will be described in more detail than would 
 otherwise be necessary. 
 
 Suppose that A, a speculator, sells to B, in June, 5,000 bushels 
 of “September wheat” at $1.10 a bushel. The next day B sells the 
 same amount at $1.11 to C. None of the parties to the transaction 
 makes any further trade in this contract before September. It is 
 clear that when delivery time arrives the situation will be the same 
 as if A had sold direct to C, except that A is entitled to only $1.10 
 per bushel when he makes delivery, while C is under contract to 
 pay $1.11, the difference constituting B’s profit. If, therefore, A 
 makes delivery to C and the prices are adjusted so that each pays and 
 receives what he would have gotten if trading had been settled by 
 separate deliveries, the result is the same as though separate deliveries 
 and payments had been effected, and a great saving in labor results 
 both for the traders and for the banks. The courts have uniformly 
 held therefore that devices by which A is substituted for B in the 
 contract with C are legal, so long as delivery is actually contemplated 
 at the time the contract is entered into. For facilitating the adjust¬ 
 ment of accounts which wholly or partially offset one another, a clear¬ 
 ing house is operated by the management of the Board of Trade. 
 This clearing house has nothing to do with the offsetting of the 
 accounts, but only provides facilities for settling the balances of pay¬ 
 ment due from one member to another. The following methods are 
 used in working out the settlement: 1 
 
 1. Direct settlement .—This kind of settlement occurs when each 
 of two houses has sold the same contract to the other. Suppose that 
 member A has sold to member B 50,000 bushels of September wheat 
 during the course of a day’s trading, while B has sold to A 60,000 
 bushels of the same option. It is clear that when September arrives 
 the trades can be settled by the delivery of 10,000 bushels by B to A; 
 
 1 This account is based chiefly on the Report of the Federal Trade Commission 
 on the Grain Trade, Vol. V, chap. v. 
 
SPECULATION IN COMMODITIES 
 
 2 11 
 
 hence the remaining account may as well be offset at once, leaving 
 on the books only the obligation to deliver and accept the 10,000 
 bushels. In this case B is said to be “short” to A 10,000 bushels; 
 A to be long from B the same amount. On the next day, A’s sales 
 to B may be the larger, so that the balance will be wiped out. 
 
 If all the trades were made at the same price no further adjustment 
 would be necessary, but since prices are constantly changing the 
 trades offset do not involve an exact offset in the cash payments due; 
 the balances due on account of offsets are therefore settled in cash. 
 In making these settlements, the clearing house is utilized to effect 
 an offset of payments due between the members. The methods used 
 are the same in principle as those used in bank clearing houses and in 
 the stock clearing house described in chapter viii. 
 
 2. Ring settlement .—A ring is formed when three or more members 
 have trades which mutually offset. If A has sold to B, B to C, and 
 C to A, and the facts are known, the trades can be canceled and the 
 differences paid quite as readily as when there are only two parties 
 to the offset. The following diagram illustrates the operation of the 
 ring system: 1 
 
 Illustration op the Ring Settlement at Chicago 
 
 (A is assumed to have bought from F at $1.51; F from E at $1.47; 
 E from D at $1.49; D from C at $1.52; C from B at $1.45; B from A at 
 
 $1.50-) 
 
 3. Transfer .—The making of rings is entirely voluntary, and not all 
 houses co-operate in the somewhat laborious task of comparing books 
 in order to locate the rings. Trades which will not “ring out,” either 
 
 1 From the Report of the Federal Trade Commission on the Grain Trade, V, 223. 
 
212 
 
 RISK AND RISK-BEARING 
 
 because of refusal of members to participate or because the chain 
 ends with a house which is accumulating or distributing a large “line,” 
 may be disposed of by an arrangement by which the house to whom a 
 particular contract was sold substitutes on its books the name of- a 
 house from which the same quantity was bought by the house which 
 is seeking the transfer, and similarly the house from which it was 
 bought substitutes the name of the one to which the transferring house 
 has sold. Thus if in the case illustrated above the ring broke, say 
 because F had sold to G instead of to A and no connection from G to A 
 could be traced, any one of the houses except A and G could be released 
 from its responsibility by transfer. For example, B might effect an 
 arrangement by which A would be substituted for B on C’s books and, 
 of course, C on A’s books. 
 
 The principal advantage of these systems of reducing the number 
 of open contracts is the immense saving in margins which results. 
 So long as contracts remain open each party has the right to protection 
 against market fluctuations to the extent of io per cent, so that if 
 there were no method of offsetting the trades the amount so tied up 
 during the course of a season would grow very burdensome to the 
 finances of the commission house. 
 
 At most grain exchanges 1 a more complete system of clearing is 
 in use, whereby the necessity of forming rings and effecting transfers 
 is eliminated, and each house is responsible only to protect the net 
 balance of its open long or short account in each contract. By this 
 method each house reports all trades daily to the clearing house, 
 which is a distinct corporation, and then substitutes the clearing house 
 on its books for the house with which the trade was made. Thus 
 each house is “long” or “short” with the clearing house by the net 
 amount by which its purchases exceed its sales of the given contract, 
 or vice versa, while the clearing house itself is “ long ” with some houses 
 exactly the amount it is “short” to others. Small margins are 
 posted by members with the clearing house, and all losses or gains 
 from fluctuations in price of the open contracts are settled daily. 
 Thus if A has sold 5,000 bushels of May wheat to B and B has sold 
 the same amount to C the clearing house will be “short” to C and 
 “long” from A. If during the life of the option the market price 
 advances two cents, A must pay the clearing house two cents a bushel, 
 or $100, and C is entitled to withdraw that amount. By this system 
 
 1 The system here described is frequently referred to as the Minneapolis 
 system. 
 
SPECULATION IN COMMODITIES 
 
 213 
 
 the members are saved a vast amount of labor which is necessary under 
 the Chicago system, and the amount of capital tied up in margins is 
 greatly reduced. 
 
 It must be emphasized that all these provisions have to do with 
 the relations of members of the exchange with one another. The 
 customer for whose account a trade is executed has nothing to do with 
 the clearing, ringing out, or other process by which one trade open 
 on the broker’s books is offset against another. Many brokers notify 
 the customer of the name of the member with whom his trade was 
 executed, but this does not put the customer into any direct relation¬ 
 ship with the other house in question. When a customer has made a 
 trade for future delivery of grain, the house through whom he has 
 made it is responsible to him to secure delivery or acceptance as the 
 case may be. If before delivery month he makes an offsetting trade in 
 the same contract through the same broker his responsibility is ended; 
 the broker must secure delivery from the member from whom he has 
 bought and make delivery to the one to whom he has sold. The cus¬ 
 tomer is allowed to withdraw his profits, and required to pay his losses, 
 at the time he makes his closing trade, although the actual delivery 
 and payment on the contract may not be made by the substituted 
 parties for many months. 
 
 This description of the methods used in disposing of contracts 
 should make it clear that immense quantities of grain can be bought 
 and sold through the exchanges with a very small amount of clerical 
 and administrative labor and with very little actual transfer of pos¬ 
 session. The process by which the total volume of sales can be made 
 thus to exceed by many times the amount of grain actually in exist¬ 
 ence is exactly parallel to the process by which the volume of cash 
 payments in a given city may in a single day exceed the amount of 
 cash held by the banks and their customers. The cash payments so 
 largely offset one another that only a small percentage of checks 
 involve a transfer of cash from one bank to another. In exactly the 
 same way, the system of offset and clearing enables the trade in grain 
 to exceed the amount of grain actually held for delivery. In both 
 cases, the soundness of the system depends on any individual’s being 
 able to get delivery on demand; so long as this can be done a trade in 
 grain is no more fictitious because the parties to the trade do not 
 handle the wheat than the payment of a debt by check is fictitious 
 because the payee does not have the actual cash transferred from the 
 bank on which the check is drawn to the one in which he deposited it. 
 
214 
 
 RISK AND RISK-BEARING 
 
 * The methods employed in other commodity futures markets are 
 in general very similar to those which have been described in connec¬ 
 tion with the Chicago Board of Trade. The most important of the 
 smaller grain exchanges are those of Kansas City and Minneapolis 
 There are no records of amounts of grain sold but the Federal Trade 
 Commission has prepared estimates based on the volume of clearings. 
 For 1916, the most active of recent trading years, the estimates are 
 as follows: Chicago, 23.8 billion bushels; Minneapolis, 1.3 billion; 
 Kansas City, 1 billion. 
 
 The only other commodity exchange which is of sufficient impor¬ 
 tance to warrant attention in a general survey of the speculative 
 markets is the New York Cotton Exchange. The methods of operat¬ 
 ing through this market are not materially different from those em¬ 
 ployed in the grain exchanges. The unit of trading is 100 bales of 
 middling cotton (each bale weighing approximately 500 pounds). As 
 in the grain markets, the contract is a basis contract, the seller hav¬ 
 ing the option of delivering grades above or below middling at a pre¬ 
 mium or discount. The system of fixed differences has never worked 
 as satisfactorily in the cotton market as it has in grain markets, ap¬ 
 parently because the differences in grade are of more importance in 
 determining the commercial value of the commodity, and because 
 varying weather conditions give rise to very wide differences in the 
 proportion of different grades produced in different years. Prior to 
 the passage of the United States Cotton Futures Act, the discounts 
 and premiums were fixed by a committee; at present they are fixed 
 by the Secretary of Agriculture on the basis of the premiums and 
 discounts actually prevailing in a large number of selected markets 
 for cash cotton. 
 
 Let us now turn our attention from the technical organization 
 and procedure of the exchange to the speculator’s methods of seeking 
 profit through them. Except in the sensitiveness of the market to 
 minor influences making for change, the ease and rapidity with which 
 trades can be effected, and the small amount of capital needed to 
 control comparatively large units of the commodity traded in, specu¬ 
 lation in grain or cotton through the futures markets, differs little 
 from speculation in commodities which are bought and sold by the 
 ordinary channels of trade. In all forms of speculation the only way 
 in which the operator can reasonably expect to secure a profit is 
 through some sort of differential advantage over the market as a 
 whole, an advantage which may arise either from special training, 
 
SPECULATION IN COMMODITIES 
 
 215 
 
 unusual ability to judge the trend of the market, or from access to 
 special sources of information not available to the general public. 
 Few persons, without special knowledge of the businesses in which the 
 commodities are used, suppose that they can, as a long run result, 
 make profits by speculating in such commodities as lumber, iron, wool, 
 or silk, though these commodities have active markets in which there 
 are unlimited opportunities for profit for those who are able to fore¬ 
 cast them. But thousands of people who would never consider the 
 advisability of buying a few thousand dollars worth of any of these 
 staples, chiefly on credit, and holding them for a rise, do habitually 
 or occasionally match their skill against the market for speculative 
 grains and cotton. 
 
 The reason for this disposition is not to be found in any greater 
 facility for forecasting the trend of the market in the case of the or¬ 
 ganized than in the unorganized markets. The most important dif¬ 
 ference is this, that in an organized futures market the commodity 
 and the methods of buying and selling it are so standardized that it 
 is possible for an individual to buy and sell without taking the trouble 
 to learn the technique of judging qualities, the methods of handling 
 and storing, the trade customs, and other details which are necessary 
 for buying and selling through the unorganized markets. Add to 
 this the facts that the amount of capital required is very small, and 
 that the markets are so sensitive that profits or losses can be realized 
 very quickly, and it is easy to see why organized markets attract a 
 following of speculators who are affiliated with the trade in the commod¬ 
 ity in no other way. The cotton market has always been particularly 
 popular for this purpose in eastern and southern circles and the wheat 
 market in the Middle West, though the violence of fluctuation of 
 prices during the war and the closing of the wheat pit during the period 
 of federal control caused a transfer of interest to the corn market, 
 and the wheat market has not fully recovered its following. 
 
 What then are the methods employed by speculators in these 
 markets, and what is the probability of success in using those methods ? 
 In the first place, it is certain that the ease with which trades can be 
 executed in the organized markets does not of itself imply that it is 
 any easier to form an intelligent judgment of the probable course of 
 prices there than in any other markets. The market price, whatever 
 it is, represents the balance of judgment of the trade, both speculative 
 and non-speculative, as to the figure at which demand and supply 
 will, during the next year or year and a half, be approximately equal. 
 
2 l6 
 
 RISK AND RISK-BEARING 
 
 Analysis of the conditions of demand and supply is a special problem 
 for each commodity, and is the same kind of problem in an organized 
 market that it is in an unorganized market. As in all other kinds 
 of speculation the average result for the whole group ol speculators 
 is always a loss, for the commissions and other expenses are running 
 against the public just as the percentage in favor of the house runs 
 against the public in a gambling hell; the minority who succeed do so 
 because their information or their judgment is better than that of the 
 market as a whole. The first question which the prospective specu¬ 
 lator should ask himself, therefore, is, what advantage have I over 
 the average man who trades in this market? If he has no definite 
 advantage, the probability is that his chances are below average, for he 
 is trading in a market where there are many men with life-long train¬ 
 ing in studying market conditions and with access to the resources of 
 large organizations for compiling crop reports and trade reports which 
 enable them to anticipate to some extent the reports on which the out¬ 
 side speculator, the average man, must rely. 
 
 This advantage of the professional must not be exaggerated, how¬ 
 ever. The saving feature of the situation, from the standpoint of 
 the average speculator, is that his colossal ignorance of the factors 
 which he needs to understand in order to forecast the trend of the 
 prices is shared to a large extent by those who are not outsiders. For 
 though it is clear that the judgment of a man of average intelligence 
 who knows nothing of the grain trade is not likely to be of much value 
 in forecasting the course of grain prices, the converse is not true. A 
 man may be an excellent judge of the qualities of grain or cotton, or 
 be expert in transportation, in storage, in bargaining with country 
 sellers, or in a dozen other ways in which technical proficiency appears 
 among those who make their living in the trade, and yet he may have 
 no opinion worth quoting in regard to the probable future trend of 
 prices. The market is too big to be judged on the basis of the facts 
 which come to the attention of any man in the course of his daily 
 routine unless his work involves constant study of the larger factors 
 which determine the price outlook. And there are large “unknowns” 
 for the most careful forecaster. In most years by far the most impor¬ 
 tant factor in making and breaking prices in the grain and cotton 
 markets is the crop outlook. Conditions of demand are relatively 
 stable, though there is more elasticity in the demand for these so-called 
 necessities than is generally supposed. 1 
 
 1 For evidence of this, cf. statistics of consumption in Report of the Joint Com¬ 
 mission of Agricultural Inquiry , Part I, chap. viii. 
 
SPECULATION IN COMMODITIES 
 
 217 
 
 Conditions of supply are extremely unstable, on the other hand, 
 so that the speculative public necessarily takes demand more or less 
 for granted and concentrates its attention on supply. This does not 
 mean that changes in the conditions affecting demand are less influ¬ 
 ential than supply conditions in determining the price at which the 
 year’s supply will move into consumption; it simply means that 
 supply conditions are discounted in the price long before they actually 
 materialize, while demand conditions are reflected in prices rather at 
 the time they actually occur. For a large part of the year, moreover, 
 the most important element in the supply problem, the future course 
 of weather conditions, is known to no man. The same thing is true, 
 as a rule, of the amount of acreage which will be planted to the next 
 year’s crop and of many of the factors of demand. Another large 
 part of the necessary data for judgment consists of the statistics of 
 visible supply, grain in farmers’ hands, crop conditions, etc., which 
 are collected by government bureaus or by private crop reporting 
 and statistical agencies, and are available to the general public. This 
 is the great argument in favor of speculation in the grain and cotton 
 markets for the average man as contrasted with the stock market. 
 No one has “inside information” concerning the weather conditions 
 next month or the crop conditions of last year. The factors which 
 are known to all and the factors which are known to no one are so 
 important that the factors which are known to only a few constitute 
 a less crushing handicap against the outsider and give him something 
 nearer an even chance to save his money than he has in the stock 
 market. But the odds are against him in either place. 
 
 The methods of studying the factors making for advance or 
 decline of prices in a commodity market admit of no such precise 
 analysis as was attempted in our discussion of the technique of invest¬ 
 ment and speculative operations in the security markets. To a large 
 extent, each successive price situation presents a new problem. In 
 general, the factors that are known are very quickly discounted in the 
 price, but the facts essential to a complete solution are so imperfectly 
 known that there is a wide margin of variation between the futures 
 price for any distant month and the prices actually realized when 
 that month arrives. In other words, the trade keeps itself well 
 informed on the situation, at least the supply side of the situation, 
 at any given time, but the situation is so frequently changed by the 
 appearance of new and unpredictable conditions that futures prices 
 only imperfectly forecast the prices that will be charged in the future. 
 
2 l8 
 
 RISK AND RISK-BEARING 
 
 The margin of error in the calculations of the market, as a whole, being 
 so large, it is not strange that it is wide in the calculations of any 
 individual operator. 
 
 Besides the general common-sense method of studying the whole 
 situation by the use of current statistics and the history of markets 
 in the past, a number of special methods which seek to isolate single 
 factors and predict relatively temporary price conditions on the basis 
 of these conditions, may be mentioned. 
 
 Calendar-trading is probably more prevalent than it is in the stock 
 market, 1 and seems rather less irrational in grain or cotton than in 
 stocks. No careful study of seasonal tendencies in the futures 
 markets seems to have been made, however. 2 
 
 Weather map-reading is an effort to forecast each day’s market by 
 study of the daily report furnished by the Weather Bureau, which 
 shows the weather conditions for all parts of the country up to 7:00 
 a.m. of each day, before the opening of that day’s market. The under¬ 
 lying theory of the map-reader is that a change in weather which will 
 directly affect the crop prospects in any section is likely to be reflected 
 immediately in buying or selling orders from that section, which may 
 be discounted by prompt action based on the weather report itself. 
 The author has no data from which a conclusion can be drawn con¬ 
 cerning the degree of success attainable by this method of operation; 
 it seems quite possible that so long as the number of map-readers is 
 small the method may give satisfactory results. A general adoption 
 of the method of study would change the problem to that of making a 
 forecast on the part of each map-reader of what the other map-readers 
 are likely to do. 
 
 Pit-scalping is trading on the floor of the exchange for small fluc¬ 
 tuations, largely those anticipated on account of situations arising on 
 the floor itself; it is very similar to the type of trading referred to in 
 connection with the stock market. 
 
 Tailing on is trading on gossip, tips, or direct information con¬ 
 cerning the market position of leaders in the trade. This is apparently 
 the least promising method of all, but it has a remarkable number of 
 adherents, if one may judge from the amount of attention given in 
 the market gossip to the doings of prominent traders. 
 
 1 See p. 164. 
 
 1 Tentative studies made under the author’s direction indicate that there are 
 probably some seasonal tendencies in futures prices, though they are not at all 
 comparable in scope or regularity to those in the cash grain markets. 
 
SPECULATION IN COMMODITIES 
 
 219 
 
 Spreading is one of the most highly specialized types of speculation. 
 This consists in selling one contract and buying another, so that the 
 profit or loss will consist in a change in the spread between the two 
 prices. For example, a trader may buy December wheat in Kansas 
 City and sell the same amount of December wheat through the same 
 commission house in Chicago. The two trades do not cancel one 
 another; each must be closed out later by a separate transaction. But 
 a market change, due to most causes, will affect one as much as it 
 will the other, and will afford neither a profit nor a loss. The spreader 
 speculates only on the factors which will affect one price more than 
 the other, such as an interruption of traffic on account of a car shortage, 
 or crop damage in the north occurring after the southern wheat has 
 passed its critical point. The range of possible variation in the spread 
 is smaller than in the prices taken separately; hence the commission 
 house can safely require much smaller margins than woulc be required 
 on either trade alone. For this reason the trader can operate in large 
 units, thereby securing a compensation for the narrowing of the pos¬ 
 sible profit per bushel. 
 
 In like manner, one may buy December and sell May futures in 
 the same market, the speculation in this case involving the premium 
 or discount on the one contract compared with the other. Or, one 
 commodity may be “spread” against another commodity, as when 
 corn futures are bought and oats futures sold at the same time. Most 
 price changes in the corn market are accompanied by similar, though 
 less extensive, movements in the oats market; if a trader foresees a 
 rise in corn prices which will not affect oats, he buys the corn and pro¬ 
 tects himself by the short sale of oats against changes due to general 
 conditions affecting both. Or the spreader may be simply a calendar- 
 trader, who has noticed that the spread has moved in the same direc¬ 
 tion at the same period in several successive years. 1 
 
 Since commissions on spreading trades are double those on single 
 trades while the probable profit per bushel in the event of a successful 
 forecast is much smaller, the commission charges are a heavy handi¬ 
 cap against the spreader. For this reason such transactions are 
 chiefly those of exchange members, who either execute their own 
 trades or pay reduced commissions. 
 
 Unorganized speculation is in large part a subsidiary feature of 
 other forms of business enterprise. A speculative element is present 
 
 1 In the cotton market, spreads between different markets are referred to as 
 straddles; in the grain trade, the latter term is frequently applied to trades in 
 which one month’s contract is bought and another month sold short against it. 
 
2 20 
 
 RISK AND RISK-BEARING 
 
 in all lines of business where goods must be held for resale, unless the 
 risk can be eliminated by hedging or by “contracting out.” Hedging 
 will be discussed in chapter xii; contracting out was discussed in 
 chapter iv. In connection with the latter discussion, attention was 
 called (p. 61) to the possibility of keeping price risk at a minimum 
 by carrying small inventories and balancing advance sales against 
 purchases. 
 
 Business men who believe themselves able to prognosticate price 
 changes frequently pursue the opposite course to that just indicated, 
 increasing inventories when they believe prices are about to advance 
 and cutting them down in anticipation of falling prices. To what¬ 
 ever extent this policy is practiced, the business assumes the char¬ 
 acter of a speculation on price changes, and all that has been said 
 concerning the difficulty of profiting consistently through any sort 
 of speculation applies to it in full. Wherever success depends on skill 
 in forecasting the course of a market it resolves itself into a problem 
 of being more skilful or more fortunate than the group whose composite 
 judgment makes the level of prices what it is, and speculation in inven¬ 
 tory, except that it is not so rapid, is quite as risky as speculation in 
 futures. 
 
 Of the specific types of unorganized speculation, only one need 
 be given special attention—the trade in land. For many generations 
 this has been the favorite American speculation, and its risks are still 
 generally supposed to be less than is the case with any other form of 
 speculative enterprise. As with other lines of unorganized specula¬ 
 tion, land speculation is largely a side issue to other lines of business, 
 in this case chiefly agriculture and building, though there is also a 
 considerable volume of speculative buying and selling by individuals 
 who have no business need to become land-owners. 
 
 As compared with the organized markets described above, land 
 speculation presents the following peculiarities: 
 
 i. There is no “short side.” In any epoch of land speculation, 
 the bulls, therefore, have full control so long as their enthusiasm and 
 capital suffice to support and advance the market. Those who believe 
 land is going higher, buy; those who believe it is going lower, except 
 as they happen to be owners of land which they can sell out, have no 
 influence on the situation. Hence, in land booms, prices rise more 
 sharply than is likely to be the case in almost any other form of specu¬ 
 lation. On the other hand, when prices once turn downward there 
 
SPECULATION IN COMMODITIES 
 
 221 
 
 are no “shorts” who must come into the market as buyers sooner 
 or later, and the lack of this kind of buying makes the collapse more 
 complete and sudden than is likely to be the case after the completion 
 of a boom in an organized market. 
 
 2. The turnover is relatively slow. Whereas the grain speculator 
 can enter into a trade, or close it out, on a minute’s notice, real estate 
 often must be held a long time till a buyer appears. 
 
 3. Prices are relatively steady. Except in occasional booms, 
 there are few fluctuations, and prices generally show an upward trend 
 from year to year. The apparent steadiness, however, is less signif¬ 
 icant than it appears, as it is largely due to the slowness of turnover 
 previously referred to. Speculative buyers of real estate expect to 
 have to hold their properties a considerable length of time; hence are 
 not apt to be caught in positions where they must sell quickly at any 
 price. Nominal prices remain steady at times when few or no sales 
 are occurring, and when a real market could be established only by 
 drastic reductions in prices. 
 
 4. Real estate speculation requires proportionately more capital than 
 does organized speculation. Whereas stocks and futures can be bought 
 and sold on margins of 10 per cent or less, the buyer of real estate must 
 usually be prepared to advance at least one-third the purchase price. 
 Hence proportionate changes in price mean proportionately smaller 
 profits and losses. This factor, together with those referred to in the 
 two preceding paragraphs (slow turnover and steady prices), accounts 
 for the somewhat smaller proportion of speedy failures among those 
 who dabble in real estate speculation as compared with stock specu¬ 
 lation or the trade in grain futures. 
 
 5. Individual judgment of qualities of land and individual skill in 
 bar gaming play a large part in determining success. In an organized 
 market, anyone may know at a glance at what price his commodity 
 is selling and may confidently expect to buy or sell at practically the 
 same price as anyone else would. In the land market, no two units 
 are alike; trades are infrequent; the prices actually paid are often 
 not made public. Hence there is an opportunity for a good judge of 
 values to profit by trading with poorer judges, quite apart from changes 
 in the level of prices of other land in the same vicinity. For the same 
 reason the element of skill in “dickering” often makes the difference 
 between a profit and a loss. 
 
 6. Profits are very generally overestimated. When land is used for 
 agricultural purposes by the owner during the life of his speculation, 
 
222 
 
 RISK AND RISK-BEARING 
 
 or is rented, a nominal profit on resale often represents a real loss if 
 account is taken of the fact that the property has failed to yield a fair 
 return on the original investment during the time it was held. Agri¬ 
 cultural land in the eastern corn belt before the war generally returned 
 less than 3 per cent on its sale value, if rented, or if worked by the 
 owner with proper allowance for the value of his own time. In most 
 localities this situation was not greatly changed by the war boom, 
 as land prices and rents and prices of farm products all advanced, 
 leaving the net return on the sale price more irregular than before, 
 but probably on the average still less than 3 per cent. In such cases 
 the excess of the selling price over the figure on which a fair return 
 can be earned represents a capitalization of anticipated future returns, 
 either in increased direct yield or in the price secured on resale. In 
 many cases apparently high prices paid for land have in fact been 
 justified by the appearance of the anticipated increases, yet the profit 
 on resale has no more than compensated for the loss of interest during 
 the years the property was held. 
 
 In the case of urban land held vacant for resale, the point just 
 made is still more pertinent. Apart from considerations of taxation, 
 unused land must double in value every twelve years to yield on resale 
 a return of 6 per cent on the investment. Urban lands held out of use 
 for speculative purposes apparently do not, on the average, increase 
 in value at as great a rate as that, and 6 per cent is certainly a low 
 return for a speculative transaction. Some individual pieces of land 
 improve much more rapidly, and many fail to gain for years at a time. 
 In other words, the “unearned increment” is not something which 
 accrues automatically as a result of investment in land, but is like 
 any other speculative gain, a differential. Such a differential gain 
 may be obtained by superior shrewdness in forecasting the lines along 
 which a city will develop, by “inside information” concerning the 
 plans of municipal governments, corporations, and individuals, or by 
 sheer good luck. Its existence in any case, however, is always a result 
 of uncertainty, for just as in every other case where future income 
 is capitalized, as soon as an increase in the value at a known future 
 date becomes certain it is immediately reflected in the present price, 
 and the income no longer represents more than pure interest on the 
 selling price. 1 
 
 1 The social interest in the activities of the land speculator is discussed below, 
 chap, xviii. 
 
CHAPTER XII 
 
 HEDGING 
 
 Among the institutions which have been developed to aid the busi¬ 
 ness man in avoiding the risks incident to our roundabout time-con¬ 
 suming methods of production and distribution, one of the most inter¬ 
 esting is the system of shifting the risks of price changes, which is made 
 possible through the use of the futures markets for “hedging ” purposes. 
 A hedging transaction may be defined as a coincident purchase and 
 sale in two markets, which are expected to behave in such a way that 
 any loss realized in one may be offset by an equivalent gain in the other. 
 
 As applied in the grain and cotton futures market, the term 
 “hedging” refers to one of two types of transactions. The first, the 
 hedging sale, arises when a country grain dealer, a terminal buyer, a 
 miller, or an exporter buys grain in the cash market and sells futures 
 contracts of an equivalent amount, as protection against a fall in price 
 during the time that the grain is in his possession. The second, the 
 hedge purchase, arises when a manufacturer has sold his product 
 ahead at a fixed price and buys futures to protect himself against an 
 advance in the price of raw material. The idea is that if the price of 
 cash grain declines a similar decline will probably occur in the futures 
 market, and the loss realized on the one transaction will be offset by a 
 gain realized on the other. It goes without saying that such a pro¬ 
 tection cannot be obtained without giving up the chances of a profit 
 from a price fluctuation in the opposite direction. Since the hedging 
 transaction involves some costs for commissions, taxes, interest on 
 margins, etc., it is clear that the average result of a long series of such 
 trades should normally be a slight loss, but this loss is regarded as a 
 premium paid for insurance against the risk of such heavy losses in an 
 unfavorable season, as would disrupt the business and prevent its 
 continuance through the long run, in which gains and losses from 
 price changes could be expected to balance. 
 
 The question may arise, why any individual would engage in trans¬ 
 actions of such a character that the chances of loss and the chances of 
 gain offset one another. The answer is that in changing grain from 
 country points to terminal markets, in milling, in jobbing flour, and 
 in other operations incident to the production and distribution of 
 
 223 
 
224 
 
 RISK AND RISK-BEARING 
 
 grain production, the trade or manufacturing profit can be expected 
 under ordinary conditions of competition without reference to any 
 gain or loss from price changes. The hedge enables the operator to 
 make his price and regulate his business on the basis of his ordinary 
 trade profit, without the possibilities of speculative loss or gain which 
 arises from the instability of prices. It is impossible to carry on such 
 operations as these without owning grain or its products through 
 a certain period of time, but the hedge enables the operator to isolate 
 the ordinary risks of competition from the special risks, which arise 
 from the instability of prices of the commodities in which he is 
 dealing. 
 
 Several advantages result from such a separation. For one thing, 
 the amount of credit which the grain or other operator can secure is 
 much greater. This is true because the protection afforded a bank by 
 the use of warehouse receipts for grain as collateral is much stronger, 
 in case the owner is protected against loss by hedging contracts. The 
 principle is the same as that involved in the custom by which the 
 mortgagors are required to keep property insured for the benefit of 
 mortgagees. In the second place, the use of the hedging contract 
 makes it possible to do business on a much smaller margin of profit. 
 Where hedging contracts are not available, commodities must be 
 handled on a wide enough margin to compensate for the risk of adverse 
 price changes. When the protection of the hedging contract is avail¬ 
 able, competition ordinarily brings about a narrowing of the profit 
 margin in accordance with the reduced amount of risk. This is of no 
 financial advantage to the grain dealers as a class, but makes it 
 possible for consumers to receive the benefit of lowered prices, or grain 
 producers to receive the benefit of higher prices, or for both these 
 things to take place, and it also makes the grain dealers’ business less 
 speculative. 
 
 It is clear that the gains from the practice of hedging are entirely 
 due to the reduction of uncertainty, and not to any reduction in the 
 probability of the unfavorable contingency against which protection 
 is sought. Whenever a man saves himself from loss by hedging 
 through the futures market, someone has to lose to keep him even. The 
 question therefore arises whether the total amount saved by hedgers 
 as a group on transactions, where they would otherwise incur loss, is 
 greater or smaller than the profits they lose in cases where the market 
 moves in their favor. The theory generally accepted among econo¬ 
 mists is that the speculators w’ho buy and sell hedges to grain dealers, 
 millers, and other tradesmen are specialists in the art of discounting 
 
HEDGING 
 
 225 
 
 the future, more expert than those with whom they are dealing, and 
 that hedgers as a class, therefore, lose something in the long run to 
 the speculators as a class. This loss constitutes the compensation 
 of the speculators for the service of reducing trade risk, and from the 
 standpoint of the grain trader, should be figured like his commissions, 
 as a premium paid for insurance against risks too great to be borne. 
 
 No statistics bearing on this question are available, but it does 
 not seem probable that, as a matter of fact, speculators are more expert 
 than the dealers with whom they trade. Grain dealers, millers, and 
 others who habitually hedge probably stay in business much longer on 
 the average than do speculators, and, therefore, accumulate more 
 experience. The speculative group includes a certain number of 
 professional large-scale operators who do succeed in staying in business 
 year after year, and presumably are making satisfactory profits, but 
 these are the survivors of a large number whose financial strength is 
 exhausted, or whose taste for speculation is satisfied before they attain 
 the dignity of professionals. A few speculators make very large prof¬ 
 its, but in all probability the business of furnishing hedging contracts 
 belongs in the list of services which, as a whole, are rendered for society 
 without compensation. 1 Another point which is frequently over¬ 
 looked in the discussing of hedging is the question to what extent 
 hedging contracts and practice furnish protection against price changes. 
 The following selection summarizes the situation in this regard: 
 
 It has been the common custom in works dealing with market 
 risks and their elimination to mention hedging contracts as one of 
 the most effective social devices for reducing and transferring risk. 
 There is in these discussions usually the implication, if not the definite 
 statement, that hedging contracts, wherever they can be used at all, 
 can be expected to give a complete protection to the user against 
 the risk of adverse price changes. 2 Such conclusions concerning 
 hedging transactions, as they are carried on in the ordinary course 
 of business through the futures markets, are not at all justified. They 
 arise from an inadequate comprehension of the nature of a hedging 
 
 1 See above p. 38. 
 
 2 For example: “Whatever it (the milling company which sells hedges) 
 gains or loses on the original purchase of cash wheat will be exactly offset by an 
 equal loss or gain on the future sale.” F. M. Taylor, Principles of Economics , 
 p. 294. “A person who is neither long nor short is running no risk; he is hedged.” 
 J. E. Boyle, Speculation and the Chicago Board of Trade , p. 34. “If wheat prices 
 have risen he loses on his wheat ‘deal’ but this loss is offset by the corresponding 
 rise in flour.” Marshall and Lyon, Our Economic Organization, p. 382. 
 
226 
 
 RISK AND RISK-BEARING 
 
 contract or from an incomplete understanding of the relations of the 
 two markets which are essential to the hedging process. 
 
 To see clearly the possibilities and limitations of hedging con¬ 
 tracts on organized produce markets it is necessary to understand 
 first what a hedging contract is. The essence of a hedging contract 
 is a coincident purchase and sale in two markets which are expected 
 to behave in such a way that any loss realized in one will be offset by 
 an equivalent gain in the other. If such behavior follows a perfect 
 hedge has been effected. The commonest type of hedging transaction 
 is the purchase and sale of the same amount of the same commodity 
 in the spot and in the futures markets. Frequently, however, the 
 trades are in different commodities, as when cottonseed oil is hedged 
 in the lard market or flour in the wheat market . 1 
 
 The spot and the futures markets are separate markets. The futures 
 market is highly centralized and highly competitive. All futures 
 transactions are made in a dozen exchanges, where buying and selling 
 orders converge from all over the world. The “spot market,” on the 
 other hand, if it can be spoken of as a market at all, is highly decen- 
 . tralized, frequently only partially competitive, and much less respon¬ 
 sive to minor forces making for change. Spot trades which it is desir¬ 
 able to hedge take place in Gopher Prairie as well as on the floor of 
 the Minneapolis Chamber of Commerce. The exporter in Baltimore 
 and the miller in Painted Post may be as anxious to hedge purchases 
 or sales as is the terminal elevator operator who buys on the floor of the 
 Chicago Board of Trade. In speaking of the spot market we may be 
 talking about the market in any one of many places. Whereas an 
 almost perfect system of communication has made the futures markets 
 practically a unit, the separate spot markets are at best only partially 
 merged into one. 
 
 Any divergence from the anticipated relationship of the prices in the 
 two markets results in an imperfect hedge. The possibility of imper¬ 
 fection in the protection offered by hedging trades has been recognized 
 by some few writers, but through all the literature of marketing there 
 runs the assumption that such variations as make the protection 
 
 1 The distinction drawn here is somewhat artificial, as it rarely happens that 
 the commodities bought and sold in the spot and futures markets respectively are 
 actually identical. Only specific “contract grades” are sold through the futures 
 market, and these are not likely to be the exact equivalent of the spot purchases 
 which are being hedged. The imperfect character of the protection offered by 
 hedging sales in the case of “off grades” is indicated in J. E. Boyle, op. cii., 
 pp 171-75- 
 
HEDGING 
 
 227 
 
 inadequate are much more abnormal and infrequent than is actually 
 the case . 1 
 
 THE ASSUMPTION OF A NORMAL SPREAD 
 
 The failure to appreciate the varying relationship between spot 
 and future prices and the resulting erroneous notions concerning 
 hedging have centered about the idea of a “normal spread,” that is, a 
 relationship between spot and future prices which is believed 
 to show itself with a high degree of regularity. It is obvious 
 that if any definite spread between the spot and the futures price 
 does appear with great frequency and permanence the hedger is 
 relatively safe in assuming that the two prices will fluctuate in uni¬ 
 son, and may place his hedge with the expectation of correspond¬ 
 ingly complete protection from adverse changes in price. The nor¬ 
 mal spread has been assumed, however, without a careful analysis 
 of the assumptions that would be necessary to make it a useful con¬ 
 cept. A presentation of the assumptions which are necessary to give 
 meaning to the idea will show the fallacy of the notion of complete 
 insurance against price changes and at the same time furnish a back¬ 
 ground against which the actual happenings and the resultant possi¬ 
 bilities of avoiding market risk by hedging may be shown more clearly. 
 
 Coincident fluctuations in any two markets can be expected only 
 under one of two sets of circumstances. In the first place, the two 
 markets might conceivably remain in line with one another because 
 both were controlled by the same forces, or second, prices in one market 
 might exercise a controlling influence over prices in the other. In 
 practice neither of these things ever happens completely in connection 
 with the spot and futures markets of the produce trades. To show 
 what does happen, it is necessary first to consider the hypothetical 
 conditions under which a perfect hedge could be effected; second, 
 to analyze the ways in which the actual marketing situation diverges 
 
 1 For example: “There is every reason to believe that if the price of cash 
 wheat rises 10 cents a bushel the September option will also have a rise of 10 cents, 
 or approximately that amount.” S. S. Huebner, “The Functions of Produce 
 Exchanges,” Annals of the American Academy of Political and Social Science , 
 XXXVIII (1911), 343. Fred M. Clark {Principles of Marketing , pp. 370-72) 
 recognizes the possibility of a situation in which futures contracts do not offer a 
 complete hedge, but seems to regard this situation as highly exceptional. L. D 
 H. Weld {Marketing of Farm Products , p. 345) refers to the failure of hedges to 
 offer complete protection on account of the tendency of futures and cash prices to 
 draw together as delivery day approaches. When futures contracts are selling 
 above cash grain this is a source of gain to sellers of hedges against grain in storage 
 or in process of manufacture. For its effect on buyers of hedges against forward 
 sales of flour, cf. below, p. 256. 
 
228 
 
 RISK AND RISK-BEARING 
 
 from these hypothetical conditions; and third, to survey the statisti¬ 
 cal evidence concerning the frequency of occurrence of the conditions 
 under which a perfect hedge can be secured. The wheat trade furnishes 
 a convenient case for both the assumed and the actual illustrations. 
 
 A SUPPOSITITIOUS SITUATION 
 
 Let us begin our discussion by considering a highly artificial and 
 simplified situation in which there would be a definite normal relation¬ 
 ship between the prices of wheat for immediate delivery and for deliv¬ 
 ery at any specified future date. We shall assume: 
 
 1. That there is no carry over; that is, the last bushel of the old crop 
 has gone out of the market at the end of the crop year, say on June 30. 
 
 2. That the entire new crop of the world has “come in” at one 
 time, July 1, and is accessible. In practice this would doubtless have 
 to mean that a very large portion of it had reached central markets 
 where it could be retained as a visible supply, and there would have to 
 be no doubt that the balance of it could be made available without 
 delay when wanted for consumption. 
 
 3. That no additional wheat could possibly reach the market 
 until July 1 of the following year. 
 
 4. That costs of storing grain do not change during the year. 
 
 5. That everyone who is interested in the wheat trade has full 
 information concerning the available supply. 
 
 6. That everyone in the wheat trade has complete information 
 concerning the fact that wheat is to be consumed uniformly through¬ 
 out the year and at such a rate as exactly to exhaust the supply on 
 June 30. 
 
 7. That everyone concerned can be counted on to act with pecu¬ 
 niary rationality. 1 
 
 With these conditions existing, one might expect to find a defi¬ 
 nite and normal relation existing at any given time between the spot 
 and the futures contract prices, and an absolute uniformity in the 
 price of each futures contract throughout its life. The situation 
 which would exist on July 1 is illustrated in Figure 1 as follows: 
 
 XA = price of cash wheat on July 1. 
 
 YC— price of June futures on July 1. 
 
 Successive ordinates ol AC represent successive prices of cash wheat 
 through the year. 
 
 1 Most of these considerations would be included in the statement that the 
 supply is known and that the effective demand is such that the total will be con¬ 
 sumed during the year and at a uniform rate. It has seemed well, however, to 
 put the situation in factual terms so far as possible. 
 
HEDGING 
 
 229 
 
 AM, AF , AH, AD represent the carrying charges to September 30, 
 December 31, May 31, and June 30. 
 
 XM, XF, XH, represent the prices of September, December, and 
 May futures; these prices are constant. 
 
 Since, according to the assumptions, the supply is known, its 
 availability certain, its total consumption fixed at a uniform rate, and 
 all persons concerned are acting rationally, the price on July 1 of wheat 
 deliverable the 30th of the following June would be higher by exactly 
 the carrying charge between the two dates. 1 The price of cash wheat 
 would increase uniformly from the beginning to the end of the year. 
 
 If at any time the “spread” between spot and future prices should 
 exceed the amounts indicated there would be an immediate and cer¬ 
 tain profit for anyone who would buy cash grain, sell futures, put the 
 grain in storage, and later deliver it on the contracts. Under these 
 conditions no one could rationally sell any cash grain. If, on the 
 other hand, the spread became less than the carrying charge it would 
 be unprofitable for anyone to hold any grain, for it would be cheaper 
 to sell one’s holdings and replace them by purchasing futures and 
 accepting delivery on them. 
 
 , A MODIFICATION OF THE ASSUMPTIONS 
 
 We may now modify our assumptions and bring them closer to 
 reality by introducing certain factors which may operate to disturb 
 the price level. Suppose there occurs a general decrease in the 
 desire to consume wheat, on account of the introduction of a popular 
 substitute. Or, a more probable occurrence, suppose it is discovered 
 during the year that the size of the crop has been underestimated. 
 Retaining our hypotheses of complete information and of the necessity 
 of getting rid of the entire crop by July 1, it is obvious that the price 
 of wheat must immediately fall to a figure which will stimulate con¬ 
 sumption sufficiently to move the entire crop into consumption by 
 June 30. There is no reason to suppose that such a change would 
 affect the premium on futures over spot prices. The triangle ABC in 
 Figure 1 would move toward the line XY, decreasing both XA and 
 XD, but AD would be unchanged. In like manner changes in the 
 proportion of the crop desired for consumption early in the year, 
 changes in costs of production, and many other factors which affect 
 prices would have the same effect on both spots and futures. Even 
 
 1 The important factors in the carrying charge are, of course, storage, interest, 
 nsurance, and shrinkage. 
 
230 
 
 RISK AND RISK-BEARING 
 
 the introduction of a carry over into the scheme would not alter the 
 relationship of cash and future prices, so far as deliveries in the 
 same crop year are concerned (though it would have a marked effect 
 on the relation of cash prices in the spring and futuies prices for new 
 crop deliveries). 
 
 If, however, we assume that, on account of ignorance or economic 
 irrationality or on account of physical difficulties in getting the crop 
 to market, the holders of a large part of the supply fail to sell it during 
 the first half of the year and then dump it on the market for consump¬ 
 tion during the last half, the case is entirely different. The only 
 
 Fig. i 
 
 possible result of this situation will be higher cash prices during the 
 first half of the year than during the last half; if the buyers of forward 
 contracts understand the situation futures prices for spring deliveries 
 will correspond to the lower prices which will actually prevail at deliv¬ 
 ery dates. 
 
 The result is illustrated in Figure 2 as follows: 
 
 As before, 
 
 XA = cash price in July. 
 
 FC = cash price in following June. 
 
 XD —price of June futures in July. 
 
 The prices of intermediate futures will be such as to reflect the 
 anticipated course of the cash grain market. AC will not necessarily 
 be straight, and may be of any degree of irregularity, except that it 
 
HEDGING 
 
 231 
 
 cannot drop below the level of DC by more than the carrying charges 
 to June 30 from the time represented by the point of intersection. 
 
 Under such conditions the market would afford very imperfect 
 facilities for hedging. 
 
 The premium DA on cash grain over futures contracts is sure 
 to disappear. Hence the hedger, if he holds grain long, must expect 
 to lose, either by an advance in the price of the futures contract which 
 he is “short,” or by a decline in the cash grain which he is ‘Tong” or 
 by both. There is no inducement to hold grain longer than is neces¬ 
 sary. 1 
 
 Such a situation as this seems on the face of things to be highly 
 abnormal, and the discussions which postulate the possibility of a 
 
 complete hedge simply assume that the condition depicted in Fig¬ 
 ure 1 is “normal” and that in Figure 2 abnormal. Our next task, 
 therefore, is to examine the extent to which the terms “normal” 
 and “abnormal” have any real application to the varying spreads 
 between spot and futures prices. 
 
 In the first place, it must be emphasized that the current assump¬ 
 tions concerning normal spreads do not apply to the relation between 
 spot prices for old wheat near the end of the crop year and contract 
 prices for new crop deliveries. Let us examine the factors which 
 
 1 Of course if DX is large relatively to DA it may be profitable for those whose 
 business requires them to own grain at such times to sell hedges against it. The 
 hedge increases the probability of a small speculative loss, which must be covered 
 by a trade profit, but protects against a large loss due to changes in other fundamen¬ 
 tal conditions which affect cash and futures prices alike. 
 
232 
 
 RISK AND RISK-BEARING 
 
 determine the relative value in May or June of wheat for immediate 
 and for future delivery. Consider first the influence of the amount 
 of old wheat on hand. So far as the spot market is concerned, this 
 constitutes the entire potential supply, and its relation to the demand 
 for wheat for immediate consumption is the most important factor 
 in determining prices. So far as the July or September prices are 
 concerned, on the other hand, the supply of old wheat is of importance 
 only as it affects estimates of the total which will be available for 
 comsumption during the coming year, of which total the carry over 
 of old wheat will constitute only a small fraction. More specifically, 
 if in May or June the supply of old wheat is small relatively to the 
 amount needed to keep mills in operation and supply current demands 
 for flour till the new wheat is fit for grinding, the spot prices at terminal 
 markets will have very little relation to the futures prices. On the 
 other hand, if the supply of old wheat is large enough so that a consid¬ 
 erable part is likely to be carried over to be sold along with the new 
 wheat, the spot price will come under the control of the factors which 
 determine the price of the futures and is colloquially said to be con¬ 
 trolled by the futures. In other words, a shortage of old wheat may 
 send the spot price to a level indefinitely higher than the price for 
 futures, but an abundance of old wheat cannot send it lower than the 
 futures price, except by the “ carrying charge,” because the surplus 
 of old wheat constitutes a part of the prospective supply which deter¬ 
 mines the price of the futures. 
 
 Spot prices at different points which are not centers of consumption 
 are affected differently by a shortage of old wheat near the end of the 
 season. If there are supplies quite near the terminal markets, and 
 the situation is not complicated by the presence of a local consumptive 
 market, their price will be closely related to the spot prices at the ter¬ 
 minals. If there are other supplies so remote that they cannot be 
 gotten to the central market before new wheat is expected, their 
 price fluctuations will correspond to those for the futures. In general, 
 the longer the time required to make delivery at a central market or a 
 point of consumption, the lower the spot price will be, provided the 
 futures are selling below the cash grain. 
 
 The spread between spot and future prices is the most obvious 
 instrument which society uses to control the carry over of grain from 
 one crop year to another. If large offerings of old wheat or a prospec¬ 
 tive shortage of new results in a premium on future contracts large 
 enough to cover the full cost of carrying, storage is encouraged; if a 
 
HEDGING 
 
 233 
 
 shortage of old wheat or the prospect of a large new crop results in 
 cash prices higher than futures, or even above the figure where the 
 premium on the futures will cover carrying costs, holders are encour¬ 
 aged to market their holdings of old and replace them by purchases 
 of futures. The social utility of an adjustment of prices which will 
 effect a distribution of the old grain between the two crop years in 
 accordance with the relations of present and prospective demand and 
 supply conditions is obvious, and in general the system, though imper¬ 
 fect, seems fairly effective. The usual situation is a premium on 
 cash over the futures. 1 If the market always behaved in a perfectly 
 rational way a very small premium on spots over futures would suffice 
 to insure that no grain would be carried forward beyond the amounts 
 actually needed to supply demands for old grain before the new became 
 fully equivalent in quality; for no one could afford to carry forward 
 for sale in a future month a commodity which he could more economi¬ 
 cally buy for delivery in that month. Some grain is carried over, 
 however, especially by farmers, in excess of what is needed, and in the 
 face of a practical certainty of lower prices in the fall. 2 
 
 The situation during the fall months is apparently simpler than 
 that which exists before the harvest, and the expression “normal 
 spread” has more meaning, but even here there is no uniformity in the 
 spreads between cash and futures markets in different years. In the 
 assumed setting given earlier we have seen how “a normal spread” 
 might be made possible. But the marketing of grain is so irregular 
 that there occurs surprisingly often a relative shortage of cash grain 
 and surplus of prospective supply. Given a certain state of demand, 
 the price of futures tends at this time of the year to be controlled by 
 
 1 To test this point an examination was made of the prices, at Chicago, of cash 
 contract wheat and July futures on the first trading day in May for the years 1901 
 to 1915 inclusive. Of the fifteen years there were twelve in which at the respective 
 low prices of the day cash grain was above the July option at its low point and only 
 one (1907) in which the premium on July futures over cash grain was as much as 
 2 cents. The figures for the low prices of the day represent the situation more 
 accurately than those for the daily high prices, because the futures price always 
 represents the bottom of the grade, while the cash quotation may represent any 
 quality not quite good enough to be classed in the next higher grade. Accurate 
 data as to carrying costs are not at hand, but figuring interest at 6 per cent on 
 90 cents a bushel and storage at 1914 rates the cost of these two items approxi¬ 
 mated 1.8 cents for the first month and 1.5 cents a month thereafter. 
 
 2 An extreme case occurred in the late spring of 1915, when many farmers were 
 holding grain for a rise, although September wheat was selling from 30 to 40 cents 
 and July wheat from 15 to 25 cents below the cash quotations. 
 
234 
 
 RISK AND RISK-BEARING 
 
 the reported size of the harvest, while the spot price depends upon the 
 supply of grain actually available. Whenever, on account of bad 
 roads, car shortage, railway strikes, farmers’ holding movements, or 
 for other reasons, the supply of grain actually coming into the central 
 markets is smaller than current reports concerning the size of the har¬ 
 vest led the trade to expect, the spot price rises above so-called “ nor¬ 
 mal” relation to the futures. A premium on cash over futures is a 
 very common phenomenon. For example, on the first trading day in 
 November from 1901 to 1915 the lowest price of spot contract grain 
 in Chicago w r as higher than that of May futures, six times, and in 
 only three years out of the fifteen was the May future as much as 
 seven cents higher than the cash. 1 
 
 Even during the spring months, when we should expect the closest 
 correspondence between the spot and the futures markets, there is 
 no discernible tendency for the futures prices to equal the cash price 
 plus a carrying charge. From 1901 to 1915 there were only nine 
 years in which at their respective low points on the first trading day of 
 March the May future was higher than the cash contract wheat. A 
 similar situation prevailed in other markets. Comparison of the 
 lowest prices for cash contract oats and for May futures on the first 
 trading day in April, for the years 1901 to 1915, gives the following 
 results: May price higher, four times; lower, nine times; the same, 
 once; data insufficient, once. Examination of figures for corn prices 
 has also failed to show any tendency for the futures to run uniformly 
 above the cash. 2 
 
 It is therefore clear that any attempt on the part of a miller or 
 other hedger to make money by taking off hedges when the spread is 
 abnormal is purely a speculation. 3 No one can ever predict from the 
 quotations themselves what either the cash markets or the futures 
 markets will do. All that can be said is that the two markets will 
 come together by the last day of the month of delivery, but whether 
 
 1 Data from Howard Bartels’ Red Books. 
 
 2 Data from sources previously cited. 
 
 3 The following passage reflects a misunderstanding on the point which seems 
 to be widespread: “Terminal elevators sometimes increase their profit by buying 
 in their hedge at times when the spread narrows more than is normal. This will 
 increase their profits, because, as it will be remembered, the spread at the time 
 they bought cash wheat and sold it for future delivery was enough to cover the 
 costs of carrying it in addition to some profit. And so, if the spread at the time of 
 sale has narrowed more than the normal amount, the profit is increased by so much. 
 They can buy again when the spread becomes normal.” Fred E. Clark, op. cit ., 
 P. 372 . 
 
HEDGING 
 
 235 
 
 the spread will disappear by .a rise of the lower price or a fall of the 
 higher, or a rise or fall of both with one moving more than the other, 
 is a question for the speculator. 
 
 The only element in the entire relationship of the spot and futures 
 which may be called a ‘‘control” is the fact that at any given time 
 the futures prices cannot get above the spot prices by materially more 
 than the carrying charge from the date in question to the date of 
 delivery. This is true because of the possibility previously noted of 
 buying grain in the spot market, selling futures to the same amount, 
 carrying until the delivery date, and delivering the actual grain. The 
 profit of any trader doing this would consist of the difference between 
 the carrying charge (plus commissions and other charges) and the 
 premium on futures over spot prices at the time he made the two con¬ 
 tracts. Such operations would at once narrow the spread by forcing 
 spot prices up and future prices down. 
 
 In this same connection, however, it is worthy of notice that it is 
 not to be expected, even if grain is marketed freely, that the futures 
 contract prices for all deliveries or for any two deliveries will fully 
 discount the carrying charge between them. If the spread between 
 the December and the May futures at any time is fully equal to the 
 cost of carrying from December to May, any speculator may buy 
 December grain and sell the same amount of May, knowing that the 
 spread will not become wider, to his detriment, and may become 
 narrower, to his profit. A speculation offering a chance of profit and 
 no chance of loss, even if the chance of profit is not great, is an ideal 
 speculation, and the competition of speculators to buy the nearer and 
 sell the more distant future is bound to be sufficient to make such a 
 situation quite abnormal and only of momentary duration. Spreads 
 between futures contracts vary widely. 1 
 
 The carrying charge bears exactly the same relation to the move¬ 
 ment of grain into storage and out into the channels of consumption 
 which the cost of shipping gold bore to the movement of specie in 
 international trade in the days before the war, with this important 
 exception, that whereas gold could be shipped in either direction, 
 grain can be carried forward for future consumption but cannot be 
 
 1 The price of May wheat at its low point on November 15. or the next trading 
 day of the years indicated, varied from the low figure for December wheat on the 
 same date by the following amounts: 1908, 4^ cents higher; 1909, if cents lower; 
 1910, 5s cents higher; 1911, 6* cents higher; 1912, 55 cents higher, 1913, 4! 
 cents higher; 1914, 6| cents higher; 1915, if cents higher. For data on carrying 
 charges see notes above, pp. 229 and 233. 
 
236 
 
 RISK AND RISK-BEARING 
 
 transported back into the past. Hence, as just noted, the premium 
 on futures over spot cannot exceed the carrying charge, but the 
 premium on spot over futures has no limit, while in the gold trade 
 a shift in the premiums could cause a movement in either direction, 
 so that the premium and the discount on foreign exchange both had 
 definite limits. 
 
 CONCLUSIONS 
 
 In the light of these conditions, the limitations of the hedging 
 market are clear. Whenever the cash price is above the futures, or 
 below the futures by less than a full carrying charge, there is no such 
 thing as a complete hedge for cash grain purchases. If the cash grain 
 and the futures contract are selling at the same price, and the carrying 
 charge till delivery month is four cents a bushel, the hedging con¬ 
 tract will afford the buyer of cash grain complete protection against 
 
 losses of more than four cents a bushel. Losses of less than that 
 
 « 
 
 amount are rendered less probable, for there are many price changes 
 due to causes which affect both markets alike, and against these the 
 hedge is complete. But there is always the risk that the markets will 
 diverge to the extent permitted by the carrying charge. 
 
 It remains to consider the case for the hedge buyer, for example 
 the man who has contracted to deliver flour at a fixed price in the 
 future and buys futures to protect himself against a rise in prices. 
 If his selling prices for flour were based on the cash prices at times when 
 the futures prices were lower, he would make an extra profit without 
 risk by buying the futures to cover his needs. Under the ordinary 
 conditions of competition, however, it is clear that sales of flour for 
 distant future delivery must be based on futures prices for wheat; 
 hence the purchase of futures is as good a hedge when futures are below 
 the spot prices as when they are above. 
 
 Sellers of flour and similar products who protect their forward 
 contracts by purchases of future contracts secure complete protection 
 if they can wait till delivery date before securing their raw material 
 and can use the grades of grain which are tendered on contracts, but 
 if they must purchase at intermediate dates their protection is only 
 partial, as the spot market in which they must buy their supplies may 
 advance without limit above the futures price. 1 
 
 ‘Adapted by permission from C. O. Hardy and L. S. Lyon, “The Theory of 
 Hedging,” Journal of Political Economy, XXXI (April, 1923), 276-87. 
 
CHAPTER XIII 
 
 LIFE INSURANCE 
 
 The subject-matter of this chapter is discussed in terms of the 
 following outline: 
 
 I. Introductory considerations 
 
 II. The risk insured 
 
 III. Policy contracts 
 
 1. General classification of policies 
 
 2. Classification according to conditions of maturity 
 
 3. Classification according to premium payments 
 
 4. Classification according to number insured 
 
 5. Classification according to right to share in profits 
 
 6. Standard policy conditions 
 
 IV. Insurance company organization 
 
 V. Selection of risks 
 
 VI. Calculation of premiums 
 
 1. Mortality tables 
 
 2. Interest rates 
 
 3. Net premium, annual renewable term policy 
 
 4. Net single premium, whole life insurance 
 
 5. Level annual premiums 
 
 6. Comparison of costs of various types of policy 
 
 7. Loading 
 
 VII. Disbursement of life insurance funds 
 
 1. Expenses 
 
 2. Settlement of claims 
 
 3. Cash surrender values 
 
 4. Policy loans 
 
 5. Dividends 
 
 VIII. Special types of life insurance 
 
 1. Group insurance 
 
 2. Industrial insurance 
 
 3. Fraternal and assessment insurance 
 
 4. Annuities 
 
 5. War risk insurance 
 
 I. INTRODUCTORY CONSIDERATIONS 
 
 As was indicated in chapter iv, the most important method of 
 getting rid of risk in business affairs through transfer to others is the 
 
 237 
 
238 
 
 RISK AND RISK-BEARING 
 
 institution of insurance. In the same chapter, reference was made 
 also to the character of the insurance contract as an agency for reducing 
 risk through combination, through special knowledge on the part of 
 insurers, and through preventive activity on their part. No further 
 attention need be given the social theory of insurance here except to 
 point out a contrast between life insurance and other forms of insur¬ 
 ance. 
 
 In general, the theory of insurance is that the insured obtains 
 a hedge against a contingency which, if it occurs, will cause him 
 actual financial loss; and that contracts which purport to insure 
 against a contingency involving no financial loss to the buyer of the 
 insurance partake of the nature of gambling transactions. 1 
 
 The chief practical consequences of this are, first, the doctrine 
 of insurable interest, under which the person seeking to effect insur¬ 
 ance is required to show that he has an actual interest in the event 
 insured against, and second, the disapproval of overinsurance. In 
 many lines of insurance, the liability of the insurer is limited to the 
 amount of loss actually realized, regardless of the amount of insur¬ 
 ance carried; and in practically all lines effort is made by insurers 
 to limit insurance to the amount of risk actually undergone by the 
 insured. In life insurance, however, the principle of indemnity can 
 receive only partial application. The doctrine of insurable interest 
 applies, but where an actual financial interest exists, insurers cannot, 
 for obvious reasons, insist on insurance being limited rigidly to the 
 amount of the actual risk. The value of a man’s life is too delicate a 
 question to be made readily the subject of contractual stipulation. 
 Moreover, an individual is always held to have insurable interest in 
 his own life; hence he is free to obtain insurance and to make it pay¬ 
 able to whom he pleases, without regard to the character of the 
 beneficiary’s interest. 2 
 
 In spite of this fact, from the standpoint of the insured and his 
 dependents, the question as to what financial hazard is involved in 
 his life risk is as vital as in any other type of insurance. Insurance 
 up to the amount required to place the beneficiaries, in the event of 
 
 1 The reader will not fail to note the sharp contrast in this respect between the 
 theory of insurance and of hedging. In speculative futures markets, while the 
 hedging function is generally asserted to constitute the chief social justification 
 of the system, the question whether a given individual in operating through the 
 market has an actual risk to hedge does not in any way affect the legitimacy of 
 his operations. 
 
 2 This is not true of the insurance written by the so-called fraternal orders. 
 
LIFE INSURANCE 
 
 239 
 
 the death of the insured, in the same financial position they would 
 have been had he lived, is a hedge, and its purchase up to this amount 
 may be sound investment policy; insurance in excess of that amount is 
 a speculation, and a poor speculation at that, for the premiums are 
 always so adjusted that the odds are in favor of the insurer. 
 
 n. THE RISK INSURED 
 
 One of the first questions which arises, therefore, in connection 
 with life insurance pertains to the character of the risk against which a 
 hedge is sought. The similar question which arises in connection 
 with other types of insurance is comparatively simple, but the loss 
 due to the death of a given individual is not susceptible of such 
 exact determination as is possible with most types of loss. 
 
 What then is the measure of the value of a human life? A 
 moment’s consideration will show that the amount of the risk on a 
 given man’s life is not closely related to the needs of those who are 
 dependent upon him. The primary object of insurance is like the 
 objective of any other business transaction which looks to the future, 
 that is, not to provide the minimum amount on which a family can 
 survive, but to provide the maximum which can be secured without 
 a cost in present sacrifices in excess of its value. 
 
 The principles upon which a correct estimate of the value of a 
 man’s life must be based are exactly the same as those governing the 
 value of any other source of income. The financial value of a man’s 
 life is the present worth of the total amount of money which he may 
 be expected to earn during the period of his normal working life 
 minus the present worth of the total amount of money which he may 
 reasonably be expected to expend for personal consumption. That is, 
 if a man will earn on the average during the next five years $5,000 a 
 year but will spend $2,000 a year for personal consumption or for 
 other expenses which will normally be stopped in case of his death, 
 the net loss to his family from his death will be $3,000 a year for the 
 five years, and the equivalent iii cash at the present time will be the 
 present worth of a five-year annuity of $3,000, or, at 3 per cent, 
 $r3,739.ro. If his normal working life is more than five years, or if 
 his probable earnings above personal expenditures will vary during the 
 period, the calculation is more complicated, but the principle remains 
 the same. This does not mean, however, that the family need be 
 protected by a whole life policy for the amount indicated. If a man 
 is assumed to earn $2,000 per year above his maintenance from age 
 
240 
 
 RISK AND RISK-BEARING 
 
 thirty-five to age sixty-five, the present worth, at 5 per cent of his 
 life at age thirty-five is about $30,745, but a year later the value will 
 be only $30,282. There will then be only twenty-nine years of work 
 left in him instead of thirty, and his value must be written down for 
 this “ depreciation.” On the other hand, the present worths of the 
 earnings of all the subsequent years must be written up to take 
 account of the shorter period for which they are now to be discounted, 
 so that the actual decrease in his capitalized earning power is not 
 $2,000 but $463. 
 
 In the case of policies taken out for business purposes, a different 
 test of the amount at risk must be applied. Such policies are of 
 several types. Sometimes insurance is carried by partners on one 
 another’s lives. Sometimes a corporation carries insurance on the 
 life of its president or other valued executive. In both cases the 
 object of the insurance is to offset the risk of loss to the business 
 through disruption of the management. Sometimes insurance is 
 carried on the lives of employees under contract, whose services are 
 of such a specialized character and whose abilities are so rare that it 
 would be difficult to replace them. Baseball players and artists 
 are frequently so insured for the benefit of their employers. 
 
 In all these cases the amount at risk must be estimated by deduct¬ 
 ing from the value of the services rendered the salary or other com¬ 
 pensation which is being paid or is anticipated to be paid during the 
 probable continuance of the business relationship. In the case of an 
 executive whose personal fortunes are bound up with the future of 
 the insuring corporation or partnership, the value of the services may 
 properly be capitalized for the whole business life of the insured, or a 
 substantial portion thereof; in the case of employees under contract, 
 only the services to be rendered during the term of the contract should 
 be considered. Estimating the value of services, particularly where 
 the services consist in large part of the use of one’s name, is very 
 difficult, but an approximation may be effected stating the question 
 in this way: How much additional salary, above that now paid or 
 expected to be paid, could the organization afford to pay rather than 
 be deprived of the services ? 
 
 Another type of business policy is that taken out to protect the 
 interest of a creditor in the life of a debtor. When the debtor pays the 
 insurance premiums as a means of securing credit, which is the usual 
 situation, the amount at risk is simply the amount of the debt, plus 
 any accretions of interest which may arise during the period con- 
 
LIFE INSURANCE 
 
 241 
 
 templated. If, however, the insurance is effected by the creditor 
 and he pays the premiums, or desires to obtain sufficient insurance 
 to protect him in case he is compelled to pay premiums in order to 
 prevent lapse, a situation arises which has been the source of much 
 confusion. It has been held, and the courts have at times sustained 
 the view, that in this case there is an insurable interest amounting to 
 the principal of the debt plus the premiums which the creditor would 
 have to pay if he kept the insurance alive through the probable life 
 of the debtor, plus interest. This appears plausible, but it is utterly 
 impossible of application, for the reason that no matter whether the 
 insurance be large or small in amount, it will inevitably be exceeded 
 by the amount of premiums required to keep it in force through the 
 life expectancy of the insured, with interest. If this were not true, 
 the contract would be an impossible one for the insurance company 
 to fulfil. 
 
 in. POLICY CONTRACTS 
 
 The contract of life insurance is expressed in a document known as 
 a policy. The life insurance policy is distinguished from most other 
 types of contract by the following peculiarities. First, it is a uni¬ 
 lateral contract. That is, the insured may cancel the contract at 
 any time, and under certain conditions may even recover a portion 
 of what he has paid under its terms, while the insurance company 
 has no such option, but is bound by the contract so long as the insured 
 fulfils his obligations. 
 
 Second, although the contract is an agreement between two parties, 
 the insurer and the insured, there is usually involved a third party, 
 known as the beneficiary, to whom the insurance is payable in the 
 event of the death of the insured within the life of the contract. 
 Though not a party to the contract, the beneficiary may have title 
 to the policy. Whether this is the case depends on the form of the 
 contract. If the policy contains what is known as a “change of 
 beneficiary clause,” that is, a clause giving the insured the right to 
 change the beneficiary at will, the title vests in the insured, and he 
 may be required to assign it for the benefit of creditors in the event 
 of his own insolvency. If there is no such clause, the beneficiary’s 
 consent is necessary for a change of beneficiary, and creditors have no 
 claim to the surrender value of the policy. In either event, under the 
 laws of most states, the proceeds of a policy payable to wife or children, 
 if matured by death of the insured, are not liable for the debts of the 
 insured, even though he was insolvent at death. Nor can such 
 
242 
 
 RISK AND RISK-BEARING 
 
 funds, as a rule, be seized by creditors of a widow or minor children, 
 so long as they are not mingled with other funds which are subject 
 to such seizure. 
 
 A third peculiarity of the life insurance policy contract is the high 
 degree of standardization which it displays. The details differ widely 
 from one company to another, but the most important features of the 
 contracts written by one company are almost identical with those 
 written by another, so that it is possible to classify and describe them 
 almost without reference to the peculiarities of practice of different 
 companies. 1 
 
 The standard types of policy may be classified on any one of several 
 bases, as is indicated in the following outline: 
 
 CLASSIFICATION OF LIFE INSURANCE AND ENDOWMENT POLICIES 
 
 I. According to conditions of maturity 
 
 1. Term insurance 
 
 2. Whole life insurance 
 
 3. Endowment life insurance 
 
 4. Pure endowments 
 
 5. Life annuities 
 
 6. Life insurance with disability provisions 
 
 II. According to method of payment of premiums 
 
 1. Single premium * 
 
 2. Limited payment life 
 
 3. Level premium 
 
 4. Natural premium 
 
 III. According to number of insured persons 
 
 1. Individual 
 
 2. Joint life 
 
 3. Group 
 
 IV. According to type of insurer 
 
 1. “Old line” or legal reserve policies 
 * 2. Fraternal benefit certificates 
 
 3. Assessment agreements 
 
 4. Government (war risk) policies 
 
 5. Miscellaneous agreements of insurance 
 
 V. According to the right of the insured to share in profits of the insurer 
 
 1. Participating 
 
 2. Non-participating 
 
 1 This statement refers particularly to the contracts written by so-called olu 
 line insurance companies. Fraternal and assessment insurance, which differ 
 radically from other types of life insurance, are discussed below. 
 
LIFE INSURANCE 
 
 243 
 
 Let us consider first the classification according to conditions of 
 maturity. 
 
 . A term insurance policy is a pure insurance contract. It provides 
 insurance for a stipulated term of years, for a premium which may be 
 paid either in advance or in a series of annual, semiannual, or quarterly 
 payments. In case of lapse, there is, as a rule, no refund to the insured, 
 and in case of expiry before the death of the insured the obliga¬ 
 tion of the insurer ceases. Renewable term policies have the additional 
 feature that the insured is entitled at the expiration of the policy to 
 • take out another contract without medical examination at the rate 
 which he would be charged at his attained age if he were accepted as a 
 new applicant. Convertible term policies provide that the insured 
 may at any time during the life of the contract, or at its expiration, 
 exchange his policy for one of the other standard types of insurance 
 contract, either paying the premium, which would be due if he were 
 taking out a new contract at the time of conversion, or else taking the 
 rate which would have been appropriate to his age at the time of the 
 original application, and paying the back premiums with interest. 
 
 Whole life policies provide that the insurance shall extend through¬ 
 out the life of the insured. As is the case with term insurance, various 
 options as to manner of payment of premiums are offered. The whole 
 life policy with level annual premium is the most popular of the 
 standard types of policy. 
 
 Endowment life policies provide insurance for a stipulated term of 
 years, most often twenty, with the provision that in case the insured 
 survives the term of the contract the insurance is due at once. The 
 pure endowment, a rare contract in its simple form, provides for the 
 payment of a stipulated sum only in case the beneficiary survives a 
 definite period. Life annuities provide an income of a stipulated 
 ‘amount throughout the life of the beneficiary. The life annuity is 
 really a series of pure endowments for successive periods. Disability 
 clauses in life insurance policies provide that the total and permanent 
 disability of the insured shall operate either to terminate liability for 
 further payment of premiums, or to mature the policy, or otherwise 
 modify the terms of the contract. 
 
 Classification according to method of payment of premiums.-—Single 
 premium insurance is paid for in advance in a single payment. Limited 
 payment life contracts provide insurance through the whole life but 
 limit the premium-paying period to a term of years, most frequently 
 twenty. Level premium means a uniform payment throughout the 
 
244 
 
 RISK AND RISK-BEARING 
 
 premium-paying period. The most frequent types are the level 
 annual premium and the level weekly premium collected on so-callec* 
 industrial policies. A natural premium is a premium which increases 
 from year to year as the risk increases. This type of premium is 
 found only in renewable term policies. 
 
 Classification according to number insured. —This classification is 
 nearly self-explanatory. Individual policies cover single lives, joint 
 life policies mature at the death of either of two or more persons; 
 group policies are written to cover a large number of persons jointly. 
 Group policies differ from joint life policies in that they are not 
 terminated by the death of one of the insured. 
 
 The classification of policies according to type of insurer is given 
 detailed consideration in later sections of the chapter, and need not 
 be analyzed here. 
 
 Classification according to right to share in profits. —Participating 
 policies provide for the return to the insured of a portion of his premium 
 in the event that earnings of the insurer justify such a “dividend.” 
 Customarily the premiums on such policies are made high enough so 
 that there is sure to be some dividend. In other words, the dividend 
 is in part a rebate of excess premium and only in part a true dividend 
 or distribution of profits. Non-participating policies, as the name 
 implies, carry no claim to dividends. “Participating policies at non¬ 
 participating rates” are sold by a few companies. These are partici¬ 
 pating policies whose premium rates carry no excess “loading” to 
 provide for dividends, hence pay only relatively small amounts, which 
 are, however, true dividends. 
 
 Standard policy conditions. —The conditions embodied in standard 
 types of policy issued by the majority of companies have been sum¬ 
 marized by one writer as follows: 
 
 1. A copy of the application is attached to the policy, so that the 
 insured may be in possession of the complete contract. 
 
 2. The policy contains a clause setting forth that it shall not go into 
 force and effect until delivered during the lifetime and good health of the 
 insured, and after the required premium has actually been paid. 
 
 3. The majority of companies have some restrictions relating to hazard¬ 
 ous occupations during the first or first two policy years. 
 
 4. Most companies have some restrictions pertaining to military and 
 naval service during war. 
 
 5. Practically every policy contains a “suicide clause” in one or another 
 form. 
 
 6. The policy becomes incontestable after one or two years. 
 
LIFE INSURANCE 
 
 245 
 
 7. Provision for reinstatement of lapsed policies is made under varying 
 conditions. 
 
 8. Thirty-one days’ grace is allowed in the payment of every premium 
 after the first. 
 
 9. Participating policies contain a clause stating the conditions under 
 which dividends will be paid. 
 
 10. Every policy embraces a table specifically indicating the surrender 
 values and loans available in each year, generally beginning with the third. 
 
 11. Most companies undertake to pay claims immediately after the 
 receipt of proofs of death. 1 
 
 Most of these clauses require no explanation. The suicide clause, 
 formerly very sweeping in the policies issued by many companies, 
 now generally covers only the first policy year. Its effect is to free 
 the company from liability in the event that the insured dies by his 
 own hand, whether sane or insane. The clauses relating to military 
 and naval service usually only have application to the first one or two 
 years, and the same thing is still more generally true of the clauses 
 which restrict the insured in the choice of occupations and in his 
 freedom of travel. 2 In all these causes, the intent of the clause is 
 not to protect the company from liability in the case of such indi¬ 
 viduals as would normally run the proscribed hazards, but simply to 
 prevent the insurer’s securing an undue proportion of such hazards 
 on account of a tendency of people to take out insurance after they 
 have decided to commit suicide, to engage in dangerous occupations, 
 or to travel in unhealthy environments. 3 The “incontestable clause” 
 operates to debar the company from contesting the policy after a 
 specified time, usually one year. Exception is always made of certain 
 cases, including those in which the policy is invalidated on account 
 of non-payment of premium, and sometimes such other items as 
 military and naval service, fraud in application, etc. In case the 
 age of the applicant has been understated, the company’s remedy is 
 not cancellation of policy, but the reduction of its liability to such 
 amount as the premium actually paid would have purchased at the 
 correct age of applicant. Incontestable clauses never waive the 
 application of this remedy. 
 
 1 Forbes Lindsay, The Policy Contract , p v 88. (Pamphlet published by the 
 Pacific Mutual Life Insurance Company of California.) 
 
 * During the Great War most insurance companies waived restrictions on 
 military and naval service, so far as the services of their own countries were con¬ 
 cerned. 
 
 3 Cf. discussion of adverse selection, p. 247. 
 
246 
 
 RISK AND RISK-BEARING 
 
 IV. INSURANCE COMPANY ORGANIZATION 
 
 Aside from the fraternal and assessment associations described 
 in a later section, life insurance organizations fall into two groups, 
 known respectively as stock and mutual companies. A stock company 
 is a business corporation organized to carry on the business of selling 
 life insurance. In internal organization such a corporation differs 
 little from corporations organized for other purposes. Customarily, 
 its surplus is very large in proportion to its capital stock, for the 
 reason that in its early history an insurance company requires but 
 little capital, and the need for additional capital as its business 
 expands can be met by accumulation of surplus more readily than is 
 the case with corporations in most lines of business. The amount of 
 owned capital needed, whether in the form of stock or of surplus, 
 grows relatively smaller with the growth of the business, for the 
 reason that very little of the capital is used for operating purposes. 
 The insurance company’s services are paid for in advance, and reserves 
 owned by the policyholders are carried to meet the demands for dis¬ 
 bursements which arise in the ordinary course of business. The 
 function of the owned capital is to serve as a secondary reserve 
 against abnormally high mortality experience, shrinkage in value of 
 investments, or other contingencies which may make the theoretically 
 adequate reserve insufficient to protect the interests of policyholders. 
 As the scale of business grows larger, the probability of considerable 
 deviations of actual from anticipated experience grows less; hence 
 the expansion of capital need not be proportionate to the growth of 
 the business. 
 
 Mutual companies have no stock. Their surplus as well as their 
 reserves belong to the policyholders, the difference being that the 
 reserve is an aggregate of individual reserves, each of a definite amount, 
 while the surplus is a single fund, the joint property of the entire group 
 of policyholders. The surplus alone performs the function which in 
 stock companies is performed by the combined capital and surplus. 
 It is the usual practice in organizing mutual companies to start with 
 capital stock which is to receive a fixed rate of return, if earned, and 
 to be retired by repayment to the stockholders when the surplus 
 becomes sufficiently large to render such retirement safe. Sometimes 
 a mutual company is formed by the retirement of capital stock of a 
 stock company which was formed with no intention of mutualization. 
 
 Mutual companies are subject to the control of policyholders, 
 who elect the trustees and officers. Since the policyholders are always 
 
LIFE INSURANCE 
 
 247 
 
 numerous and widely scattered, the individual policyholder, as a rule, 
 has very little interest in the results of elections, and the tendency 
 is strong for control once lodged in a certain group of individuals to 
 remain in their hands so long as they care to exercise it. In this 
 respect, however, there is little difference between the situation in a 
 mutual company and that in a stock company with numerous small 
 stockholders. 
 
 Stock companies are far more numerous than mutual, but so many 
 of the larger companies are of the mutual type that the volume of 
 business done by the mutuals is decidedly in excess of that done by the 
 stock companies. 
 
 V. SELECTION OF RISKS 
 
 One of the most important problems confronting the management 
 of any insurance company is the proper selection of risks to be insured. 
 This is particularly true in life insurance, for the reason that the com¬ 
 pany has no option of canceling the contract, if after completion it is 
 found to be unfavorable to the company’s interests. 
 
 In a consideration of the methods used in selecting risks, it must 
 be emphasized at the outset that it is not the purpose of selection to 
 secure for the company an abnormally favorable experience. Insur¬ 
 ance rates are based on statistical experience of mortality, and if the 
 statistics are representative of the group to be insured there is no 
 occasion for precautions to obtain a more favorable result than that 
 which they forecast. The necessity for selection in favor of the insurer 
 arises from the necessity of preventing selection adverse to its inter¬ 
 ests, for there is a constant tendency for persons who believe them¬ 
 selves to be poor risks to present themselves as applicants for insur¬ 
 ance in greater proportionate numbers than do good risks. It has 
 been well said that an insurance company could afford to insure at 
 uniform rates all the people who pass a certain street corner on a given 
 day, provided the fact of such intent were not made public, but if the 
 facts were known a stream of the lame, the blind, and the stricken 
 would be sure to pass that corner. In order to prevent discrimination 
 against themselves, insurers are obliged to examine every application 
 with great care, and the necessity for this scrutiny adds greatly to 
 the expense of effecting insurance. 
 
 The principal methods used in selecting risks are, first, discrimina¬ 
 tion against certain occupations; second, discrimination against resi¬ 
 dents of certain localities; third, discrimination against individuals 
 who attempt to procure insurance in amounts obviously in excess of 
 
248 
 
 RISK AND RISK-BEARING 
 
 their normal needs—this includes cases in which the beneficiary has 
 no insurable interest in the life of the insured; fourth, inspection and 
 inquiry, designed to aid in estimating the moral hazard; fifth, medical 
 examination; and sixth, family history. In the better companies, 
 the medical examination is very thoroughgoing, and frequently 
 results in the discovery of defects previously unknown to the applicant. 
 
 The immediate result of all these methods of selection is to secure, 
 not the homogeneous group of risks aimed at, but the introduction of a 
 group of extra-favorable risks. At the earlier and middle years of 
 life, the mortality among persons who have recently passed an exami¬ 
 nation for life insurance is about half the normal mortality of those 
 whose examination was five or more years previous. The “benefit 
 of selection” decreases rapidly and is imperceptible after five years. 
 
 VI. CALCULATION OF PREMIUMS 
 
 The following discussion of the method by which life insurance 
 premiums are determined makes no pretense of constituting an ade¬ 
 quate discussion of the actuarial problems involved in the science of 
 life insurance. Actuaries have developed a considerable body of 
 mathematical science, making possible the calculation of premiums 
 with a minimum of labor. The formulas given in this chapter are 
 the basic formulas from which the actuarial short cuts have been 
 developed, and are useful from the standpoint of justifying the rates 
 rather than actually calculating them. 
 
 The calculation of an appropriate rate for an insurance policy 
 requires that two fundamental assumptions be made. First, the 
 assumption that among the group of insured deaths will occur with a 
 definite frequency, and second, that the funds paid into the insurance 
 company will be invested to yield a definite rate of interest. Both 
 the rate of mortality and the interest earnings are of course estimates, 
 and in the case of contracts which have to run for periods varying 
 from less than a year to perhaps seventy-five years, there is obviously 
 room for a considerable variance of opinion in making the estimate, 
 and consequently a necessity for conservatism in making up the rates, 
 so as to insure solvency on the part of the insurer throughout the life 
 of the contract. 
 
 The standard device for calculating the rate of mortality is the 
 mortality table, which enumerates the anticipated number of deaths 
 from year to year in a hypothetical group of lives. The table most 
 frequently used for this purpose in America, the so-called American 
 Experience table, runs as follows: 
 
LIFE INSURANCE 
 
 249 
 
 AMERICAN EXPERIENCE TABLE OF MORTALITY 
 
 Age 
 
 Number 
 
 Living 
 
 Number 
 
 Dying 
 
 IO. 
 
 100,000 
 
 749 
 
 11. 
 
 99,251 
 
 746 
 
 12. 
 
 98,505 
 
 743 
 
 13. 
 
 97,762 
 
 740 
 
 14. 
 
 97,022 
 
 737 
 
 15. 
 
 96,285 
 
 735 
 
 l6. 
 
 95,550 
 
 732 
 
 17. 
 
 94,818 
 
 729 
 
 l8. 
 
 94,089 
 
 727 
 
 19. 
 
 93,362 
 
 725 
 
 20. 
 
 92,637 
 
 723 
 
 21. 
 
 91,914 
 
 722 
 
 22. 
 
 91,192 
 
 721 
 
 23. 
 
 90,471 
 
 720 
 
 24. 
 
 89,751 
 
 719 
 
 25. 
 
 89,032 
 
 718 
 
 26. 
 
 88,314 
 
 718 
 
 27. 
 
 87,596 
 
 718 
 
 28. 
 
 86,878 
 
 718 
 
 29. 
 
 86,160 
 
 719 
 
 30. 
 
 85,441 
 
 720 
 
 31. 
 
 84,721 
 
 721 
 
 32. 
 
 84,oco 
 
 723 
 
 33. 
 
 83,277 
 
 726 
 
 34. 
 
 82,551 
 
 729 
 
 35. 
 
 81,822 
 
 732 
 
 36. 
 
 81,090 
 
 737 
 
 37. 
 
 80,353 
 
 742 
 
 38. 
 
 79,611 
 
 749 
 
 39. 
 
 78,862 
 
 756 
 
 40. 
 
 78,106 
 
 765 
 
 4i. 
 
 77,341 
 
 774 
 
 42. 
 
 76,567 
 
 785 
 
 43. 
 
 75,782 
 
 797 
 
 44. 
 
 74,985 
 
 812 
 
 45. 
 
 74,173 
 
 828 
 
 46. 
 
 73,345 
 
 848 
 
 47. 
 
 72,497 
 
 870 
 
 48. 
 
 71,627 
 
 896 
 
 49. 
 
 7o,73i 
 
 927 
 
 5°- • .. 
 
 69,804 
 
 962 
 
 5i . 
 
 68,842 
 
 1,001 
 
 52 . 
 
 67,841 
 
 1,044 
 
 Age 
 
 Number 
 
 Living 
 
 Number 
 
 Dying 
 
 53. 
 
 66,797 
 
 1,091 
 
 54. 
 
 65,706 
 
 1,143 
 
 55. 
 
 64,563 
 
 1,199 
 
 56. 
 
 63,364 
 
 1,260 
 
 57. 
 
 62,104 
 
 1,325 
 
 58. 
 
 60,779 
 
 i,394 
 
 59. 
 
 59,385 
 
 1,468 
 
 60. 
 
 57,917 
 
 1,746 
 
 61. 
 
 56,371 
 
 1,628 
 
 62. 
 
 54,743 
 
 i,7i3 
 
 63. 
 
 53,030 
 
 1,800 
 
 64. 
 
 51,230 
 
 1,889 
 
 65. 
 
 49,341 
 
 1,980 
 
 66. 
 
 47,36 i 
 
 2,070 
 
 67. 
 
 45,291 
 
 2,158 
 
 68. 
 
 43,133 
 
 2,243 
 
 69. 
 
 40,890 
 
 2,321 
 
 70. 
 
 38,569 
 
 2,39i 
 
 7i. 
 
 36,178 
 
 2,448 
 
 72. 
 
 33,730 
 
 2,487 
 
 73. 
 
 3i,243 
 
 2,505 
 
 74. 
 
 28,738 
 
 2,501 
 
 75. 
 
 26,237 
 
 2,476 
 
 76. 
 
 23,761 
 
 2,43i 
 
 77. 
 
 21,330 
 
 2,369 
 
 78. 
 
 18,961 
 
 2,291 
 
 79. 
 
 16,670 
 
 2,196 
 
 80. 
 
 14,474 
 
 2,091 
 
 81. 
 
 12,383 
 
 1,964 
 
 82. 
 
 10,419 
 
 1,816 
 
 83. 
 
 8,603 
 
 1,648 
 
 84. 
 
 6,955 
 
 1,470 
 
 85. 
 
 5,485 
 
 1,292 
 
 86. 
 
 4,i93 
 
 1,114 
 
 87. 
 
 3,079 
 
 933 
 
 88. 
 
 2 ,146 
 
 744 
 
 89. 
 
 1,402 
 
 555 
 
 90. 
 
 847 
 
 385 
 
 9i. 
 
 462 
 
 246 
 
 92. 
 
 216 
 
 137 
 
 93. 
 
 79 
 
 58 
 
 94. 
 
 21 
 
 18 
 
 95. 
 
 3 
 
 3 
 
 This table was prepared in the late sixties from the experience of 
 two life insurance companies, and is not, as a matter of fact, an accu¬ 
 rate table. Typically the experience of life insurance companies 
 shows that the deaths in a given year are not more than from 65 to 
 75 per cent of those anticipated according to the table. More 
 accurate tables have been compiled in recent years, but their adoption 
 
250 
 
 RISK AND RISK-BEARING 
 
 is retarded by two considerations. In the first place, a tremendous 
 amount of expense would be involved in changing from one table to 
 another. In the second place, since the error consists of an over¬ 
 statement of the mortality, its effect is to give the insurer a margin 
 of safety, so that there is little inducement for any company to be the 
 first to break away from the established practice. An overstatement 
 of the mortality by 30 or 40 per cent does not necessarily mean that 
 the insured is charged a correspondingly excessive premium. The 
 premium includes not only a mortality charge but an allowance for 
 expenses, and if the margin of safety in the mortality table were 
 removed by the adoption of a more accurate table, the allowance for 
 expenses would have to be increased. In fact, a few companies now 
 write certain policies for a premium equal to that required by the 
 theoretical mortality and the theoretical interest rate, getting their 
 entire expense allowance out of the mortality saving and the surplus 
 interest. So long as competition is active, the question whether the 
 mortality table is a high or a low table presumably does not have 
 very much bearing on the rates that will be charged. It does have 
 a very definite bearing, however, on the relative rates charged for 
 insurance at various ages and for this reason the continued use of a 
 table which is now obsolete and probably never was accurate offers 
 ground of criticism. 
 
 Interest rate .—The other fundamental assumption of actuarial 
 science is the assumption of a rate of interest to be earned on the 
 funds which are being accumulated during the life of the insured. 
 The rates most frequently used at the present time for this purpose are 
 3 and 3J per cent. Judged by the rates which have prevailed in the 
 investment market during the last few years, these rates seem very 
 low. It must not be forgotten, however, that the reserve on a given 
 policy may remain in the company’s hands for half or three-quarters 
 of a century, and the company must guarantee its rates to the policy¬ 
 holder for a corresponding period. When the states first began estab¬ 
 lishing legal tests for solvency of insurance companies some sixty-five 
 years ago, the rates used were nearly always either 4 or 4! per cent. 
 These rates were considered conservative, and they were in fact well 
 below the actual earnings of well-managed companies. For forty 
 years, however, the trend of interest rates was downward, and the 
 states have twice had to change the rate to a lower one. Therefore, 
 despite the high rates to be obtained on safe securities during recent 
 years, it does not seem unlikely that before the maturity of contracts 
 
LIFE INSURANCE 
 
 251 
 
 now open, 3 per cent will once more seem a fair return on such high- 
 grade security as that offered by the policies of strong life insurance 
 companies. 1 
 
 Before examining the methods used in calculating premiums, 
 several terms must be defined. The net premium is the amount which 
 the insurance company must charge, assuming a given mortality 
 table and interest rate, in order to meet the claims of holders of 
 maturing policies, without allowance for expenses or profit to the 
 insurer. The loading is the amount added to the net premium to 
 provide for these elements. The gross premium is the actual premium 
 charged, being the sum of the net premium and the loading. The 
 mortality charge is that portion of a premium which is required to meet 
 death claims during the year in which the premium is collected. The 
 reserve is the accumulated fund resulting from the excess of net 
 premiums over mortality charges, together with interest accumulations 
 on the reserve itself. The surplus is the fund of accumulated profits 
 of the insurer. It arises from four, principal sources: deficiency of 
 mortality below that anticipated in accordance with the table; 
 excess of interest earnings on the reserve over the rate assumed in 
 figuring the premium; excess of loading over actual expenses incurred; 
 and interest on the surplus itself (in the case of a stock company on the 
 capital also). 
 
 The simplest type of rate-making problem is presented by the 
 annual renewable term policy. To simplify it still farther, we will, 
 for the present, disregard expense loading and confine attention to 
 the calculation of the net premium. 
 
 ‘ Let us assume then that we wish to insure for $1,000 each for one 
 year a group of men of normal health of age thirty-five. Our first 
 problem is to determine the risk. The American Experience Table 
 of Mortality shows that of 81,822 men living at age thirty-five, 732 
 
 will die within one year. The risk, therefore is, 
 
 732 
 
 and if the 
 
 81,822, 
 
 premiums were paid at the same time that the policy falls due, the 
 
 net premium charge would be , or $8.9 5. However, insur- 
 
 $81,822 
 
 ance premiums are paid at the beginning of the year and death losses 
 are paid after the deaths occur. An accurate calculation, therefore, 
 must take account of interest on the premiums from the time they are 
 
 1 Cf. Zartman, Life Insurance Investments , pp. 55-60. (Henry Holt & Co., 
 1906.) 
 
252 
 
 RISK AND RISK-BEARING 
 
 paid until the average time that the death losses occur. This is han¬ 
 dled in practice by the simple assumption that the losses are all paid at 
 the end of the year. Such an assumption is of course inexact. If death 
 losses occurred uniformly during the year, the average time from the 
 payment of premiums to the death of the insured would be six months, 
 and the average time till the payment of the policy would be somewhat 
 greater, say seven months. Since the mortality rate increases with 
 advancing age, the actual tendency is for more than a proportionate 
 number of deaths to occur in the latter part of each insurance year, 
 hence the average time till the date of payment is still further length¬ 
 ened. It is however considerably less than the full year assumed 
 in the insurance calculations, and to that extent the standard method 
 of calculation involves an injustice to the insuring company, which 
 must be offset by an allowance favorable to the company at some other 
 point in the calculations. As we have seen previously, the mortality 
 tables overstate the actual mortality; this circumstance much more 
 than offsets the advantage which, the insured gains from the assump¬ 
 tion of payment at the end of the policy year. 
 
 The present worth at 3 per cent of $1 due one year hence is 
 $.970874. Under the terms of the contract, an insurance company 
 issuing 81,822 policies may expect to have to pay 732 losses, which 
 we will assume to be of $1,000 each. The present worth of $732,000 
 due one year hence may be expressed as $1,000 X 732 X .970874, 
 which is the amount the company must collect in premiums at the 
 beginning of the year. The net premium on one $1,000 policy is 
 therefore 
 
 $1,000X732 X.970874 
 81,822 
 
 or $8.69. 
 
 Our next step is to develop the net single premium for whole 
 life insurance. This is the amount which paid in at once to the 
 insurance company will enable it to pay each of the insured the face 
 of his policy at the time of death. This involves simply a repetition 
 of the preceding calculation for each successive year of life to the end 
 of the mortality table. Out of a group of 81,822 persons of age thirty- 
 five, the table shows that 737 will die at age thirty-six. To provide 
 for losses on their policies, we must have in hand, not $737,000, but 
 an amount which, if kept at interest for two years, will amount to 
 $737,000 or $i,oooX737X.97o874 a . In like manner, to provide 
 for the losses of the third year, we must have in hand $i,oooX742X 
 .970874 3 , and to provide for the death losses of the ninety-fifth year, 
 
LIFE INSURANCE 
 
 253 
 
 when the last three survivors are expected to die, we will need $i,oooX 
 3X.970874 61 . The sum of the amounts necessary for payments 
 due on account of those who die in the various years of life is of 
 course the amount required to provide for all the death claims, and this 
 sum divided by 81,822 is the necessary contribution of each member of 
 the group. This is known as the net single premium for a whole life 
 policy for $1,000 at age thirty-five. 
 
 Annual renewable term policies and whole life policies sold for 
 single premiums are rare. The most common type of insurance is the 
 whole life policy with level annual premium, and it is this premium 
 which we must next examine. The expression for this premium, using 
 the same age, interest rate, and mortality table as before, is 
 
 $1,000 (732X.97 o 874+737X.97 o 874 2 + .... 3X.97o 874 6t ) . 
 
 81,822+81,o9oX.97 o8 74+8o,353 X-97o 8 74 2 + .... +3X.970874 60 
 
 This formula is derived as follows: The numerator represents the 
 sum of the present worths of the amounts to be paid out during each 
 year of life, and is the same as the net single premium calculated 
 above, except that it has not been divided by 81,822. In other words, 
 it is the net single premium for the group, not for the individual policy. 
 The denominator represents the sum of the present worths of the 
 amounts, which will be paid in to the insurance company if each of the 
 insured pays one dollar a year for his natural life. One dollar from 
 each of the insured yields $81,822, which is paid now; $81,090 will 
 be paid one year hence by the survivors at that time, and therefore 
 must be discounted at 3 per cent; $80,353 will be paid in two years and 
 is discounted at 3 per cent compound interest for the two years; so 
 we proceed to the sixty-first term, which is the present worth of $3, 
 paid by the three survivors sixty years hence. Since the numerator 
 of our fraction represents the present worth of the series of sums which 
 the insurance company has to pay out, and the denominator repre¬ 
 sents the present worth of the series of sums which the company would 
 take in if it charged each policyholder $1 a year, the fraction, as a 
 whole, must represent the number of dollars a year which each of the 
 insured must pay during his lifetime in order that the company may 
 come out even on the whole transaction. 
 
 If this formula is thoroughly understood, the derivation of the 
 premiums for the other usual types of insurance is comparatively 
 easy. If, for instance, we desire to obtain the premium for a twenty- 
 payment life policy, we notice that the sums to be paid out by the 
 
254 
 
 RISK AND RISK-BEARING 
 
 company are exactly the same as under a whole life policy, but that 
 the premium receipts stop at the twentieth payment, nineteen years 
 hence. Hence, we keep our numerator unchanged, but cut off all 
 but the first twenty terms of the denominator. If a twenty-year 
 term policy is in question, the level annual premium is obtained by 
 taking the first twenty terms of both the numerator and the denomi¬ 
 nator, the first twenty terms of the numerator representing the 
 amounts to be paid out, those of the denominator representing the 
 amounts that will be received in that time at $i a year from each 
 surviving member of the group. For a twenty-year endowment 
 policy, the calculation is the same as for a twenty-payment life policy, 
 except that for the last term of the numerator we must substitute 
 “$i,000X65,706X .970874 20 ,” the numeral 65,706 representing the 
 total number who survive to age fifty-four. Some of these will die 
 during that year, the rest will draw $1,000 each at the end of the 
 year; for purposes of calculating the premium the result is the same 
 as though all died during the year. This calculation is therefore 
 exactly the same as the calculation for a whole life policy would be if 
 the mortality table showed that all survivors died at age fifty-four 
 instead of age ninety-five. It will be noticed that the whole life policy 
 is the same thing as an endowment at age ninety-six, and is also the 
 same thing for purposes of figuring the premium as a sixty-one-year 
 term policy at age thirty-five. 
 
 The premium for single payment life is obtained in exactly the 
 same way as the premium for twenty-payment life, except that only 
 the first term of the denominator is retained, instead of the first twenty 
 terms, giving us the expression: 
 
 t 
 
 $1,000 (732X.970874+737X.970874 2 .... 3X.97Q^74 6t ) . 
 
 81,822 
 
 The premium for a whole life policy is much larger than the 
 premium for annual renewable term insurance at the same age. 
 In other words, the purchaser of a whole life policy pays in the early 
 years considerably more for his insurance than it costs the company 
 to furnish it. The excess premium is held in reserve to enable the 
 insurance company to furnish insurance at less than the mortality 
 charge in the later years of life. 
 
 The sum total of these excess payments, together with their 
 accumulated interest, constitutes what is known as the reserve. The 
 reserve is not the property of the insurance company but is of the 
 
LIFE INSURANCE 
 
 255 
 
 nature of a trust fund held by the insurance company as an advance 
 payment for insurance to be furnished later. It should be noted, 
 carefully, however, that the amount in the reserve does not depend 
 on the actual mortality of the insured group nor on the rate of interest 
 actually earned. It is the amount which would accumulate if the 
 mortality ran exactly according to the table and the interest earnings 
 were exactly as assumed. Any saving or gain due to lowered mortality 
 or higher interest earnings goes not into the reserve but into the 
 surplus, and is the property of the company. 
 
 The theory underlying the popularity of all types of level premium 
 insurance is, that if insurance is charged for at the current cost of 
 furnishing the insurance, the cost gets prohibitively high in the later 
 years of life. It will be seen, however, from the foregoing analysis 
 of the way in which the,premium is calculated, that the cost of insur¬ 
 ance in the later years of life is just as great on the level premium plan 
 as under the natural premium plan. The only differences are that 
 under the level plan the individual pays a part of the cost of his 
 insurance many years in advance and is credited with the interest at 
 about the savings bank rate on these payments; and second, that under 
 this plan those who die in the early years of life get no added return 
 for the added payment they have made, while those who live through 
 to an advanced age get the benefit of a lower premium on account 
 of the contributions of their fellows. Of a typical group insured at 
 age thirty-five, 20 per cent die within twenty years. The difference 
 between what this 20 per cent pay for insurance under a level plan and 
 what they would pay under the natural premium plan is their loss and 
 the other policyholders’ gain. This gain brings up the return on 
 their advance payments for the 80 per cent who survive, from 3 or 3J 
 per cent to about 5 per cent. In other words, the level premium plan 
 offers the policy-buyer, in early middle life, a combination of two 
 opportunities: First, to buy an insurance policy at what is presumably 
 a fair rate for the insurance, and second, to invest the difference 
 between the cost of insurance and the level premium in a security which 
 offers a 20 per cent chance of loss and a 5 per cent rate of return, if the 
 loss does not occur. Surely such a contract hardly constitutes an 
 extremely attractive speculative investment. If it is judged favorably, 
 it must be on account of its insurance, not its investment, feature. 
 
 What has just been said in disparagement of whole life, as com¬ 
 pared with renewable term insurance, applies with much more force 
 to limited payment life policies and with the greatest force to endow- 
 
256 
 
 RISK AND RISK-BEARING 
 
 ment policies. In these higher-priced policies, the proportion of the 
 premium which pays for the insurance service is relatively small and 
 the remainder is an investment on which nothing will be realized 
 unless one lives out the term of the contract, and no more than good 
 interest if he does. 
 
 It is true that under the renewable term plan the cost of insurance 
 becomes relatively very high after about age fifty-five. But, quite 
 apart from the fact that many men no longer have dependents by the 
 time they reach that age, it must be remembered that the amount 
 of insurance needed by the time that age is reached is comparatively 
 small, even if there are persons totally dependent on the earnings of 
 the insured. At age fifty-five the average man has no more than ten 
 years’ probable earning life, and even though those be years of high 
 earnings, the capitalized value of the short period is much less than 
 the loss in case of death earlier in life. Moreover, if the money saved 
 by buying term insurance, rather than limited payment or endow¬ 
 ment policies, has been invested in safe securities the savings accumu¬ 
 lations have operated to reduce the volume of insurance needed in 
 the later years of life. The logical plan, therefore, is to reduce the 
 amount of insurance during the later years in order to offset the effect 
 of the rapidly advancing renewal rate. 
 
 It will be argued in reply that man will not save except under 
 pressure, and that the endowment or limited payment policy is there¬ 
 fore the better purchase because it stimulates a more or less automatic 
 type of saving. There are undoubtedly cases where this has been true, 
 and the argument is not without force, though it can hardly be argued 
 that enforced saving is always a gain. There must be some cases 
 where the savings are carried over from a time when they are more 
 needed to a time when they serve a less important want, but they are 
 probably relatively few. It is undoubtedly true that most men who 
 buy low-priced policies are apt to spend, rather than save, the money 
 they thus cut off their insurance bill. But most men who take out 
 high-priced insurance policies do not keep up the payments on them 
 either. 
 
 There is no real pressure on anyone to keep up premium payments 
 after a policy has been in force long enough to make the full reserve 
 available as a surrender value; indeed the larger the surrender value 
 grows, the greater becomes the incentive to take advantage of it. 
 
 The most serious practical objection to investment insurance is 
 the fact that the saving it represents is nearly always made at the 
 
LIFE INSURANCE 
 
 257 
 
 expense of needed protection. Most men in moderate circumstances 
 carry far less insurance than is necessary to protect their families. 
 They cannot afford the premium payments necessary to give complete 
 protection if in order to secure the protection they must also make 
 payments to accumulate an endowment fund or to pay for the cost 
 of protection at the advanced years of life; if pure protection were 
 readily available and were encouraged as a sales policy, there would 
 probably be a great increase in the amount of protection carried. 
 
 Loading .—It remains to consider the procedure by which the 
 theoretical premium derived from the mortality and compound inter¬ 
 est tables is weighted to provide for the expenses connected with the 
 operation of the insurance company, the dividends paid to stockholders 
 or policyholders, and the increase of surplus which is necessary if the 
 company is to be enabled to take care of an increasing volume of 
 business with safety. The addition to the net premium made for 
 these purposes is called the loading. 
 
 The process of figuring loading is less scientific than that employed 
 in figuring net premiums, and the results obtained differ greatly from 
 one company to another. The difficulty in determining proper loading 
 arises from the fact that while most companies write a wide variety 
 of policies, the major part of their expenses are either jointly due to 
 the whole volume of business, or if attributable to specific policies 
 cannot be assessed to them accurately in advance. Approximations 
 must be made, and the degree of accuracy in these approximations, 
 which it is worth while to aim at, is a matter concerning which opin¬ 
 ions differ widely. 
 
 The following are the fundamental principles which are generally 
 accepted as governing the proper distribution of expense: First, all 
 expense directly attributable to the investment operations is taken 
 care of by the investment department. This expense appears as a 
 reduction in the percentage earned on the investments; hence does 
 not have to be taken account of in the loading. Second, expenses 
 which vary with the amount of the premium (such as commissions) 
 are best assessed as a percentage of the net premium. Third, expenses 
 which vary with the size of the policy, and in general those which do 
 not fit into either of the other categories are best taken care of through 
 a charge proportionate to the face of the policy. General adminis¬ 
 trative expenses and settlement costs are examples of the charge most 
 often assessed in this manner. It is this third group of expenses 
 which are handled in the least satisfactory manner, as a considerable 
 
258 
 
 RISK AND RISK-BEARING 
 
 proportion of the expenditure really depend on the number of separate 
 policies rather than on their size. The logical method of assessing 
 these costs would be a flat charge of so much per policy, but such a 
 charge is never used in practice, presumably because it would make 
 the smaller policies disproportionately expensive and thereby create 
 difficult problems for the sales force. 
 
 The methods usually employed are the following, the details of 
 application showing, as already noted, great variation: ( a ) a straight 
 percentage of the net premium; ( b ) a percentage varying with the 
 type of policy; (c) a flat sum plus a percentage of the net premium; 
 (d) a percentage of the net premium plus the same percentage of the 
 corresponding net premium for ordinary life policies. The last 
 method is defended on the ground that the cost of the insurance 
 features of the contract, rather than the cost of the combined insur¬ 
 ance and investment features, should be given considerable weight, 
 since the investment fund carries its own expense loading separately. 
 This method results in a higher loading on all policies issued at 
 advanced ages, and also on the cheaper forms of policy, such as term 
 policies, but this is deemed equitable in view of the fact that these 
 are the types of policy on which the gains from favorable mortality 
 experience are normally least. 
 
 Participating policies regularly carry an excessive loading, intended 
 to make certain the payment of dividends. The method used in 
 determining the amount of this excess loading is of little importance 
 to the policyholder, provided the method used in apportioning divi¬ 
 dends is consistent with it. 
 
 VII. DISBURSEMENT OF LIFE INSURANCE FUNDS 
 
 The funds received by an insurance company from its policy¬ 
 holders are disbursed in five principal ways. The first charge against 
 them is of course the cost of doing business. A second principal class 
 of expenditure is the payment of matured policies. A third is the 
 payment of surrender values. A fourth is the making of loans to 
 policyholders, and a fifth is the payment of dividends to stockholders 
 and policyholders. 
 
 Expense .—The expense item needs no special discussion. It 
 includes commissions on new business and on renewals, expense 
 of medical examination and the investigation of applications, the 
 investigation of claims and the contesting of those whose character 
 makes contest advisable, the control of investments, and the general 
 
LIFE INSURANCE 
 
 259 
 
 administrative and clerical costs. The heaviest costs are those 
 involved in selling, in investigating applications, and in recording 
 the issuance of policies. Usually, this initial expense amounts to 
 75 or 80 per cent of the first year’s premium. 
 
 Settlement of claims. —The disbursement of funds in payment of 
 matured policies is not an expense but a return of capital to its owners. 
 There is probably no large class of claims, with the exception of 
 requests for withdrawal of bank deposits, which are settled with so 
 little friction as the settlements made under life insurance policies. 
 It is the policy of reputable companies to contest claims only in cases 
 where there is fairly conclusive evidence that the company has no 
 real liability. In the early days of insurance, some companies fol¬ 
 lowed the policy of contesting claims on technical grounds, though 
 this practice was probably more prevalent in fire than in life insurance. 
 Such contests are expensive, partly because juries are apt to be preju¬ 
 diced in favor of claimants, and judges interpret the contracts as 
 strictly as possible against the companies, partly because of the 
 adverse advertising which an insurance company gets from its contests. 
 
 Optional settlements. —Most insurance policies provide for an 
 optional settlement in the form either of a cash payment in full or of an 
 annuity to the beneficiary. The instalment plan provides simply that 
 the insurance company shall pay the amount of the insurance in, say, 
 twenty instalments to the beneficiary or the beneficiary’s estate. 
 In this case there is an allowance for interest which substantially 
 increases the sum to be paid. 
 
 The life annuity plan of settlement provides a payment of a certain 
 sum per annum to the beneficiary for life. The amount of the annual 
 payment, under this contract, depends upon the age of the beneficiary 
 at the time the contract is taken out. 1 
 
 A continuous instalment contract is a combination of the instalment 
 and annuity plans, providing for the payment of the insurance in 
 annual instalments over the life of the beneficiary, or for a specified 
 term of years, whichever is the greater. 
 
 Under all these instalment contracts, the beneficiary is relieved of 
 the problem of investing the proceeds of the policy, and incidentally 
 also of the payment of taxes upon such investments. The rate of 
 interest allowed is not, by present standards, high, but the fact that 
 the rate is guaranteed for a term running far into the future, the high 
 degree of safety, and the relief of the beneficiary from responsibility 
 
 1 For further discussion see pp. 276-80. 
 
26 o 
 
 RISK AND RISK-BEARING 
 
 go far to compensate for the moderate interest rate. Except in the 
 cases where the proceeds of a cash settlement could advantageously 
 be used to pay off existing indebtedness, some sort of annuity or instal¬ 
 ment settlement is more likely than not to be of advantage. 
 
 The following quotation emphasizes, but does not exaggerate, 
 the advantages of the annuity as a method of settlement: 
 
 There are two modes of settlement of a life insurance benefit at the 
 death of the insured. The first is to pay down the whole sum at once; and 
 this method has been followed, with only rare exceptions, since life insurance 
 began. The second mode is to pay an annuity to the beneficiary for a 
 certain period or for life; this has been the exception. But this latter plan 
 received impetus through legislation in New York State in 1906, which 
 included in a standard form of policy contract a privilege by which the 
 insured during his life might elect to have the principal sum paid in periodical 
 instalments after his death. Since then one after another of the American 
 companies has issued policies containing on their face specific provision for 
 the payment of the benefits in monthly instalments of selected amounts and 
 for selected periods. 
 
 Fire insurance on a merchandise stock is for the purpose of providing 
 funds with which the stock, if burned, may be replaced without loss to the 
 merchant. In this case, the sum to make replacement is required to be 
 available immediately after loss by fire in order that new stock may be 
 purchased and business resumed. But human life is different, it is in no 
 sense possible of replacement except by in some manner arranging for a 
 continuance of its income or productive value which would cease at death. 
 And, moreover, the capitalized value of the life paid in one sum is not 
 needed and cannot be used for the emergency called for by family insurance, 
 except that it be invested to produce income. 
 
 It is in the nature of things that humankind should be possessed of 
 ungratified wants which more means would fill; it has been so since com¬ 
 mencement of time; without this human trait material progress would 
 cease. It is common in both man and woman; but possession of means 
 earned by one’s self checks desires; unearned means fosters them, hence 
 because man has more commonly been the earner and provider and woman 
 the dependent and recipient, the trait is more pronounced in her. With 
 the beneficiary of the small insurer it manifests itself in wish for better 
 quality and make of articles of dress—in a new hat instead of one made 
 over on last year’s frame; in small articles of personal adornment which 
 have been promised since long ago but have never come. Yes, so many 
 things are needed; it seems as though they had been accumulating since 
 wedding day. And so they have; and so they will continue co do; for it 
 is the rare nature of wants that their fulfilment gives birth to greater 
 
 ones. 
 
LIFE INSURANCE 
 
 261 
 
 Doubtless some beneficiaries under lump sum life insurance policies are 
 endowed with a measure of mental and moral poise which no great calamity 
 could overturn. But this cannot be known of a certainty as to any partic¬ 
 ular one until the test is made. This one may possess the quality of self- 
 denial in degree that would safely guard against use of the fund for unneces¬ 
 sary self-expenditures; but this is only another way of describing her who 
 has a good and charitable heart, for charity and self-denial go hand in hand. 
 Caution would prevent bestowal of any portion of her insurance money in 
 charity on strangers. Would it help if the supplicant were a relative ? 
 
 All have poor relations; the insured may not have been able to help 
 during his lifetime, but there is now a large sum of money in bank. It is 
 not charity that is asked, merely a loan is wanted; and long before the 
 money is needed it will be repaid, if all goes well. Shall it be refused ? 
 No. Husband would give it if he were alive; he often said he would be 
 glad to help if he could; but he never had so much money in bank without 
 immediate use for it. Nay, this excuse would not be required; the money 
 would be “loaned” in any event; for denial would be impossible to this 
 kind-hearted woman with the means at hand. Nor would repeated requests 
 of the same nature be denied if accompanied by valid or plausible reasons. 
 
 Thus under lump sum policies have thousands of men unwittingly 
 insured their lives in part for the benefit of needy relations and friends 
 whom during lifetime they could not afford to assist. For unless he does 
 help in the support of poor relations and friends during his lifetime, no man 
 intentionally includes provision for them in his life insurance. If he does 
 provide for them during life, then it is unfair to his beneficiary if he does 
 not include account of them in his insurance. But if he cannot help them 
 while living, it is unlikely that he can afford the high premium payments 
 necessary to provide for them after death. 
 
 The possession of a sum of ready money renders its owner liable to 
 become the object of designing persons seeking dishonest advantage with 
 plausible schemes dressed up as sound investments. The beneficiary is 
 inexperienced in investments. Knowledge of this is not lost on promoters, 
 and leads to her being sought out as an easy mark for their designs. No 
 sooner does the fund reach her hands than skilled wits are placed in the 
 balance against hers. With what result is well known; a woman unso¬ 
 phisticated in sharp business practices is attacked by a swindler at a time 
 when she is without defense, and imposed on and robbed. 
 
 But assuming the investment to be a good one, still a difficulty and a 
 danger remain. Will the income be sufficient to meet expenses? If not, 
 then a part of the security must be disposed of from time to time to obtain 
 principal to eke out living expenses. But this may not be necessary. Will 
 the money be left invested? The security is transferable, and therefore 
 salable; the better the value, the lower the interest; the lower the interest, 
 the greater the temptation to sell and reinvest in something paying more; 
 
262 
 
 RISK AND RISK-BEARING 
 
 and the higher the interest the less the value, and the more danger of loss 
 of interest, or of both principal and interest. It may be borrowed upon any 
 day. It is an object of taxation. It is subject to attachment. And 
 finally, no matter how high the rate, the interest income from the invest¬ 
 ment will be equivalent to a low rate on the whole amount received from 
 the insurance company, because it is unlikely that all of the insurance 
 money will be invested. 
 
 These modes of paying the benefit may be had in any form of policy— 
 Term, Whole Life, Limited Payment Life or Endowment. It costs nothing 
 extra; the premium charged is exactly proportionate to that for a policy 
 providing for an equivalent single sum benefit. The company acts as 
 trustee and pays out to the beneficiary the sums provided, in amount and 
 in time approximating the manner in which the income of the insured was 
 received during life. At the death of the insured the financial result is 
 the same as if the discounted value of the unpaid instalment benefits pro¬ 
 vided for became automatically invested at 3^ per cent compound interest; 
 and future payments continue to earn and compound at the interest rate 
 until all of both principal and compounded interest is paid as provided. 
 Thus, for example: in a policy providing for $50 per month for forty years 
 the discounted value of the future benefits to be paid is $13,089, and it is 
 on this sum that the insurance premium is charged; but the total sum 
 guaranteed to be paid over forty years is $24,000, or $13,089 of principal 
 and $10,911 of accumulated interest. 
 
 A life insurance benefit left in this rpanner can be used only for the 
 purpose intended: namely, for the necessities of life and to keep home 
 together. It cannot be sold or borrowed upon, because it is not transferable. 
 It can be attached for debt only if contracted for the necessaries of life. 
 It is free from taxation and charges of fees of any kind whatsoever; and 
 finally, the law prohibits the company from discounting and paying the 
 amount in one sum to the beneficiary upon her request unless the insured 
 so consented during his life. 1 
 
 The continuous instalment is particularly advantageous in cases 
 where the insured desires to provide an income for a widow for life 
 and for children for the period of their minority. The life annuity 
 feature insures an income to the widow throughout her life, while 
 the “continuous” feature provides that in case of her early death the 
 payments will be continued for a term of years sufficient to bring the 
 youngest child to the age of self-support. 
 
 Surrender values are now a regular feature of practically all 
 life policies written by legal reserve companies, except term policies. 
 During the early history of life insurance, it was quite commonly 
 
 1 From an anonymous pamphlet, Luxuries or Necessities. 
 
LIFE INSURANCE 
 
 263 
 
 true that a policyholder who failed to keep up his premium payments 
 forfeited all his rights under the policy. Such a practice, however, 
 was obviously unfair to the holders of the higher-priced policies, such 
 as endowment policies, for the man who lapses after carrying a high 
 premium policy for a number of years has paid much more than the 
 man who has been carrying whole life or term insurance, and has 
 received no more in return. The issuance of policies containing a 
 provision for surrender value began in the late fifties, and in 1861 
 Massachussetts passed the first non-forfeiture law. Similar laws 
 have since been enacted by most states. 
 
 The provisions regarding surrender relate, first, to the length of 
 time a policy must be carried before any surrender value accrues; 
 second, to the amount of such surrender value; third, to the manner 
 in which it shall be paid. In most cases there is no surrender value 
 till the third or fourth year, though some grant it in the second year. 
 From what has been said above concerning the excessive proportion 
 of the expenses which attach themselves to the first policy year, it is 
 obvious that a company cannot afford to grant liberal surrender 
 values till a sufficient number of premiums have been paid to compen¬ 
 sate it for this expense. 
 
 From the third year to a later date, varying from the fifth to the 
 fifteenth year, the surrender value consists of the legal reserve minus 
 a surrender charge which gradually decreases as the policy grows 
 older, and in no case, with most companies, exceeds 2J per cent of 
 the face of the policy. The tendency both of legislation and of com¬ 
 petition between insurance companies has been to increase the liber¬ 
 ality of the surrender values, and the popularity of these provisions 
 is evidenced by the fact that from one-fourth to one-third of the 
 policies terminated are surrenders and lapses. 1 
 
 Three methods of payment of the surrender value are generally 
 provided: cash settlement, extended insurance, and paid-up insurance. 
 Under the extended insurance plan, the policy continues in force for a 
 limited period; under the paid-up insurance settlement, the face of 
 the policy is reduced and the policy remains in force throughout the 
 life of the insured. Under both the extended insurance plan and the 
 paid-up insurance plan, the amount of insurance is such as the cash 
 surrender value will purchase as a single net premium. If the insured 
 
 1 The statement is perhaps too sweeping, as a very large proportion of the 
 lapses occur in the first or second year, before the liberality of the surrender pro¬ 
 visions is a factor. 
 
264 
 
 RISK AND RISK-BEARING 
 
 indicates no option, but simply stops paying premiums, the extended 
 insurance plan is applied automatically. At the close of the extended 
 insurance period, the company, before closing the account, must 
 obtain evidence that the insured is still living. As the beneficiaries 
 of lapsed policies are frequently ignorant of the existence of the 
 extended insurance, which may run for many years, there is often no 
 small difficulty in determining whether liability actually exists. 
 
 Another method of handling lapsed policies has recently been 
 introduced—the automatic premium loan. Under this plan, the 
 cash surrender value is applied as a series of loans to meet successive 
 premium payments, and the policy is kept in force till the cash value 
 is exhausted. The advantage of this plan over the extended insurance 
 plan, to which it is very similar in effect, is that under the premium 
 loan plan the policy does not technically lapse, so that the insured 
 retains the right to reinstate himself by paying the back premiums, 
 with interest, without medical examination. On the other hand, the 
 policy expires somewhat sooner under this plan, as 5 or 6 per cent 
 interest is charged against the premium loan, while the reserve is 
 accumulating interest at the rate of only 3 or 3J per cent. 
 
 Policy loans .—While the making of loans on the security of policies 
 is not theoretically a method of disbursing funds except for temporary 
 purposes, in practice a large proportion of the accumulated reserve 
 is actually returned to policyholders, through loans which stand as 
 permanent obligations of the policyholders and are deducted from the 
 face of the policy at maturity. From the standpoint of an insurance 
 company, a loan made to a policyholder and secured by his policy, 
 provides an investment in most respects ideal. There is no cost for 
 investigation of the application, or for collection, and there is no risk, 
 for the applicant is borrowing only his own funds, and can never 
 secure a loan in excess of the surrender value of his contract. More¬ 
 over, the rate of interest charged on policy loans is higher than that 
 obtainable in most years upon safest investments, though this is not 
 necessarily true in the years of high interest rates when the largest 
 volume of policy loans are made. 
 
 From the standpoint of the company, there are two objections to 
 policy loans. In the first place, the loan privilege creates some risk 
 of embarrassment through an excessive number of demands for loans 
 at the same time. With the present almost universal acceptance of 
 the principle of making loans on demand up to the full cash surrender 
 value of the policy, the risk of a run on the reserves of insurance 
 
LIFE INSURANCE 
 
 265 
 
 companies, in time of financial crisis, is not negligible. Some authori¬ 
 ties are inclined to regard this as a serious objection to the extension 
 of the loan privilege, though no trouble has yet resulted from it. 
 Upon the whole, the risk seems much less serious in the case of insur¬ 
 ance companies than is the similar risk in the case of savings banks, 
 and the experience of the latter indicates that the danger is not suffi¬ 
 cient to justify the abandonment of such a profitable field of invest¬ 
 ment. 
 
 The other objection to policy loans, more serious from the stand¬ 
 point of insurance administration, is the fact that the issuance of policy 
 loans has a marked influence in increasing the lapse rate. The reasons 
 for this tendency will be made clearer by an examination of the 
 advantages and disadvantages of the policy loan from the standpoint 
 of the policyholder. 
 
 Policy loans are usually taken out under one of two conditions: 
 either the insured resorts to the company as a source of temporary 
 accommodation to meet some special need or else he secures capital 
 for permanent investment, or for the retirement of debts elsewhere, 
 by contracting a loan which he has little or no intention, at least no 
 prospect, of repaying. 
 
 The first class of loans are sound financial operations. If an 
 individual is going to borrow the money somewhere anyway, the 
 reserve on his life insurance policy offers several advantages. The 
 insured can secure the loan on demand without any investigation of 
 his credit standing, and he will not be interrogated as to the purpose 
 for which he intends to use the money. Moreover, after the first 
 six months he can pay off his loan at any time, without loss of interest, 
 and the rate charged is usually lower than the rate he would pay at 
 his bank. 
 
 Comparatively few policy loans, however, are of this type. It 
 is stated in fact that only 8 per cent of policy loans are ever repaid 
 before the maturity of the policy. 1 Most students of the question 
 seem to agree that such permanent policy loans are objectionable 
 from the standpoint of the real interests of the borrower. The follow¬ 
 ing statement from a prominent insurance company official is typical 
 of the opinion generally expressed on this question, both by insurance 
 company officials and by academic students of insurance theory. 
 
 The policyholder’s privilege of borrowing a portion of his reserves on 
 the security of his insurance contract was a development of competition, 
 
 1 Riegel and Loman, Principles of Insurance, p. 107. 
 
266 
 
 RISK AND RISK-BEARING 
 
 and like the giving of surrender values, the idea grew and the original 
 privilege was extended until the plan became permanently fixed upon the 
 business by being made a requirement of the law. 
 
 As originally intended, this privilege would have been a great service to 
 the policyholder and to the companies as an attractive feature or induce¬ 
 ment to insure, but as in the case of surrender values, the loan privilege has 
 been carried to extremes, the general practice now being to loan, as well as 
 to pay as a cash value, the full reserve upon a policy after the tenth year of 
 insurance. 
 
 The primary purpose of this law, which fastens a banking function upon 
 life insurance, was to enable the policyholder to have the use of his reserves 
 in time of financial stress. It was believed that this would be of great 
 value in preventing lapses by permitting the insured to apply his reserves 
 to the payment of premiums when short of cash, and that the plan in 
 general would prove an attractive one as an inducement to the taking of 
 insurance. 
 
 These advantages are freely conceded, but experience has demonstrated 
 that they have been largely neutralized by the disadvantages and the 
 abuses which have resulted from the expansion of this loan privilege. These 
 loans operate directly against the beneficiary by reducing the protection, 
 for only a small per cent of the loans are repaid by the borrowers and the 
 rest must be deducted from the claims at death or from surrender values. 
 They also encourage lapsing by the additional burden placed upon the 
 policyholder. Many borrowers, finding their protection reduced, their 
 premiums remaining the same and an annual interest charge to pay, become 
 discouraged and lapse or abandon their policies. An injustice is also done 
 the remaining policyholders by the low withdrawal charge and the possible 
 danger of a “run” on reserves in time of panic. Broadly speaking, the 
 policy loan privilege discourages saving and encourages spending. • 
 
 Ratio of Loans 
 
 Year to Reserves 
 
 (Per Cent) 
 
 1890. 2.97 
 
 1895. 3- 62 
 
 1900. 6.13 
 
 1905. 9-83 
 
 I9IO. 15.35 
 
 1915. 17-86 
 
 Those who borrow on their policies are not satisfied with small amounts. 
 They are tempted to withdraw all the money they can get, and having 
 gotten it, they are tempted to spend it for pleasure or to risk it in busmess 
 or speculative ventures. The result is that a temporary loan develops 
 into a permanent obligation, and the idea of repaying it is abandoned 
 Consequently when death comes the widow finds that her life insurance 
 
LIFE INSURANCE 267 
 
 has been materially reduced and then bitter disappointment and some¬ 
 times misery and hardship follow. 
 
 It is not surprising, therefore, that the practice of borrowing on policies 
 has come to be known as borrowing from the widow and orphan. No con¬ 
 cession ever granted to policyholders has operated so greatly to the dis¬ 
 advantage of beneficiaries. 
 
 One class of loans—those taken out on policies issued for the protection 
 of business ventures or for purely commercial purposes—are justifiable; 
 they are serving a purpose for which the contract was entered into. But 
 one cannot view with equanimity the taking of loans on policies issued for 
 family protection, and unfortunately the greater number of loans are taken 
 on this class of policies. 1 
 
 The case presented against the policy loan is forceful, but in the 
 author’s opinion not convincing. Let us examine it more closely. 
 In the first place, the characterization of insurance borrowing as 
 borrowing from the widow and the orphan, which is a standard point 
 in the case against policy loans, carries with it an implication that 
 borrowing from some other source would not have the same effect 
 on the financial status of the widow and the orphan. It is obvious 
 that if the policyholder borrows from some other source, and the debt 
 remains unpaid at the time of his death, it will operate to reduce his 
 estate just as the policy loan operates to reduce the face of his policy. 
 Assuming that the beneficiaries are the heirs, the only case where they 
 benefit from placing the loan somewhere else, rather than with the 
 insurance company, is the case where the widow and the orphan 
 desire to evade the payment of the debt, and the estate, aside from 
 insurance, is not large enough to cover it. The proceeds of insurance 
 policies, so long as they are kept intact, are in most states exempt 
 from the claims of all creditors except the insurance company. Hence, 
 whoever desires to borrow in such a way that his heirs may be able 
 to evade the payment should avoid the policy loan. Such cases, 
 however, are not particularly frequent, and ought not to work a 
 condemnation of the loan privilege. The real test of the desirability 
 of contracting a loan is not the source from which the funds are 
 obtained but the purposes for which they are used. If the money 
 is used to invest wisely in a home, in the reduction of existing indebted¬ 
 ness, or for safe investment elsewhere at a higher rate of return than 
 the interest charged by the n urance company, there is no reason 
 why the reserve should not be borrowed. 
 
 1 Adapted by permission from J. B. Lunger, “The Problem of Cash Surrender 
 and Loan Values,” Annals of the American Academy of Political and Social Science , 
 LXX (March, 1917), 54-58. 
 
268 
 
 RISK AND RISK-BEARING 
 
 The real objection to policy loans, aside from an ancient objection 
 to all borrowing, which seems to be nearly obsolete except as it appears 
 in discussions of this particular question, lies in the fact that such loans 
 are expensive. The money which the policyholder borrows from the 
 company at 5 or 6 per cent is the same money which he is loaning to 
 the company at 3 or 3! per cent. To make the case concrete, let us 
 examine the case of an individual who is carrying a whole life policy, 
 premium $15.63, on which he has made twenty payments. His 
 loan value is $230.50. If he is to borrow that amount of money at 
 all, he probably cannot do better than to borrow it from the insurance 
 company. If he does so, however, and pays 6 per cent interest, he 
 begins at once to pay $29.46 per annum for $769.50 insurance. If 
 he is still a good insurable risk, it will pay him better to let his policy 
 lapse, take the cash surrender value, and take out a new whole life 
 policy for $1,000 at a premium, of say, $30.05, thus gaining $230.50 
 additional protection for 59 cents additional annual cost. 1 A recog¬ 
 nition of the relatively expensive character of the protection afforded 
 by policies on which the reserves have been borrowed must be a 
 fundamental reason for the high lapse rate among borrowers. 
 
 The borrowing transaction does not, however, create the unfavor¬ 
 able financial situation in which the borrower finds himself. It merely 
 calls attention to it. If the policyholder in our illustration does not 
 borrow on his policy at all, but merely keeps it in force, he still pays, 
 not $15.63 for $1,000 insurance, as he doubtless believes, but $15.63 
 
 1 The rates used in the illustration are those charged by a well-known company. 
 A similar calculation for the tenth year of the life of the same policy shows a gain 
 of $98 in protection and an actual reduction of 93 cents in annual cost from lapse 
 and reinsurance as compared with borrowing the reserve at 6 per cent. Like 
 calculations using the rates of three other companies show the following results: 
 Lapse and reinsurance at the end of ten years, as compared with permanent bor¬ 
 rowing of the reserve, results in a reduction of annual cost of 96 cents in company A, 
 74 cents in company B, and $1.04 in company C, with a gain in protection of $98 
 in each case. At the end of twenty years, lapse and reinsurance give an added 
 cost of 80 cents in company A, 97 cents in company B, and $4.23 in company C, 
 for which $230.50 additional protection is obtained. In this calculation, reserves 
 have been figured on the basis of 3 per cent; if they are figured at 3I per cent the 
 gain from lapse and reinsurance is slightly increased. If policy loans are figured 
 at 5 per cent, the gain from lapse is much less, but in most cases is still apparent. 
 The foregoing calculations are all for non-participating policies; in the case of 
 participating policies, the calculation is much more complicated and involves a 
 large element of approximation. On account of the practice of paying increased 
 dividends on older policies, it is probable that in most cases permanent borrowing 
 on participating policies is cheaper than lapse and reinsurance. 
 
LIFE INSURANCE 
 
 269 
 
 plus the income he could secure from $230.50 for $769.50 of insurance. 
 For the individual who has become uninsurable since he took out his 
 original policy, such a contract may be very favorable, but for the 
 good risk it is much less favorable than it appears. 
 
 The reason for this tendency of an insurance policy to become more 
 and more expensive, so far as its real insurance features are concerned, 
 is primarily the fact that the longer one carries his policy, the large 
 the fund which he has accumulated and on which he is receiving only 
 savings bank interest. The man who is borrowing at 6 per cent, 
 from any source, cannot afford to invest at 3! per cent. 
 
 All this fortifies the contention of a previous section, that renew¬ 
 able term insurance, first, when obtainable, and next to that whole 
 life insurance, are the most economical and logical types of insurance 
 from the standpoint of the policyholder, except in those cases where 
 the mild degree of compulsion afforded by the insurance contract 
 enables a policyholder to save what he would otherwise squander. 
 
 VIII. SPECIAL TYPES OF LIFE INSURANCE 
 
 Group insurance .—One of the newest developments in life insur¬ 
 ance is the group policy. This is a term policy written on the lives 
 of a large number of individuals, employees of a single firm, and paid 
 for by the employer. The typical provisions of such a contract are: 
 
 1. No medical examination is required, except when the number of 
 employees is small. Reliance is placed on the operation of the law of 
 large numbers to secure a normal mortality experience, while the 
 character of the group is usually such as to protect the insurer against 
 the adverse selection, which would be likely to result from the omission 
 of medical selection on ordinary life policies. A group of from fifty 
 to a hundred lives is considered sufficient to insure working of the 
 law of averages. 
 
 2. The policy is taken out by the employer; the premiums are 
 paid by him; but the proceeds are payable to the heirs of the insured 
 employees, either directly or through the employer. 
 
 3. Each policy is written as the result of a special investigation. 
 The rate charged depends on such factors as the age distribution of 
 the insured; 1 the proportion of women employees, the standard of 
 living; the occupational risk of injury or disease; and similar factors. 
 
 1 Not simply the average age. Examination of the mortality table will show 
 that two groups of the same average age, but having differing proportions of persons 
 of very advanced and early age, will show very different mortality rates during 
 the life of a short term policy. » 
 
270 
 
 RISK AND RISK-BEARING 
 
 4. New employees ordinarily come under the protection of the 
 policy automatically, under specified conditions, the premium rate 
 being adjusted from month to month as the hazard changes. 
 
 5. Employees severing their connection with the organization 
 automatically lose the protection of the policy, unless the employer 
 chooses to continue paying premiums to maintain insurance on the 
 lives of employees during temporary lay-offs. In some cases the 
 employee is given the privilege of retaining protection by assuming 
 responsibility for payment of premiums at a rate appropriate for his 
 age. Returns of unearned premium, without surrender charge, are 
 made in cases where the liability of the insuring company is reduced 
 through the separation of employees from the pay-roll. 
 
 6. Several methods of determining the amount of liability are 
 in use. The following alternatives are suggested by one insurance 
 company which has been a leader in the development of group insur¬ 
 ance: 
 
 1. The same amount of insurance for all employees, such as $500, 
 given either immediately on employment or after a waiting period, such as 
 six months or one year. 
 
 2. An amount equal to the annual wage of an employee or some per¬ 
 centage thereof. 
 
 3. An amount to be based on length of employment, such as an initial 
 amount of $500 after one year of employment and adding thereto $100 for 
 each additional year of service until a maximum of some fixed amount has 
 been attained, such as $1,000 or $1,500. Any other plan or formula which 
 meets conditions more favorably than those suggested, may be adopted. 1 
 
 7. Provision is frequently made that the policy shall mature 
 immediately as to any employee who becomes totally and permanently 
 disabled. In such cases it is customary to provide for the payment of 
 the insurance in instalments. 
 
 The primary purpose of group insurance is to increase employees’ 
 good will toward the organization which they serve, thereby reducing 
 labor turnover and adding to the efficiency of the individual laborers. 
 It is believed that in many cases money expended in paying premiums 
 on a group policy will buy more added productive effort than will a 
 similar amount of money spent for the same purpose through increased 
 wages. It is also argued that an insurance policy will serve as an 
 especially attractive feature of the service in the case of married 
 
 1 From an analysis of group insurance published by the Travelers’ Insurance 
 Company. 
 
LIFE INSURANCE 
 
 271 
 
 employees and, in general, among the steadier class of workers whose 
 continuous services it is especially important to retain. 
 
 So far as the insurance features of the group insurance plan are 
 concerned, the device seems so far to have been eminently successful. 
 The elimination of medical examination, the small amount of work 
 connected with the issuance and recording of policies, the simplifica¬ 
 tion of collections, and the lowered commissions which may properly 
 be paid to agents for selling insurance on the wholesale plan, combine 
 to make this an especially economical and at the same time profitable 
 type of insurance. Whether the plan has been equally successful as a 
 device for improving the relations of employers and employees is 
 uncertain. The question is at best a difficult one to answer accurately, 
 and the period during which group insurance has been in vogue is so 
 short, and labor conditions have been <0 unstable during that period, 
 that no real test can as yet be said to have occurred. 
 
 Industrial insurance .—Another type of insurance which deserves 
 particular mention is the so-called industrial policy. This is a policy 
 for a small amount, usually less than $500, on which the premiums 
 are collected weekly by a house-to-house canvasser, instead of being 
 mailed to an agent of the company, as is the practice with most 
 forms of life insurance. The amount of the premium, instead of the 
 face of the policy, is stated in round numbers, the most frequent unit 
 being five or ten cents per week. The term “industrial” is applied 
 to these policies not because they have any connection with industry 
 but because the greater number of such policies are sold to wage¬ 
 workers. Such policies are regularly written on the lives of children 
 as well as of adults, the object being to provide for the expenses of last 
 sickness and burial. For this purpose such insurance performs a 
 useful service. 
 
 The chief objection to the industrial policy is its high cost, the 
 premium usually working out about double the cost of whole life 
 insurance of the ordinary type. No cash surrender or loan value is 
 usually allowed, until the policy has run for a very long period, but 
 paid-up insurance for a portion of the face is allowed in cases where 
 the policy has been carried for a few years. 
 
 The high cost of this type of insurance is due primarily to the 
 excessive cost of collection. Another reason is found in the high 
 lapse rate, which makes the selling cost greater than would be the 
 case if the policy once placed did not so frequently have to be replaced 
 by another in order to keep the volume of business constant. A third 
 
272 
 
 RISK AND RISK-BEARING 
 
 reason for the high cost is found in the mortality rate, which is con¬ 
 siderably higher than is the case with ordinary policies, partly on 
 account of a somewhat higher normal death-rate in the class of the 
 population who make up the bulk of the policyholders, and partly 
 on account of the lack of medical examination. Formerly it was the 
 practice to require a very superficial examination by a physician, but 
 the present practice, so far as policies of less than $500 are concerned, 
 is to place on the agent the responsibility of inspecting the candidate 
 and certifying to his apparent good health. Naturally, this method 
 leaves opportunity for rather more adverse selection than is possible 
 where regular medical examination is required, though the difference 
 is less than might readily be anticipated. 
 
 Fraternal insurance .—One of the most interesting developments 
 in American life insurance is the insurance written by the various fra¬ 
 ternal orders, beginning with the organization of the Ancient Order of 
 United Workmen, in 1868. The original idea underlying the work of 
 these companies was to make insurance incidental to the operation 
 of a system organized primarily for the purposes of mutual assistance 
 and social intercourse within a selected circle. Insurance of this 
 sort characterized the medieval guilds, and has frequently been 
 written as incidental to organizations formed for other puiposes. 
 In the case of the fraternal orders, however, the insurance feature has 
 proved so popular as to overshadow the social side of many of the 
 organizations, so that they have become insurance societies with a 
 fraternal feature rather than fraternal societies with an insurance 
 feature. This development indirectly led, in many cases, to the under¬ 
 mining of the insurance feature itself. The original plan was a straight 
 assessment plan, each member paying his share of the sum due to the 
 relatives of the deceased. Such a system can be worked successfully 
 with a cost very much lower than the rates charged by legal reserve 
 companies for “old line” insurance, provided the membership remains 
 from year to year of the same fairly low average age. In a labor 
 union, for example, the tendency is for the older members to drop 
 out of the organization and be replaced from year to year by young 
 men, so that the average age and the average mortality remain 
 unchanged. Assessment societies among the employees of corpora¬ 
 tions have operated very successfully, the tendency being here also 
 for the older members to drop out of employment, so that the mor¬ 
 tality is the relatively low mortality of people who are able to stay on 
 the pay-roll. 
 
LIFE INSURANCE 
 
 273 
 
 In the fraternal insurance society, on the other hand, there is 
 just the opposite tendency. The older the member gets, the less 
 likely he is to drop out. As a result, the average age increases and the 
 assessments grow heavier. As the assessments grow heavier, it 
 becomes more difficult to secure young members, the younger men 
 finding it more advantageous to go into newer societies with a lower 
 assessment rate. As soon as the younger members stop coming in, 
 the death of the organization, so far as its insurance features are con¬ 
 cerned, becomes merely a matter of time. As each member dies, a 
 larger assessment on the remaining members is necessary until, if 
 the plan were carried through to the end, the last surviving member 
 would have to pay the entire face of the policy of the next to the last 
 member, and would then be left himself without insurance. Long 
 before this contingency arises, however, assessment orders cease to 
 function. 
 
 As the weakness of assessment insurance became apparent in the 
 eighties and early nineties, the stronger fraternal orders shifted from the 
 straight assessment plan to the graded assessment, a plan under which 
 the assessment varies with the age of the member at entrance. Such 
 a plan is theoretically workable, but in practice has not proved much 
 more stable than the original flat assessment, for the reason that the 
 assessments have not been large enough to provide adequate reserves 
 and the lack of reserves has made it necessary to increase the number 
 of assessments as the orders grow older, so that the same tendency 
 for younger men to drop out and older men to stay in has appeared. 
 
 Since about 1910, the weakness of the ordinary type of fraternal 
 insurance without adequate reserves has become so apparent that 
 there has been a general movement to reorganize the fraternals on a 
 “legal reserve” basis. The reorganization has involved the adoption 
 by the fraternal companies of the fundamental actuarial principles, 
 which we have seen above applied to ordinary commercial insurance. 
 A fully reorganized fraternal society with adequate reserves differs 
 from an “old line” company only in the following respects: 
 
 First, the fraternal companies use their own mortality table, 
 which shows a somewhat lower mortality and is probably considerably 
 more accurate than that used by the old line companies. 
 
 Second, the interest allowance is figured in some cases at 4 per cent. 
 
 Third, the government of a fraternal order is much more demo¬ 
 cratic than that of an old line company, even though the latter be 
 mutual in character. 
 
274 
 
 RISK AND RISK-BEARING 
 
 A considerable proportion of the members take some part, as a 
 rule, in shaping the policies of the order. From the local unit, the 
 lodge, delegates are sent to district, state, and national conventions, 
 and important matters of policy are settled directly by these national 
 conventions. Fraternal newspapers do much to create an effective 
 public opinion among the members. 
 
 Fourth, the expense loading in the premiums is very low, though 
 not as low as in a few of the old line companies. The actual expenses 
 of the fraternal organization are almost invariably lower. This is 
 partly because, in line with democratic precedent, it is their custom 
 to pay relatively small salaries to their officers, and partly because 
 the fraternal features have enabled them to keep their selling costs 
 very low, a large part of their publicity being secured by the unpaid 
 work of the membership. 
 
 In the early history of the fraternal orders there were no paid agents 
 at all, but more recently there has arisen a system whereby “deputies” 
 are paid small commissions to visit the local lodges and put on cam¬ 
 paigns for new members. Their commissions, however, can be kept 
 relatively small because, whereas the agent for an old line company 
 has to find his own prospects and close his own sales, the fraternal 
 deputy operates by stirring up the enthusiasm of the members and 
 getting them to do much of the work, often through the medium of 
 contests between neighboring lodges, or between picked teams in the 
 same lodge. 
 
 Fifth, fraternal insurance certificates carry, as a rule, no cash 
 surrender value and no loan value. 
 
 Sixth, a fraternal insurance certificate is not a contract whereby 
 the order promises to furnish a given amount of insurance for a stipu¬ 
 lated sum. The rates are always subject to readjustment by action 
 of the order, and the amounts payable may be scaled down in case the 
 order is unable to pay the full amount. Hence, it is almost impossible 
 for a fraternal order to become technically bankrupt. Its liabilities 
 consist only of its matured claims. 
 
 Seventh, the beneficiary has no legal equity in a contract of fra¬ 
 ternal insurance. The insured can change the beneficiary at any 
 time, although as a rule he cannot insure in favor of anyone except a 
 dependent. The beneficiary cannot sell, assign, or transfer his claim 
 prior to the death of the insured, because he has no legal claim to 
 transfer, nor can a legal equity be created by the payment of premiums 
 by the beneficiary. 
 
LIFE INSURANCE 
 
 275 
 
 Fraternal insurance has been looked upon with disfavor by most 
 insurance authorities in this country, chiefly because of the unsound 
 actuarial practices with which it has so frequently been associated. 
 Nevertheless, it has rendered a very large service and in the author’s 
 opinion is worthy of a better rating than it generally gets. Fraternal 
 insurance frequently gets a “black eye” in a community, because of 
 the experience of members Who after paying insurance for twenty- 
 five or thirty years and becoming too old to secure insurance elsewhere, 
 and after having their rates raised to two or four times their previous 
 levels, have been compelled to drop their policies. What is overlooked 
 in these cases is that the individuals in question have really had very 
 cheap protection during the productive period of their lives, and if they 
 had bought the insurance as term insurance, would have had no reason 
 to be dissatisfied with their bargains. An individual who gets less 
 than he bargained for, even though he gets as much as he paid for, is 
 likely to express discontent, and this has very frequently been the 
 situation of the buyer of fraternal insurance. 
 
 The history of the fraternal movement in this country can never 
 be understood if it is viewed merely as a phase of the history of life 
 insurance. It is a part of the great social democratic movement of the 
 late nineteenth century of which the Greenbackers, the Farmers 
 Alliance, the Populist party, the Free Silver movement, the United 
 States Grain Growers, Incorporated, and the Non-Partisan League 
 are more conspicuous manifestations. The fraternal insurance 
 enthusiast of the eighties and nineties was an apostle of freedom, an 
 advocate of the rights of the downtrodden masses against the greedy 
 barons of Wall Street. The enthusiasm with which the fraternal 
 organizers of that early day denounced the practices of the old line 
 life insurance companies amounted almost to a religious faith. In the 
 thought of these apostles, mortality tables, compound interest calcula¬ 
 tions, legal reserves, were implements of darkness, designed to separate 
 the trusting citizen from his money and place it at the disposal of the 
 stock manipulators and trust magnates of the East. As these devices 
 have become better understood, the ardor of the crusaders for their 
 abolition has waned. 
 
 In any evaluation of fraternal insurance, the value of the social 
 features must not be overlooked. As noted above, fraternal insurance 
 has been sold at a low figure because, among other reasons, the 
 membership as individuals have carried the selling costs. This 
 method of propagating the order has been possible only because the 
 
276 
 
 RISK AND RISK-BEARING 
 
 local lodge and, to a less extent, the larger organization, have supplied 
 a real social need. 
 
 In every small community in the country, particularly before the 
 advent of the u movie,” the lodge furnished for many men the only 
 excuse for staying away from home. The ritual of the order has often 
 been elaborate; its mastery has supplied a stimulating exercise, and 
 the opportunity for a genuine intellectual triumph, while the holding 
 of office in a fraternal order has furnished an opportunity for self- 
 expression and an object of ambition. The opportunity to wear a 
 resplendent uniform, to appear in pomp at the funeral of a deceased 
 brother, the winning of a banner for surpassing neighboring lodges 
 in the percentage of members who appear in procession at an annual 
 county rally, and the gaining of a free oyster supper by beating a 
 rival team in a contest in securing new members—all these activities 
 minister to genuine human wants, and because this is true the orders 
 have been able to propagate themselves without expensive selling 
 organizations and to furnish insurance at a minimum cost. 
 
 Life annuities .—The life annuity is a contract designed to afford 
 protection against the hazard of the individuals’ outliving their pro¬ 
 ductive capacity and becoming a burden upon the community. In 
 many respects this type of contract is exactly the reverse of the insur¬ 
 ance contract. Just as the insurance policy insures against the 
 financial loss due to premature death, the annuity policy insures 
 against loss due to prolongation of one’s existence beyond his earning 
 period. Insurance policies are usually paid for in annual instalments 
 and mature in one lump sum, while the annuity is paid for in a lump 
 sum and matures in a series of annual instalments. No medical 
 examination is necessary for an annuity, as the only adverse selection, 
 from the company's standpoint, is that arising from the tendency 
 of persons who anticipate long life to purchase annuities, rather than 
 persons who know themselves to be in doubtful health. If it were 
 feasible, it would be logical to establish medical selection to eliminate 
 the abnormally good risks, but abnormalities in the direction of a 
 tendency to excessive length of life are not readily identified. The 
 inaccuracy of the mortality table to which reference was made on 
 page 249, which works in favor of the company in ordinary life insur¬ 
 ance, would work against it in writing annuities, hence a separate 
 mortality table is used for this purpose. 
 
 The computation of annuity premiums is similar to the computa¬ 
 tion of insurance premiums and needs no extended discussion. The 
 
LIFE INSURANCE 
 
 277 
 
 present worth of the sums to be paid to the various members of a 
 typical group, as shown by the mortality table, is divided by the 
 number of individuals in the group, to get the net single premium for 
 the policy, and loading is then added just as in the case of life insur¬ 
 ance. The uses and the characteristic features of life annuities are 
 brought out with such fulness in the following account that little 
 further discussion is necessary: 
 
 The primary function of the life annuity is to insure that a given sum 
 of money will produce a life income larger in amount than could be safely 
 secured through the channels of ordinary investment. The regular life 
 annuity contract is a promise to pay, in consideration of a single cash sum, 
 a fixed amount periodically during the lifetime of a designated person, 
 called the annuitant. Annuities in practice are paid yearly, half-yearly, 
 quarterly or monthly. 
 
 The correct method of computing annuity premiums is essentially as 
 follows: The mortality table, upon which the computation is based, con¬ 
 sists fundamentally of a series of numbers, showing how many persons out 
 of a given number alive at the youngest age in the table, survive to each 
 age throughout the possible range of life. Given, therefore, a large group 
 of persons all of the same age, the mortality table renders it possible to 
 forecast how many of the group will be alive one year hence, two years 
 hence, three years hence, and so on until all of the members of the group 
 have passed away. If, therefore, a promise should be made to pay a yearly 
 annuity of a dollar to each member of the original group, it could be fore¬ 
 told how much would have to be paid at the end of the first year to those 
 surviving at that time, how much would have to be paid at the end of the 
 second year and at the end of the third year, and so on throughout the 
 number of years covering the possible span of life of any of the members 
 of the group. This series of payments may be compared to a serial bond 
 issue maturing in definite amount throughout a period of years. And just 
 as the banking house computes the present value of the principal payments 
 under the serial bond issue, so the actuary computes the present value of 
 the series of annuity payments that will be made to the members of the 
 annuity group. Dividing the present value of the complete series of future 
 annuity payments, by the original number of members of the group, he 
 arrives at the true present value of the life annuity on the basis of the 
 mortality table employed and of the rate of interest assumed in determining 
 the present value of the future payments. 1 
 
 A casual inspection of the table on page 278 explains at once why it is 
 that few annuities are sold at the younger ages. The percentage return at 
 
 1 In practice, this extended method of computation is not actually required, 
 since mathematical short cuts have been developed which greatly facilitate the 
 actuarial calculation. The final results of the short method, however, are identical 
 with those obtained by the extended process described. 
 
278 
 
 RISK AND RISK-BEARING 
 
 these ages is not sufficiently in excess of the return upon funds invested 
 through the regular channels to induce prospective annuitants to hazard 
 the loss of a considerable portion of their principal by investing in an annuity. 
 At the older ages, however, where the return exceeds say 8 per cent, the 
 annuity makes its greatest appeal. In no other manner can a sum of money 
 be invested to yield an absolutely certain life income of so large an amount. 
 
 TABLE SHOWING COMPARATIVE RETURNS ON MALE AND FEMALE 
 ANNUITIES, AVERAGE OF 15 AMERICAN COMPANIES 
 
 Age 
 
 
 Male 
 
 Female 
 
 15 American 
 Companies 
 
 15 British 
 Companies 
 
 15 American 
 Companies 
 
 15 British 
 Companies 
 
 
 
 Lowest 
 
 5-40 
 
 5-4i 
 
 5-29 
 
 5-21 
 
 40. 
 
 • 
 
 Average 
 
 583 % 
 
 5-88% 
 
 5-53% 
 
 5-56% 
 
 
 
 Highest 
 
 6.29 
 
 6.21 
 
 6.08 
 
 5-85 
 
 
 
 Lowest 
 
 6-57 
 
 6.61 
 
 6.22 
 
 6.13 
 
 50. 
 
 
 Average 
 
 7 03% 
 
 7-14 % 
 
 6-Si% 
 
 6-59% 
 
 
 
 Highest 
 
 7-58 
 
 7 -46 
 
 7.07 
 
 6.82 
 
 
 
 Lowest 
 
 8.55 
 
 8-75 
 
 7.89 
 
 7.78 
 
 60. 
 
 
 Average 
 
 9-21% 
 
 9-4t% 
 
 8.31% 
 
 8.36% 
 
 
 
 Highest 
 
 9.87 
 
 9-63 
 
 8.8 3 
 
 8.58 
 
 
 
 Lowest 
 
 11.91 
 
 12.80 
 
 11 -39 
 
 11 33 
 
 70. 
 
 
 A verage 
 
 13-27% 
 
 U-73% 
 
 H-94% 
 
 12-14% 
 
 
 
 Highest 
 
 13-85 
 
 14.00 
 
 12.47 
 
 12.35 
 
 
 
 Lowest 
 
 17.76 
 
 
 16.57 
 
 
 80. 
 
 
 A verage 
 
 10 ■ v>% 
 
 
 17 ,6n% 
 
 
 
 
 Highest 
 
 22.47 
 
 
 20.20 
 
 
 Annuities have reached their greatest development in older, longer 
 established countries where there are large accumulations of capital and 
 where interest rates are relatively low. Pioneer countries, where available 
 capital is urgently needed for development of their resources and where 
 the return upon investments is correspondingly large, know little of annuities. 
 For this reason, America has had less experience with annuities than has 
 Great Britain. 
 
 An important, but less well known, application of the annuity is to the 
 problem of liberating for the urgent needs of the present capital that would 
 otherwise be held invested because of the income it produces. An excellent 
 example taken from the literature of a company that has made a specialty 
 of the annuity business will serve to make this application clear: 
 
 A father, 69 years of age, had two sons, one a lawyer, age 27, and the 
 other a doctor, age 29. Each was struggling to build up a practice in 
 London. The father realized that his boys were then more in need of 
 financial assistance than they were likely to be in later years after he had 
 passed away. His income, about £400 a year, derived from investment 
 of £12,000, was just sufficient to meet his own requirements. If he gave 
 his sons any of the capital he reduced his own income. He solved the 
 
LIFE INSURANCE 
 
 279 
 
 difficulty by purchasing an annuity of £400 payable £100 a quarter. This 
 cost him about £3,184 of his capital. The balance of £8,816 he equally 
 divided between his sons, enabling the doctor to move to Harley Street, 
 and the lawyer to secure a remunerative partnership. 
 
 The deferred annuity .—An annuity of much value is the deferred annuity. 
 The first payment under this annuity is deferred for a period of years, say 
 to the end of the annuitant’s income-earning period. It may be purchased 
 by a single premium or by a series of premiums. Upon the death of the 
 annuitant the contract terminates. For an additional premium, provision 
 may be made for the return, upon the death of the annuitant, of such Dart 
 of the premiums as may not have been returned in annuity payments. 
 
 The deferred annuity is particularly adapted to men and women, 
 without present or prospective dependents, who desire to provide during 
 their income-earning period against possible dependency in old age. There 
 is no more economical manner in which this provision may be made; though 
 it is essential if there be dependents, that the deferred annuity should be 
 supplemented by additional provision for their support. To meet this 
 latter contingency, contracts involving both the annuity principle and the 
 insurance principle have been developed. 
 
 The reversionary annuity .—One of these combination contracts devel¬ 
 oped to meet the demand for a method of protecting a dependent in the 
 event of the death of the breadwinner, is the reversionary annuity which 
 provides for the payment of a life annuity to a beneficiary commencing 
 upon the death of a designated person known as the insured. 
 
 For example, a son may employ the reversionary annuity to insure a 
 life income to his mother, should she outlive him. The contract may be 
 paid for by a single premium 01 by a limited number of annual premiums, 
 continuing, however, only so long as the mother and son both live. Upon 
 the death of the son, the annuity payments to the mother commence. 
 Should the mother die before the son, the contract terminates and all 
 premiums paid are forfeited. 
 
 Where there is a considerable difference in the ages of the insured and 
 beneficiary, the reversionary annuity renders its greatest service, and 
 under these circumstances it is well adapted to the protection of the older 
 of the two lives in the event of the death of the younger. Where the ages 
 are more nearly equal, however, or where the beneficiary is younger than 
 the insured, the reversionary annuity possesses many weaknesses. 
 
 The monthly income policy .—A modified form of the same contract is 
 the monthly income policy. The monthly income policy remedies in large 
 measure the weakness discovered in the reversionary annuity. In the 
 first place, the income payable upon the death of the insured under a 
 monthly income policy is payable monthly for a fixed number of years 
 certain and thereafter during the remaining lifetime of the beneficiary. By 
 the phrase “fixed number of years certain” it is meant that when the 
 
RISK AND RISK-BEARING 
 
 280 
 
 income becomes payable by the death of the insured, the income during 
 the so-called “period certain” is guaranteed irrespective of the life of the 
 beneficiary. On this account, it is possible to change, ad libitum , the 
 beneficiary who shall receive the “income certain”; and as the “period 
 certain” is frequently twenty years, the privilege is a valuable one. The 
 income payable after the expiration of the period certain is usually payable 
 only during the lifetime of the beneficiary originally designated. 
 
 Immense improvement of the income policy upon the reversionary 
 annuity is that it protects any children who may be living at the death of 
 the insured. The fact that the income is payable certainly, for say twenty 
 years, insures that the children will receive an income until they have 
 acquired an education and have become self-supporting. 
 
 Furthermore, the monthly income policy possesses a cash surrender 
 value based upon insurance value of the income payable during the period 
 certain; whereas the reversionary annuity makes no provision for cash 
 surrender. 
 
 The most complete form of monthly income policy adds to the one just 
 described, a further provision under which the income commences upon the 
 insured’s living a specified number of years, or say to age sixty or sixty-five. 
 In this event, the income is paid to the insured during his remaining life¬ 
 time, and after his death to the beneficiary,‘with a guaranty that payments 
 for a period certain will be made if both the insured and the beneficiary die 
 during the period. If the insured dies before the date when his income is 
 due to commence, the income is paid to the beneficiary for life, with the 
 guaranty of income for a period certain. This contract is adapted to 
 furnish complete protection to a husband and wife, and also protection, 
 during minority, to any children living at the death of the insured or at the 
 time the income to the insured commences. 1 
 
 Disability clauses in life insurance policies present innumerable 
 differences of detail, but fall into two general types. Some provide 
 simply for the cessation of premiums during the continuance of total 
 disability, prior to a specified age, usually sixty or sixty-five. Such a 
 provision may be very useful in enabling the insured to keep his 
 policy in force at a time when he is unable to earn anything, but its 
 benefits are of very small financial significance, as the average length 
 of life of disabled persons below age sixty, as generally estimated, 
 is less than a year and a half. 
 
 The second type of disability clause provides for the payment of 
 benefits under the policy, usually in instalments, in the event of total 
 and permanent disability. A great variety of clauses of this general 
 type are offered. Some simply provide for the payment of the face 
 
 1 Adapted by permission from M. A. Linton, “Life Annuities,” Annals of the 
 American Academy of Political and Social Science , LXX (March, 1917), 20-35. 
 
LIFE INSURANCE 
 
 281 
 
 of the policy, with interest, in annual or more frequent instalments 
 over a period of twenty years, from beginning of total disability, with¬ 
 out regard to the time of death of the insured. Others provide for 
 payment of such instalments during the period of disability, and the 
 payment at death of any balance remaining unpaid at that time. Still 
 others provide for payment of the instalments during continuance of 
 disability, and also the payment of the full amount of the insurance 
 at death. The rates also vary a great deal, as there are no generally 
 accepted tables indicating the extent of the risk insured against under 
 these clauses. A number of companies are using their own experience, 
 which has not been published. 
 
 Disability clauses of the first type, those providing only for 
 cessation of premiums, cost very little (twelve cents per thousand 
 dollars per year on a thirty-year term policy at age thirty-five, accord¬ 
 ing to one company’s rates), but the clauses which provide for the pay¬ 
 ment of disability benefits of a substantial character are relatively 
 expensive. 
 
 Logically, every contract of life insurance should contain a clause 
 providing for the payment of the face value, either in cash or in 
 instalments, in the event of permanent total disability. The con¬ 
 tingency insured against in a life policy is the loss of income due to 
 death. The loss incurred in the event of total disability is of the same 
 character as that sustained in the event of death, and is even greater 
 in amount, for the cost of support of the insured individual, which 
 ceases at death, continues and may even increase at disability. In 
 the present unstandardized state of the disability clause, however, the 
 disability clause requires very careful scrutiny in order that the 
 insured may be assured that he is getting value equivalent to the cost. 1 
 
 War risk insurance .—One of the most interesting experiments in 
 recent life insurance history is the establishment of the War Risk 
 Bureau under the federal government to furnish life insurance for 
 soldiers and sailors during the Great War. The idea underlying the 
 establishment of this type of insurance was that the soldier or sailor 
 should be given the opportunity to secure protection for his dependents 
 against the risk of death during military service, or the years following, 
 on terms which would throw upon the government the cost of pro¬ 
 tection against hazards due to the war, while the individual paid 
 
 1 Leading discussions of disability clauses are Bruce D. Mudgett's two articles, 
 “Total Disability Provision in American Life Insurance Contracts,” Annals of the 
 American Academy of Political and Social Science, Vol. LIX (May, 1915), and “Five 
 Years’ Progress in Disability Protection,” ibid., Vol. LXX (March, 1917). 
 
2 82 
 
 RISK AND RISK-BEARING 
 
 the cost of insuring him against t’he ordinary hazards of peace. This 
 was accomplished through the creation of the War Risk Bureau, which 
 undertook to write life insurance on the entire military and naval 
 force. The policies as originally written were five-year term policies, 
 and the premiums were net premiums without loading, the entire 
 expense of administration being absorbed by the government. 
 
 As the mortality during the war was very high and was expected 
 to be still higher, there was no expectation that the premiums would 
 be adequate to meet the losses. The government spent a large amount 
 of money in urging those eligible to take advantage of the insurance 
 offered,.and was successful in writing more than four million policies. 
 As soon as the armistice was signed, however, the greater proportion of 
 the policyholders ceased the payment of premiums. In 1919 it was 
 reported that less than a million policyholders were keeping up their 
 payments. In order to check the decline the Secretary of the Treasury 
 issued a ruling permitting discharged soldiers, sailors, and marines 
 who had dropped or canceled their policies to reinstate within eighteen 
 months after discharge without medical examination and without the 
 payment of back premiums, except one month’s premium to cover the 
 period of grace when the policy was in force. The only limitation on 
 the privilege was that the applicant should be in as good health as he 
 was at the date of his discharge. In spite of this liberality the decrease 
 in number of policyholders continued so that only about 550,000 
 policies are now in force. 
 
 As a very large proportion of the holders of these policies were 
 young men without dependents, who in the normal course of events 
 would not have been in the market for insurance for some time and 
 would not have bought $10,000 policies for many years, it is not 
 strange that the lapse rate has been very high. The tendency to 
 discontinue payment of premiums was aggravated by dissatisfaction 
 over the large number of errors made by the Bureau and the extreme 
 slowness with which it worked. The necessity of converting the term 
 policies into higher-priced policies also, in all probability, contributed 
 to this tendency to lapse, as did the very liberal policy of reinstatement. 
 
 The optional conversion privilege offered a choice of whole life 
 policies, twenty- or thirty-year limited payment or endowment 
 policies, and endowments maturing at age sixty-two. 
 
 Most of the liberal policy features developed by legislation or by 
 the competition of life insurance companies in recent years were 
 included—high loan and surrender values, option of monthly, quar- 
 
LIFE INSURANCE 
 
 283 
 
 terly, or annual premium payments, exemption of proceeds from taxa¬ 
 tion and from the claims of creditors, and incontestability from date 
 of issuance, the last provision one which seems to offer an unnecessary 
 incentive to fraud. The disability clause is extremely liberal, pro¬ 
 viding for payment of $5.75 per thousand dollars insurance monthly 
 for the period of total disability, or for 240 months in case of death 
 before the expiration of that period. Similar clauses in private 
 insurance contracts usually cover only disability incurred before a 
 specified age, sixty, sixty-five, or seventy years. In view of the very 
 large proportion of aged persons who incur disability, this feature is 
 of considerable importance. 
 
 With regard to the success of the government’s experience with 
 life insurance, opinions will differ for many years. In the author’s 
 judgment, the fundamental principle on which the cost was divided 
 between the insured and the government was thoroughly sound, and 
 the object aimed at, namely, the avoidance of the pressure for pensions 
 for dependents in years to come, was an eminently worthy object. 
 In view, however, of the progressive liberalization of the policy and the 
 pressure for other types of financial assistance to veterans of the war, 
 it appears extremely doubtful whether the insurance will not prove 
 to be an addition to, instead of a substitute for, our traditional pension 
 legislation. 
 
 The wisdom of handling the insurance through a government 
 bureau is more debatable. At the time the experiment was under¬ 
 taken no life insurance company was in a position to handle the 
 volume of business created by the war emergency, and few companies 
 would have cared to risk the loss of good will resultant from disrupting 
 their organizations in an attempt to do so. As the number of the 
 insured grows smaller, however, the necessity for handling this pro¬ 
 gram through a government bureau grows less. From a purely busi¬ 
 ness standpoint, it would probably be desirable to transfer the con¬ 
 tracts in time to a syndicate of insurance companies if it were politically 
 feasible to do so. No such action appears probable, however. 
 
 The chief criticisms which may fairly be leveled at the insurance 
 
 * t 
 
 administration have to do, not with the routine clerical labor but with 
 matters of policy. In the first place, the selling methods which have 
 at times been used by the Bureau have been the subject of well- 
 merited criticism. For instance, in 1918, a circular issued by the Bu¬ 
 reau set forth the claim that the government policy offered insurance 
 at a rate 30 per cent below that offered by any commercial company, 
 
284 
 
 RISK AND RISK-BEARING 
 
 a figure which was apparently arrived at by treating a policy for 
 $10,000 payable in monthly instalments over a period of twenty years 
 as the equivalent of a policy for $10,000 payable in cash, without 
 regard for the item of interest. 
 
 The exclusion of term insurance from the list of policies to be 
 issued after live years from the close of the war, is also hard to justify. 
 Term policies are not popular, the candidate for insurance being apt 
 to infer that if he lives out the term of the contract he has given 
 something for nothing. The hostility of most insurance companies 
 to term insurance has encouraged this attitude. The War Risk 
 Bureau had an opportunity to do an excellent piece of educational 
 work on this point, but has chosen instead to adopt the traditional 
 viewpoint, treating the term policy as a makeshift and urging early 
 conversion into the more “permanent” types of investment policy. 
 
 As already noted, the feature of incontestability from date of 
 issuance seems to be unnecessarily liberal, and to offer incentive to 
 fraud. The complete exemption of the proceeds of policies from all 
 claims of creditors enlarges upon a bad custom. Such exemption is 
 very general, so far as life policies payable to dependents are con¬ 
 cerned; the government policy offers such protection even to the 
 proceeds of endowment policies. There is little justification for such 
 exemption in any case, and least in the case of endowments. 
 
 Sweeping statements by the Bureau that the government will 
 never turn this business over to private companies, while they will 
 probably be justified by the results, do not seem to be justified by 
 the present legal situation. There is no legal difficulty in the way of 
 any future Congress abolishing the Bureau, and either turning the 
 insurance over to private companies or canceling the policies and pay¬ 
 ing the policyholders the cash surrender value of their insurance. 
 Such an action seems at the present time politically impossible, but 
 in view of the startling changes of political outlook, which frequently 
 take place in a few years, the positive statements to the contrary by 
 the Bureau’s representatives are hardly justified. 
 
 From the standpoint of the insured, the war risk policy is decidedly 
 attractive. In the first place, it offers a standard policy at net table 
 rates, the lowest rates at which non-participating insurance can be 
 offered by a legal reserve company. Second, the policy, as already 
 noted, contains a very liberal disability clause, for which no allowance 
 is made in figuring the premium. This feature makes the policy the 
 cheapest insurance of its type in the market. Third, the policy is 
 
LIFE INSURANCE 
 
 285 
 
 a participating policy, sold at non-participating rates. To be sure, 
 this feature does not, on the face of things, appear to be of much 
 importance, for of the three chief sources of dividends on insurance 
 policies, only one appears to be available in connection with the war 
 risk policy. There can be no savings from expense loading, for there is 
 no loading. Mortality savings appear very remote, for the experience 
 during the war was very unfavorable, and the present list of policy¬ 
 holders contains a high proportion of disabled veterans, among whom 
 the mortality must be excessive. There remains the possibility of 
 gains from investments. The statement of assets and liabilities as 
 of December 31, 1921, showed total assets in the government life 
 insurance fund, amounting to $45,515,362.12, over $42,000,000 of 
 which was invested in United States bonds (book value). Assuming 
 earnings of 4J per cent on the entire body of assets, the gross invest¬ 
 ment earnings would be less than $2,000,000, of which amount over 
 $1,000,000 is required for interest accumulation on the policy reserve 
 of $29,387,889, leaving less than $1,000,000 to offset excess mortality 
 and provide for dividends. Yet $1,750,000 was shown in the same 
 statement as reserved for dividend payments during 1922. In 
 the absence of definite information as to the way in which earnings 
 have been figured, it is difficult to resist the conclusion that such 
 distributions as have been made were based rather on political expedi¬ 
 ency than on bona fide earnings. 1 
 
 This last point suggests a fourth advantage of a war risk policy, 
 from the standpoint of the holder, namely its speculative value, which 
 arises from the uncertainty which exists concerning future changes in 
 the rights and obligations of the policyholder. That future legislation 
 will reduce the benefits to be derived from the ownership of these 
 policies seems highly improbable, while there is a considerable chance 
 that changes may be made which will reduce the premium payments 
 
 1 The dividends paid in 1922 ranged from $1.53 to $2.04 per $1,000 of insurance 
 on ordinary life policies, and from $1.68 to $213 on twenty-year endowments. 
 Inquiry from the War Risk Bureau concerning the source of dividend earnings has 
 elicited only the information that “the fund from which dividends on converted 
 policies may be apportioned is accumulated from two sources: savings due to 
 deferred mortality and excess interest earnings.” On the other hand, a pamphlet 
 issued by the War Risk Bureau in 1920 stated that more than $1,000,000,000 in 
 claims had been allowed, and only about $300,000,000 had been collected in pre¬ 
 miums. New and Liberal Features of War Risk Insurance, p. 7. It is of course 
 possible that the 1922 dividends were based on 1921 mortality experience, without 
 consideration of the accumulated excess mortality. 
 
286 
 
 RISK AND RISK-BEARING 
 
 or increase the benefits. Under our system of government, the odds 
 in such a speculation are all in favor of the holder. He has a hand in 
 the treasury, and the longer he holds his policy, and the more generally 
 his fellows surrender theirs, the more valuable does his position become. 
 From a purely financial point of view, therefore, it seems clear that 
 any holder of a war risk policy who now has, or expects ever to have, 
 need of insurance, has much to gain and little to lose by keeping his 
 policy in force. 
 
 QUESTIONS 
 
 1. Explain the meaning of the following terms: adverse selection, benefit 
 of selection, reserve, loading. 
 
 2. What are the advantages of each of the leading types of “old line” life 
 insurance policy? 
 
 3. Why should the cost of insurance in the later years of life, under the 
 natural premium plan, become prohibitive ? Is insurance bought more 
 cheaply by paying for it years in advance ? 
 
 4. Calculate the value of your own life for insurance purposes, making 
 reasonable assumptions concerning your prospective earnings and per¬ 
 sonal expenditures. 
 
 5. At what time of life is the maximum amount of insurance necessary in 
 order to cover the amount at risk ? 
 
 6. How much insurance is it good business policy to keep in force on the 
 life of a retired business man ? Does the state of his health at the time 
 of his retirement have any bearing on the answer ? 
 
 7. An unmarried woman, 35 years of age, a teacher, is the sole support of 
 her mother, aged 73. She is advised to take out $4,000 of twenty-year 
 term insurance, and $4,000 of twenty-payment life insurance, in order 
 to combine protection for her mother with provision for her own old age. 
 Could you give her better advice? (Her salary is $1,750 per annum). 
 
 8. A and B are brothers, sons of C, a widower. C at age 65 notifies A and B 
 
 that he will no longer keep up premium payments on two policies in their 
 favor on his life, one of which is an ordinary life policy in a legal reserve 
 company, taken out at age 35, the other a beneficial certificate in a 
 fraternal order, taken out at age 28. Both the insurance company and 
 the fraternal order bear good reputations. C is in excellent health. A 
 and B are in no way dependent on C’s income, which is chiefly derived 
 from investments, though he earns enough to pay his living expenses from 
 the practice of a profession. The rate on the fraternal certificate is $9 00 
 per thousand, on the old-line policy $21.00. A and B decide to keep up 
 the payments on both contracts. Is this decision wise ( a ) in the case of 
 the legal reserve policy ? ( b ) in the case of the fraternal benefit certifi¬ 
 
 cate ? 
 
LIFE INSURANCE 
 
 287 
 
 In the case above cited, three years after the brothers assume responsi¬ 
 bility for the premium payments, A proposes to B to sell his interest in 
 the fraternal policy. C is still in good health. The following bargain 
 is struck: B is made sole beneficiary. B is to pay A the present worth 
 of half the face of the policy, discounted at an agreed rate of interest for 
 the term of C’s life expectancy as shown by the American Experience 
 Mortality Table, less the present worth of the premiums on the half 
 policy which would fall due within said life expectancy. 
 
 Is this a fair bargain ? If not, what other factors should be taken 
 account of to determine a fair price for A’s interest ? 
 
CHAPTER XIV 
 
 FIRE INSURANCE 
 
 Of the various types of property insurance, fire insurance is much 
 the most important from the standpoint of the amount of insurance 
 written and the number of individuals protected. The usual types 
 of fire insurance transaction will therefore be discussed in some detail, 
 leaving other kinds of property insurance to be dealt with more briefly 
 in chapter xv, chiefly by comparison of their practice with that of 
 fire insurance. 
 
 The subject-matter of this chapter will be discussed in accordance 
 with the following outline: 
 
 I. The risk insured 
 
 II. Policy contracts 
 
 III. Special provisions in insurance contracts 
 
 1. The mortgage clause 
 
 2. Coinsurance 
 
 3. Three-quarter loss clauses; three-quarter value clauses 
 
 4. Use and occupancy, profit, and rent insurance. 
 
 IV. Company organization 
 
 1. Stock companies 
 
 2. Mutual companies 
 
 3. Lloyds associations 
 
 4. Reciprocal insurance 
 
 V. Rates and rate-making 
 
 1. Methods of rating: judgment, schedule, experience rating 
 
 2. Rate schedules: the Universal Mercantile; the Dean 
 
 I. THE RISK INSURED 
 
 The risk covered by fire insurance, the hazard of loss from the 
 destruction of property by accidental or incendiary fire, is one of the 
 most serious risks with which business has to contend. The extremely 
 destructive character of accidental fires, the frequency with which 
 they occur, the irregularity in the incidence of the loss, and the con¬ 
 stant change in the character of the hazard combine to make the prob¬ 
 lem of elimination of fire risk one of the most difficult in the whole 
 field of business. The advance of civilization has brought about a 
 great improvement in the techniques of fire prevention and the fight- 
 
 288 
 
FIRE INSURANCE 
 
 289 
 
 ing of fires, but it has also brought in innumerable new hazards. 
 Each change in the methods of heating, lighting, building, in the kind 
 of power used in manufacture, in the methods of transportation 
 employed, in short, in almost any phase of the industrial and com¬ 
 mercial life, brings new hazards. The substitution of electric lighting 
 for kerosene lamps reduced the number of fires, but it resulted in a 
 larger proportion of very destructive fires, because fires resulting from 
 faulty wiring are more likely to remain undiscovered till they have 
 gained headway. Railway transportation brought in the hazard of 
 fires from sparks; automobile transportation is bringing new hazards 
 from the storage of fuel. The transition of the United States from a 
 rural to an urban civilization made possible a great improvement 
 in fire protection and encouraged more substantial construction, but 
 led to a concentration of risks. The net result was, on the one hand, 
 to bring about a great increase in the proportion of trifling fires, and, 
 on the other hand, to increase the hazard of conflagration. The fire 
 loss fluctuates widely from year to year and from community to 
 community, some of its vagaries being quite inexplicable. 
 
 There is a striking parallel between the fire loss and the cost of 
 depreciation. Both the deterioration due to weathering and the 
 loss due to fire are inevitable costs of doing business. Both involve 
 the ultimate destruction of the capital exposed to them and hence 
 require the occasional investment of large sums for replacement pur¬ 
 poses. The most important difference between them is that depre¬ 
 ciation goes on at a rate sufficiently uniform to enable a fairly accurate 
 calculation of the time at which the replacement will be necessary 
 while fire loss is highly irregular. Hence, it is more practicable to 
 make provision for depreciation through setting aside annually a 
 designated sum out of earnings. If the amount of a corporation’s 
 property exposed to fire is great enough and the sweep of time involved 
 in the calculation extensive enough, it is possible to make provision 
 for destruction by fire in the same way. The number of risks and the 
 range of time involved in most men’s calculations, however, are not 
 great enough to make such replacement practical, hence the payment 
 of insurance by numerous firms into a common fund is necessary in 
 order to equalize the burden. Like the depreciation charge, the insur¬ 
 ance premium is an annual contribution out of the gross income for 
 the replacement of wasting capital, and through the medium of insur¬ 
 ance, or through the diversification which is occasionally possible, an 
 analogous degree of regularity in its incidence is secured. 
 
2QC 
 
 RISK AND RISK-BEARING 
 
 The principal elements which make up the fire hazard on any 
 property are the construction, the occupancy, the protection, the 
 exposure, and the moral hazards. Construction and occupancy are 
 self-explanatory. The chief points of importance in connection with 
 construction are the combustibility of materials and the readiness with 
 which flames can spread from one part of the building to another. 
 Occupancy, so far as the hazard of the building is concerned, is chiefly 
 important from the standpoint of the tendency of the processes 
 carried on to cause fires to originate, though the tendency of the con¬ 
 tents to transmit fire readily is also an important factor. In insuring 
 the contents of a building, attention must also be given to a third 
 factor, the extent to which the contents are susceptible to damage 
 either from fire or from smoke, water, dirt, and exposure incident to 
 removal on account of fire. 
 
 “Protection” is the term appliedito the facilities available for stop¬ 
 ping the progress of fires. It includes both the public fire-fighting 
 service and the provision made in connection with the property itself, 
 such as automatic sprinklers, fire pails, services of watchmen, etc. 
 
 The term “exposure” refers to the risk of damage through fire 
 originating outside. Nearly 30 per cent of fires are due to exposure; 
 hence careful attention must be given to such factors as distance from 
 neighboring buildings, location of windows, character of processes 
 carried on in adjacent buildings, and similar sources of risk. 
 
 One phase of the exposure hazard is of so much importance as to 
 deserve special discussion. This is the so-called conflagration hazard, 
 the risk of a fire so serious as to outrun the fire fighting facilities of a 
 city and burn itself out without effective opposition. The distribu¬ 
 tion of the loss due to conflagrations constitutes one of the most diffi¬ 
 cult problems in insurance policy. Conflagrations do not occur with 
 sufficient frequency or regularity do make possible an accurate esti¬ 
 mate of the amount of loss which may be anticipated on account of 
 them. The period of time required to determine the statistical fre¬ 
 quency of so infrequent a phenomenon as a two million dollar fire is 
 so great that before sufficient data can be assembled conditions change 
 and the earlier experience becomes valueless. Before every great 
 conflagration in recent years, it has been argued that the improvements 
 in fire protection and the regulation of building construction had so 
 reduced the conflagration hazard of the larger cities as to make it 
 negligible. During the past few years, comparative immunity has 
 in fact been obtained, but it will be many years before it can safely be 
 
FIRE INSURANCE 
 
 291 
 
 said that experience has confirmed the conclusions of those who deny 
 the continued significance of the conflagration hazard. 
 
 It is almost impossible to make satisfactory provision for meeting 
 this kind of fire risk. Fire insurance rates, as a whole, are based on 
 regional experience, and the experience of most sections of the country 
 has not included a conflagration so recently that its effect shows in 
 the tables of average losses. Sections which have had conflagrations, 
 on the other hand, object to having their.rates based on the heavy 
 loss ratio which results from averaging in the conflagration losses 
 with the minor losses which occur from year to year, arguing rightly 
 that the fact of a conflagration’s destroying the major part of a given 
 city does not create a presumption of a heavier loss ratio in succeeding 
 years for the whole state or other geographical subdivision in which 
 the city happens to be located. Moreover, if rates were so adjusted 
 as to take care of the full risk of loss due to conflagration hazard, and 
 no conflagration occurred for many years, it would be difficult to pre¬ 
 vent stockholders, buyers of insurance, and taxing bodies from drawing 
 the conclusion that the large excess t revenues resulting from the high 
 rates were a profit available for distribution as dividends. The only 
 way companies can protect themselves is to keep their risks so scat¬ 
 tered that no single conflagration can wipe out their surpluses, then 
 if heavy losses are incurred charge them to surplus as business losses. 
 Usually, after a great conflagration, a number of companies go into 
 bankruptcy, thereby throwing part of the loss on policyholders, and 
 frequently rates are raised for a time to enable the surviving companies 
 to recoup themselves. This is quite justifiable, so far as urban proper¬ 
 ties are concerned, but the increasing of rates on rural property, not 
 subject to conflagration hazard, in order to take care of the losses due 
 to a great conflagration, involves a real injustice. 
 
 The moral hazard includes both the danger of deliberate destruc¬ 
 tion of property, caused either by the owner, in order to collect insur¬ 
 ance, or by others out of spite, and the hazard due to carelessness. 
 The moral hazard is greater in fire insurance than in most kinds of 
 insurance, because of the ease with which property can be burned, and 
 the difficulty with which companies are able to protect themselves 
 by preventing overinsurance. Only a small proportion of insured 
 properties are inspected to guard against overinsurance at the time 
 policies are taken out, and even where this is done there is great diffi¬ 
 culty in precluding the later appearance of overinsurance through 
 depreciation of buildings, price changes, decline of prosperity of the 
 
292 
 
 RISK AND RISK-BEARING 
 
 community or of the individual concern, or changes in building or 
 contents made by the owner. Hence, there is a constant temptation 
 to policyholders to recoup their business losses or rid themselves of 
 unsalable property by arson, and a still greater temptation to neglect 
 precautions which would probably be taken if the fire hazard repre¬ 
 sented a real risk to the owners. 
 
 The importance of the moral hazard is easily exaggerated, how¬ 
 ever. Its importance does not consist in the number of fires which 
 are caused through moral shortcomings, but rather in the necessity 
 of constant watchfulness and effort to prevent an increase in their 
 number. Unless nearly all the fires due to unknown causes (usually 
 about 15 per cent of the total) are due to incendiarism, the proportion 
 of losses due directly to moral hazard is relatively small. 1 
 
 What risks are insurable ? As was noted in chapter xiii, the the¬ 
 ory of insurance is that the effect of the contract is to relieve the insured 
 from the risk of financial loss due to the event insured against, and not 
 to guarantee him a certain sum of money inthe event of certain things 
 happening. In fire insurance this is known as the doctrine of indem¬ 
 nity. On account of the great moral hazard in this type of insurance, 
 it is especially important that the insured be not given an opportunity 
 to profit by the occurrence against which insurance is sought. The 
 results of this situation are, first, a strict application of the requirement 
 of insurable interest on the part of the insured; second, strict pro¬ 
 vision that overinsurance shall not create a claim for compensation 
 in excess of the loss actually sustained, even in the event of total loss; 
 third, the concept of insurance as a personal contract, designed to off¬ 
 set a given individual’s personal risk, and not transferable except with 
 the express permission of the insurer. 
 
 The doctrine of insurable interest means simply that the insured 
 shall have an actual financial interest in the event insured against. 
 If such interest exists, it is immaterial whether the insured is the actual 
 owner of the property or not. Insurable interest includes those of 
 mortgagees, tenants, agents, common carriers, warehousemen, con¬ 
 tractors, receivers, and many others. 2 
 
 If insurable interest does not exist the contract creates a specula¬ 
 tion on the part of the insured. As has been noted previously, such 
 
 1 About 10 per cent of fires are attributed to incendiarism. It is frequently 
 stated that industrial depressions cause an increase in the fire loss, which is appar¬ 
 ently due to the decline in value of property and the increased financial pressure. 
 The statistics of fire losses afford little support for this line of reasoning, however. 
 
 2 For detailed analysis see Huebner, Property Insurance, chap. iii. 
 
FIRE INSURANCE 
 
 293 
 
 a speculation is always unfavorable to the insured and favorable to 
 the insurer, unless the insured either has knowledge superior to that of 
 the insurer or has the power to control the outcome. In tornado 
 insurance, the insurance companies can well afford to write insurance 
 in unlimited amount, if their rates are properly adjusted and their 
 risks are well scattered. But in fire insurance the insured often has 
 superior knowledge of certain elements of risk and nearly always has 
 some opportunity to exert control over the outcome; hence, it is 
 extremely important that his interest in the policy be limited to the 
 amount which he actually has at risk. 
 
 This limitation is regularly secured by the contractual stipulation 
 that in the event of total loss only such amount shall be payable as 
 represents the actual value at the time of the fire. In some states, 
 however, this provision has been set aside by the enactment of what 
 are known as valued policy laws. The effect of such a law is to require 
 the insurance company, in case of a total loss, to pay the full amount of 
 the policy, irrespective of the question whether the property was 
 worth that much or not. Thus it puts the burden on the insurance 
 company, in cases where overinsurance is claimed, to prove actual 
 fraud instead of leaving open the easier defense of disputing the value 
 of the property. 
 
 Such legislation is strongly opposed by insurance companies and 
 by insurance authorities generally, on the ground that it is a deliberate 
 encouragement to overinsurance and to the wilful destruction of 
 property. Advocates of such legislation, on the other hand, contend 
 that in the absence of a valued property law, insurance companies 
 can collect premiums for excess insurance, keep the premiums in the 
 cases where no loss occurs, and in cases where the property is actually 
 destroyed, evade the payment of part of the face of the policy by 
 raising the issue of overinsurance and refunding the excess premium. 
 
 There is a certain amount of force in this contention, but since 
 no one is under obligation to take out more insurance than he has 
 reason to think he can collect in the event of total loss, the insurance 
 company has the better case. Valued policy laws, undoubtedly, 
 increase the moral hazard, and do not carry with them sufficient com¬ 
 pensating advantages to justify their enactment. 
 
 The third result of the concept of insurance as indemnity is to make 
 it strictly a personal contract, by which is meant that the insurance 
 company assumes responsibility only for the loss accruing to a desig¬ 
 nated individual or firm. Hence, in the event of a sale or other change 
 
294 
 
 RISK AND RISK-BEARING 
 
 of interest on the part of the insured, the insurance never follows the 
 property, and may be assigned only with the written consent of the 
 insurer. Such provisions are especially necessary in types of insur¬ 
 ance, like fire insurance, where the moral hazard is great, but their 
 application is not limited to those particular types. 
 
 Who needs fire insurance? All who own property subject to 
 damage by fire have a risk to carry, but not all such individuals can 
 wisely cover this risk by insurance. As in all types of insurance, it is 
 necessary that the insured group, as a whole, shall pay into the insur¬ 
 ing organization more than they withdraw in payment of losses. The 
 economic value of the institution arises from the two circumstances: 
 first, that a single large loss is apt to be more disastrous than an equiva¬ 
 lent amount lost in a series of small items, and second, that an unex¬ 
 pected loss is apt to be more serious in its effects than one which is 
 known and planned for in advance. 
 
 The advisability of a given individual’s carrying any sort of prop¬ 
 erty insurance depends entirely upon the proportion between the prob¬ 
 able amount of his loss, in case luck runs against him, and the total 
 resources from which the loss, if it occurs, will have to be subtracted. 
 This comparison reduces itself chiefly to a question of the extent to 
 which one’s resources are concentrated so as to be exposed to the hazard 
 of a single disaster. It is not at all a question of the financial strength 
 of the property owner, except in so far as greater financial strength 
 increases the probability that one’s resources will be scattered. A 
 corporation which owns $1,000,000 worth of inflammable goods, all 
 under a single roof, cannot afford to leave them uninsured any more, 
 nor any less, than can an individual who has only $1,000 worth of 
 goods, all under the same roof. In each case, the loss which is rea¬ 
 sonably probable is sufficient to wipe out the capital and interrupt 
 the course of business, causing, in addition to the direct damage a loss 
 of good will and destruction of earning capacity. Even though, in a 
 series of years, the amount paid in by the insured in premiums exceeds 
 the amount which could have been lost by a single fire, the prevention 
 of these indirect losses makes the transaction worth while. On the 
 other hand, a corporation or individual having $100,000 worth of 
 property scattered in a hundred separate lots, in different cities, has 
 little need for fire insurance, unless some of the units exposed to a single 
 possible fire are disproportionately large. The distribution of risk 
 secured by such holdings is less complete than that secured by a com¬ 
 pany which insures thousands of separate properties, but the loss in any 
 
FIRE INSURANCE 
 
 295 
 
 year is not likely to equal many times the total amount of the premi¬ 
 ums which would have to be paid to secure insurance. The fact that 
 the loss from one fire will be small relative to the total worth of the 
 business means that the company has the same sort of protection from 
 indirect losses that a company with more concentrated resources would 
 have to secure through insurance. Whenever the property owner 
 can put in sufficient outside capital to replace his property without 
 seriously upsetting his established plans of operation elsewhere, he 
 can avoid the indirect losses at the point where the fire occurs just as 
 well as though he replaced his capital by the investment of money 
 coming from an insurance company. Thus, railway companies have 
 no need to insure their smaller station buildings, though their large 
 city terminals may advantageously be insured. 
 
 Corporations which practice self-insurance, as the practice of 
 carrying one’s own risk is called, should protect themselves against 
 sudden calls for capital to replace fire losses by maintaining reserves 
 in the form of marketable securities or other liquid assets which can 
 be drawn upon for the purpose. 
 
 IT. POLICY CONTRACTS 
 
 One outstanding difference between the situation in fire insurance 
 and that in life insurance is the relative degree of standardization which 
 has been attained. The legal reserve life insurance companies all 
 use the same mortality tables and approximately the same interest 
 rates, and the principal types of contract which are offered by one 
 company are offered by nearly all. The effect of competition, how¬ 
 ever, has been to develop a large number of contracts differing from 
 one another in relatively unimportant details. These details are then 
 used as selling points to establish the superiority of one company’s 
 offerings over those of another. There is a constant stream of new 
 types of disability clauses, double indemnity for accident, variant 
 methods of treating the distribution of dividends, and variant methods 
 of paying the proceeds of the policy. The elements with which the 
 actuary deals are so few that the really important variations in the 
 contract are not numerous, but the exercise of salemen’s ingenuity 
 has sufficed to create an appearance of wide diversity. 
 
 In fire insurance, on the other hand, although the experience of 
 different companies has not been pooled so as to establish any satis¬ 
 factory basis for standardizing the premium charge, the effect of 
 competition has been just the opposite to its effect in life insurance, 
 
296 
 
 RISK AND RISK-BEARING 
 
 namely, to bring about a very high degree of standardization, both of 
 the terms of the policy contract and of the premiums charged. To 
 some extent this standardization has been the result of legislation 
 requiring the use of standard types of policy, but in general the causal 
 influence has operated in the opposite direction. That is, it has been 
 the initiative of the insurance companies which has led to the uniform¬ 
 ity in legislation rather than the legislation which has brought the 
 companies into line. Such diversity in contracts as exists at the pres¬ 
 ent time is due more to the divergence of ideas among legislators and 
 insurance commissioners in different states than it is to a difference 
 in the attitude of insurers themselves. 
 
 This difference in the effect of competition on the form of the con¬ 
 tract is apparently due to a difference in the attitude of most purchasers 
 of insurances toward the two types of contract. Fire insurance is 
 regarded as a necessity by most property owners, and competition 
 between companies consists largely of a competition between agents 
 to get to the prospective customer first. In life insurance, on the 
 other hand, there is very little spontaneous consumer demand, and 
 insurance is sold not so much by getting to the consumer first as by 
 holding on to him longest. Hence, the possession of a special feature 
 which can be played up as a talking point in making the payment is 
 desirable from the standpoint of the life insurance agent, whose job 
 is primarily one of creating interest, while in the case of fire insurance 
 a divergence of the individual policy from that usually written would 
 merely create additional work for the salesmen in explaining the varia¬ 
 tion to a customer who is ready to buy before he is approached. 
 
 Whatever the explanation, the tendency toward extreme standard¬ 
 ization in the fire insurance contract is very clear. The policy most 
 frequently written is the New York standard policy, which has been 
 adopted without material modification in most states. The principal 
 provisions of this policy may be summarized as follows: 
 
 1. As previously noted, the policy insures only against damage 
 sustained by the insured or his legal representatives. 
 
 2. The policy covers loss sustained by fire and by removal of goods 
 from premises endangered by fire, but does not cover currency, deeds, 
 accounts, money, notes, or securities, nor does it cover damages caused 
 directly or indirectly by invasion, insurrection, riot, and similar dis¬ 
 turbances. 
 
 3. The policy is rendered void by the placing of other insurance on 
 the same property without the consent of the insurer. This provision 
 is not intended to discourage the distribution of insurance between 
 
FIRE INSURANCE 
 
 297 
 
 different insurers, but simply to enable the insuring companies to keep 
 track of the amount of insurance outstanding. Permission to place 
 other insurance is always given as a matter of course unless its effect is 
 to increase the total amount beyond what the insurers consider con¬ 
 servative limits. 
 
 4. The insurance company is relieved from liability during the 
 continuance of certain conditions which operate to increase the hazard, 
 including alterations of the building (requiring more than fifteen days 
 for completion), storage of certain inflammable compounds, operation 
 of factory buildings at night, vacancy of building beyond ten days, 
 and, in general, any condition known to the insured which increases 
 the hazard beyond that contemplated when the amount of premium 
 was agreed upon. 
 
 5. Both parties to the contract reserve the right of cancellation 
 at will. In case the contract is canceled by the insurance company 
 the insured is entitled to return of the full proportion of premium not 
 yet earned, but in case of cancellation by the insured he is entitled only 
 to the difference between the premium he has paid and the “short 
 rate” for the period during which protection has been enjoyed. 
 
 6. In case property at the time of damage is covered by more than 
 one policy, the loss is divided among the insurers in proportion to 
 their total liability. In case some of the insurers are unable to meet their 
 liability, which is likely to be the case in the event of conflagration, 
 the other insurers are liable only for their proportion of the total, not 
 simply the collectible insurance. 
 
 7. The insurance company is entitled to an assignment of any 
 rights of recovery the insured may possess against any party for loss 
 or damage, to the extent that payment is made by the company. 
 This is known as subrogation. 
 
 8. Detailed provisions, which need not be summarized here, 
 establish the requirements in case of loss, including notice, proof of 
 loss, protection of salvaged property, appraisal, method of payment, 
 etc. The company reserves the option, rarely used, of replacing the 
 property instead of paying the loss, but the insured does not have the 
 option of abandoning the property to the company and claiming a 
 total loss. 
 
 The indorsement which fits the standard policy to the conditions 
 of a particular risk is known as the rider form. This indorsement 
 includes the name of the insured, the character of his interest in 
 the property, and the description of the property insured. These 
 forms are standardized, to a large extent, and serve as the basis 
 
298 
 
 RISK AND RISK-BEARING 
 
 of a classification of policies according to the character of the coverage. 
 A specific policy covers a definite item or group of items in a definite 
 place. A general policy covers different kinds of property in a specific 
 place, the amount of each being specified. A blanket policy covers 
 different kinds of property or property in different places under one 
 item, the amount of each remaining unspecified. A distribution clause 
 in a blanket policy provides that in the case of two or more lots not 
 subject to the same hazard the insurance shall apply to each lot in the 
 proportion that its value bears to the value of the entire group of items 
 covered. A floating policy follows goods in transit. An excess floater 
 indemnifies the owner to the extent that specific insurance carried 
 may at the time of the loss be insufficient to cover the amount of the 
 loss. It may apply at one or at several locations. 
 
 III. SPECIAL PROVISIONS IN INSURANCE CONTRACTS 
 
 To the standard policy, standardized riders may be attached 
 covering such matters as the protection of the mortgagee, protection 
 against gas explosions, permission to store kerosene, gasoline, and 
 other inflammable commodities upon the property in excess of the 
 amount permitted by the standard policy, vacancy permits, etc., and 
 special modifications may be made to take care of matters not covered 
 by the standard policy. Of these special provisions some of the most 
 important are the following: 
 
 The mortgage clause .—There are several ways in which the 
 interests of a mortgagee may be protected. He may himself take out 
 insurance to protect his own interest; he may receive an assignment 
 of the insurance from the mortgagor; or he may be protected by 
 indorsement of the policy creating a claim in his behalf. The legal 
 effect of these various devices has been interpreted quite differently 
 in different jurisdictions, and as a result there has been developed a 
 standardized mortgage clause, which is generally considered the most 
 satisfactory method of protecting the interests alike of mortgagor 
 and mortgagee. This clause provides, first, that the insurance shall 
 be payable to the mortagee, as his interest may appear; second, that 
 the rights of the mortgagor shall not be invalidated by any act of 
 the mortgagee, nor by change of title, increase of hazard, failure of 
 payment of premium; third, that the mortgagee must on demand pay 
 any premiums which are not paid by the owner, and shall notify the 
 company of any change in hazard or condition voiding the policy which 
 comes to his knowledge and pay any increased premium necessitated 
 by such conditions; fourth, that in case of cancellation of the policy by 
 
FIRE INSURANCE 
 
 299 
 
 the insurance company the mortgagee is entitled to ten days’ notice, 
 
 instead of the five days’ notice required in other cases of cancellation. 
 
 These provisions seem extraordinarily favorable to the mortgagee and 
 
 unfavorable to the insurance company, but they are almost necessary 
 
 if the mortgagee’s interest is to be protected, since it is impossible for 
 
 *■ 
 
 him to control all the conditions which may operate to invalidate a 
 policy, when the property is in the hands of the mortgagor. In other 
 words, there is a large element of risk against which neither the insur¬ 
 ance company nor the mortgagee can guard; the effect of this clause 
 is to put this class of risks on the insurer so long as the mortgagor acts 
 in good faith. In case the clause operates to create a claim on behalf 
 of the mortgagee under a policy which would not be valid against the 
 mortgagor, the insurance company is subrogated to the claim of the 
 mortgagee against the mortgagor, to the extent of the amount it has 
 paid. In other words, if the insurance company has to pay a debt for 
 a debtor who has not complied with the conditions necessary to keep 
 his policy in force, the insurance company succeeds to the mortgagee’s 
 position as a creditor. On the other hand, if payments are made under 
 this clause to a mortgagee under a policy which is fully valid, the debtor 
 is entitled to have such payments credited as payments on the debt 
 which the mortgage secures. 
 
 Coinsurance .—Coinsurance is a device adopted to protect insur¬ 
 ance companies from a kind of adverse selection which arises in com¬ 
 munities where most losses are partial. Under this clause the insured 
 property owner can collect for partial losses only in the proportion that 
 the insurance actually carried by him bears to a certain percentage of 
 the value of the property. Insurance to the amount of this required 
 percentage is nominally required, but the policyholder is under no 
 compulsion to buy it; if he carries a smaller amount he is himself a 
 coinsurer for the balance up to the stipulated percentage. The effect 
 of the clause may be illustrated by the following cases: 
 
 Value of Property 
 
 Coinsurance 
 
 Clause 
 
 Insurance 
 
 Carried 
 
 Loss 
 
 Amount 
 
 Collectible 
 
 $10,000. 
 
 Per Cent 
 
 80 
 
 $4,OOO 
 
 $1,000 
 
 $ 500 
 
 10,000. 
 
 80 
 
 4,000 
 
 7,500 
 
 3,750 
 
 10,000. 
 
 80 
 
 4,000 
 
 8,000 
 
 4,000 
 
 10,000. 
 
 80 
 
 4,000 
 
 9,000 
 
 4,000 
 
 10,000. 
 
 80 
 
 8,000 
 
 1,000 
 
 1,000 
 
 10,000. 
 
 80 
 
 8,000 
 
 9,000 
 
 8,000 
 
 10,000. 
 
 IOO 
 
 4,000 
 
 1,000 
 
 400 
 
 10,000. 
 
 IOO 
 
 4,000 
 
 9,000 
 
 3,6od 
 
300 
 
 RISK AND RISK-BEARING 
 
 In case of total loss, the coinsurance clause has no effect on the amount 
 payable. 
 
 The argument in favor of the clause is briefly as follows: In 
 cities where there is good fire protection, and particularly in buildings 
 where parts of the property are separated by fireproof walls, the prob¬ 
 able amount of the loss from a given fire is not large in proportion 
 to the value of the property. In fact, taking the experience of 
 insurance companies throughout the country into consideration, the 
 proportion of total losses is not above 5 per cent, and in centers where 
 the insurance protection is good it runs much below that figure. In 
 the absence of a coinsurance clause, the effect of this large proportion 
 of partial losses is to make partial insurance nearly adequate to pro¬ 
 tect the property owner, and to make additional insurance after the 
 probable loss has been covered extremely expensive in proportion to 
 the risk. If, for instance, an individual insures property worth $10,000 
 for $3,000, he is protected fully against probably three-fourths of the 
 hazards his insurance is intended to cover. Another $3,000 insurance 
 is much less expensive for the company to furnish and protects him 
 against a much less serious risk. The additional $4,000 necessary to 
 protect his property fully, protects him against a still more remote 
 hazard, in many cases against little more than the risk of conflagration, 
 
 A more logical method of meeting this situation would be to split 
 the risk, charging a different rate for successive increments of insurance 
 so that a small policy would be paid for in proportion to the risk it 
 imposed upon the insurer. 1 A coinsurance clause accomplishes the 
 same purpose in a simple way by making it practically necessary for 
 the insured to take out a sufficient amount of insurance to satisfy the 
 requirements of the underwriters. 
 
 The commonest form of coinsurance is probably the 80 per cent 
 clause, although requirements run all the way from 40 to roo per cent. 
 
 When property covered by blanket policies is scattered in dif¬ 
 ferent localities or the contents of a given building are stored in 
 compartments entirely separated from one another by fireproof 
 walls, the case for coinsurance is the strongest. No company could 
 afford to write blanket insurance without some sort of protective 
 clause on property stored in this way. Before the introduction of the 
 coinsurance clause, it was the practice to require a separate specific 
 insurance on each compartment, but this was awkward and it was 
 frequently the case that property was shifted so frequently from one 
 
 1 This method is used in insuring fireproof buildings, under the Universal 
 Mercantile Schedule. 
 
FIRE INSURANCE 
 
 3 QI 
 
 compartment to another that it was impossible to adjust the premiums 
 and the losses equitably. This was especially true in the case of manu¬ 
 facturing enterprises where the raw materials went in process from one 
 section of the plant to another. 
 
 The coinsurance clause is compulsory in many European countries, 
 but in this country it has not been made compulsory and in many states 
 has been prohibited by law or discouraged through administrative 
 rulings. 
 
 Three-quarter loss and three-quarter value clauses. —The hazard 
 involved in insuring rural property is quite different from that con¬ 
 nected with urban risks. The chief difference arises from the fact that 
 the proportion of total losses is much greater in the case of rural prop¬ 
 erty. This is true because frame construction is more common in 
 rural than in urban architecture, because farm buildings are more 
 likely to be left unobserved long enough for a fire to gain headway, and 
 most important of all because of the lack of fire protection. Thus the 
 moral hazard is rendered more serious in the case of rural than with 
 urban property, for it is only in the case of total losses that there is 
 much danger of the company’s being called upon to pay materially 
 more than the amount actually lost. 
 
 The result of the circumstances just outlined is that instead of 
 encouraging full insurance by coinsurance clauses and similar devices 
 the primary interest in rural insurance is to keep the amount of insur¬ 
 ance relatively low in proportion to the value insured. In regions 
 where insurance experience has been unfavorable and the proportion 
 of total losses is high, insurers find it desirable to include in policies a 
 clause limiting liability to three-quarters the value of the property, 
 or in still more drastic form, to three-quarters the amount of the loss. 
 
 Use and occupancy , profit, and rent insurance: —As has been noted, 
 the standard fire insurance policy covers only the destruction and 
 damage which result directly from fire, or from efforts to extinguish 
 fire or rescue property from its effects. It does not provide for the 
 personal or business losses which may result from interruption of the 
 use of the property. Yet these indirect losses are of considerable 
 volume, occasionally indeed almost as significant as the direct loss 
 of property. If, for instance, a canning factory is destroyed by fire 
 at the beginning of its active operating season and the full value is 
 promptly paid by the insurance company, the delay incident to 
 investing the proceeds in a new building and new equipment will 
 probably mean the loss of an entire year’s profits together with the 
 indirect costs incident to maintaining the organization during the 
 
302 
 
 RISK AND RISK-BEARING 
 
 period of interrupted production. Likewise, the destruction of a 
 merchant’s stock of goods, even though the goods are replaced within 
 a reasonable time, may well mean the loss of one turnover from the 
 year’s business. 
 
 To provide for such indirect losses as these, a number of special 
 types of insurance have been devised which may be attached to the 
 standard policy, or may be written as separate policies. Use and 
 occupancy insurance, or as it is sometimes more clearly designated, 
 “business interruption insurance,” is written on buildings, and 
 provides protection (a) against the loss of anticipated profit on goods, 
 the production of which is prevented by the occurrence of a fire; 
 ( b ) against the loss of fixed charges and expenses necessarily continued 
 during such interruption; but, (c) not to exceed a specified proportion 
 (usually 3^) of the amount of the use and occupancy insurance 
 for each working day lost. Fixed charges and expenses include, for 
 purposes of this type of insurance, not only ordinary salaries, rentals, 
 and maintenance of property, but also such items as taxes, interest, 
 insurance premiums, royalties, and advertising expense. 
 
 Profit insurance is written on merchandise held for sale, and 
 covers the loss of profit which might reasonably have been anticipated 
 from the sale of the goods destroyed. A similar policy is written to 
 protect commission merchants against the loss of commissions on 
 goods consigned to them. 
 
 Rent insurance is written in a variety of forms. It includes 
 insurance to protect a landlord against the loss of income during the 
 period when his property is untenable on account of fire; “leasehold 
 insurance,” payable to a tenant to protect him against the risk of 
 having to pay higher rental during an interruption of his tenure of 
 property held under lease, or to protect his profits from subleasing; 
 and “rental value insurance,” which protects an owner occupying 
 his own building against the risk of having to pay rent elsewhere 
 while his building is being repaired or rebuilt. 
 
 Use and occupancy, rent, and profit insurance are increasing rapidly 
 in popularity; a further increase in their use seems probable, as they 
 become better known, for they furnish protection against a hazard 
 which is quite as inescapable as is the fire hazard itself. 
 
 IV. COMPANY ORGANIZATION 
 
 Stock companies .—The dominant type of fire insurance organiza¬ 
 tion is the ordinary stock corporation, organized for profit. It is 
 
FIRE INSURANCE 
 
 303 
 
 customary to combine the business of fire insurance with marine insur¬ 
 ance, and frequently other types of property insurance are also written. 
 
 As in life insurance, it is customary to accumulate a large surplus 
 to serve as a secondary reserve against extraordinary losses, and in 
 the case of old companies this surplus may come to be much larger 
 than the capital stock. In the early history of a company, no great 
 amount of capital is needed, and under ordinary conditions it is pos¬ 
 sible to expand the surplus out of earnings as fast as the capital needs 
 expand. The chief function of the surplus is to provide a reserve for 
 the conflagration hazard, which is a much more serious hazard than 
 the corresponding catastrophe hazard in any other form of insurance 
 (except crop insurance). 
 
 Just as is the case in life insurance, the insuring company is required 
 to hold reserves against its policies, which are not the property of the 
 company, but of the policyholders. In the case of an insurance com¬ 
 pany, it is not considered necessary, however, to keep a separate 
 account of the reserve on each policy. The reserve consists simply 
 ot the premium paid in advance for which no protection has yet been 
 given; hence can be computed for the group of similar policies, as a 
 whole, more readily than it can be done in life insurance policies, 
 where the reserve arises from excess premiums paid in to secure low¬ 
 ered rates many years in the future. The usual custom is to treat all 
 policies issued in a given fiscal year as though they were issued at the 
 beginning of that year; that is, to hold at the end of the year a reserve 
 of one-half the premium against all one-year policies issued during the 
 current year, three-fourths against two-year policies issued during the 
 year, one-fourth against two-year policies issued during the pre¬ 
 ceding year, and so on. This method works out slightly in favor of 
 companies which are expanding rapidly, as more than half of each 
 year’s business is likely to be done in the last half of the year, so the 
 amount actually due policyholders as unearned premium is somewhat 
 larger than the reserve figured on the customary basis. 
 
 Mutual insurance companies .—The two most important groups 
 of mutual fire insurance organizations are the farmers’ mutuals and the 
 factory mutuals. 
 
 The Farmers’ Mutuals constitute one of the best examples of co¬ 
 operative enterprise in the distribution of risks. There are about two 
 thousand of these organizations in the United States, the usual scope 
 of their operations varying from a township to several counties. Their 
 organization is very simple, there being, as a rule, only one or two paid 
 
304 
 
 RISK AND RISK-BEARING 
 
 officials who look after the accounting, collections, settlements, etc., 
 while an executive committee which receives only a nominal compensa¬ 
 tion passes on application for insurance and decides matters of policy. 
 The method of operation in some cases is to collect the regular premium 
 charged by the stock companies, and then make rebates to members 
 on the basis of the percentage saved. In other mutuals no premiums 
 are collected and assessments are made to meet claims of policyholders. 
 Members often give notes for a fixed sum, which is the limit of their 
 liability. 
 
 In nearly every case, the insurance written is limited to three- 
 fourths or two-thirds the value of the property insured. This cir¬ 
 cumstance, together with the fact that the members are usually well 
 acquainted with one another’s business, makes the moral hazard very 
 low, especially in those mutuals which confine their operations to a 
 unit as small as one county. Few men are as ready to try to throw 
 an illegitimate loss on the shoulders of their neighbors as to impose it 
 on a distant, wealthy, and impersonal stock insurance company. 
 
 While many farm mutuals have failed, the showing of the group, 
 as a whole, is creditable. In states where this type of insurance is 
 highly developed, the mutuals have effected for their members’ savings 
 amounting to more than half the rates charged by the stock companies. 
 This saving is due in part to the lower loss ratio, due to superior 
 inspection and lower moral hazard, and in part to the economy of 
 operation. Just as is the case with fraternal life insurance, the sell¬ 
 ing costs have been, in large part, eliminated by the co-operative efforts 
 of the members. Mutuals have also, in most cases, received special 
 favors from the state in the form of tax exemption. Moreover, the 
 homogeneous character of the risks they insure enables them to avoid 
 the expense of maintaining rating bureaus, compiling experience of loss 
 on different types of property, and other expense connected with the 
 making of rates. Finally, it is probable that in many cases the owner 
 of farm property has been charged a rate disproportionate to that 
 charged upon certain classes of urban property. Farm mutuals, by 
 isolating their own class of risks, have been enabled to secure insurance 
 at rates which give them the full benefit of their immunity from con¬ 
 flagration hazard, while their use of the three-quarter value clause has 
 freed them from much of the disadvantage resulting from the high 
 proportion of total losses which characterizes farm property insurance. 1 
 
 1 Cf. V. N. Valgren, “Farmers’ Mutual Fire Insurance,” Year Book of the 
 Department of Agriculture , 1916, pp. 424-28. 
 
FIRE INSURANCE 
 
 305 
 
 Factory mutuals .—Outside the field of rural insurance the most 
 important application of the mutual principle in fire insurance is in 
 the field of factory protection. The cotton-mills of New England 
 have been particularly successful in reducing the cost of their fire pro¬ 
 tection through mutual insurance. The plan of organization is similar 
 to that of the farmers’ mutuals described above. The factory mutuals 
 have not only effected great reductions in the cost of insurance through 
 economies of operation, but have been of especial value on account of 
 the service they have rendered in reducing the actual fire hazard. 
 The leading factory mutuals co-operate to maintain an elaborate 
 inspection service and set a very high standard of fire protection. It 
 is said that their activities have transformed some of the worst of fire 
 traps into the safest kind of buildings in America. As a rule the 
 factory mutuals collect the same premium that the stock companies 
 charge, then make rebates of the unused premiums. These rebates 
 frequently run to 50 per cent of the premium. 
 
 Lloyd's .—A Lloyd’s Association is a voluntary association of indi¬ 
 vidual insurers who divide among themselves the risk under insurance 
 contracts, the number of individual insurers and the proportion of risk 
 taken by each being determined separately for each transcation. The 
 Association itself does not write insurance; it simply furnishes a place 
 of doing business, establishes a standard form of policy, arbitrates 
 disputes, and looks after matters of mutual interest to the members. 
 
 The policy written at Lloyd’s is very simple and has been the 
 subject of much less litigation than is the case with other types of fire 
 insurance policy, for the reason that it is the regular practice for no 
 insurer to assume liability for an amount large enough to justify his 
 disputing a claim except in cases where the claim is obviously unjusti¬ 
 fied. Proposals for insurance are made to the insurers through 
 brokers, and the insurers sign for such amount as each of them sees 
 fit to accept at the price agreed upon. In case any insurer repents 
 of his bargain, he is free to reinsure, and often does so at a much higher 
 premium, thus passing on the risk or distributing it over a wider group 
 of insurers. 
 
 By far the most important of the Lloyd’s Associations is the origi¬ 
 nal London Lloyd’s, which is primarily an association for insuring 
 marine risks, but includes in its activities insurance against a very 
 wide variety of hazards, including fire. Most of the American Lloyd’s 
 have been of small importance, though there are a number of exceptions. 
 The London Lloyd’s does a large volume of business in this country. 
 
306 
 
 RISK AND RISK-BEARING 
 
 Lloyd’s Associations are especially important as a source of insur¬ 
 ance against unusual hazards which ordinary insurance companies 
 do not care to handle. The insurer at Lloyd’s, being a private indi¬ 
 vidual who sets his own standards, can take chances with novel types 
 of hazard to which a great stock company would find it very difficult 
 to adapt itself. American insurance tradition is particularly hostile 
 to the acceptance of risks of such unique character that no satisfac¬ 
 tory mathematical estimate of the hazard can be made. But English 
 insurers, particularly the insurers at Lloyd’s, have exactly the opposite 
 tradition, and will furnish insurance against almost any contingency. 
 For example, during the Great War, Lloyd’s insurance was regularly 
 written against the war ending, or not ending, before a fixed date. 
 Much Lloyd’s insurance is written against such contingencies as bad 
 weather on holidays, causing loss to tradespeople. A Lloyd’s repre¬ 
 sentative, in a western city a few years ago, worked up a thriving trade 
 in insuring fur coats against fire, theft, accidental damage, and any 
 unfortunate event not due to the will of the owner. One applicant is 
 said to have secured a Lloyd’s policy insuring him against any loss 
 incurred through future damage suits against him for violence he 
 might commit in a fit of anger against one of his family connections. 
 
 Reciprocal insurance .—Reciprocal or interinsurance against fire 
 is a development of the co-operative principle, which is intermediate 
 in character between an ordinary mutual and a Lloyd’s organization. 
 It is like the mutual form in that its members are at the same time 
 insurers and insured, and in some of its forms it differs little from the 
 ordinary factory mutual; in other cases its members are practically 
 Lloyd’s insurers writing policies on one another’s property. The 
 following article describes the reciprocal organization so well that 
 further description is unnecessary: 
 
 A reciprocal or inter-insurance exchange is a place where business con¬ 
 cerns exchange with each other contracts of indemnity against lire and light¬ 
 ning (or other hazard) for certain definite amounts. A is insured by B, C, 
 D, and E. B is insured by A, C, D, and E. C is insured by A, B, D, and E. 
 D is insured, by A, B, C, and E. E is insured by A, B, C, and D. To make 
 the exchange of contracts each applicant for insurance, called a subscriber, 
 gives a power of attorney to a manager, called the attorney-in-fact, who 
 conducts the exchange. Suppose 101 concerns are to make the exchange, 
 each having authorized the attorney to bind it for a sum not to exceed $1,000 
 on each risk. If Concern No. x wishes $110,000 of insurance, it cannot be 
 had, tor f here are only 100 other subscribers. It can get a $100,000 policy. 
 The standard hre policy ot the state in which the applicant resides is written 
 
FIRE INSURANCE 
 
 3°7 
 
 up. At the end of the policy a clause is added specifying the liability of 
 each signer to be one one-hundredth part of the face, or $1,000, and the signa¬ 
 ture of each of the hundred other concerns is affixed by the attorney-in-fact. 
 If Concern No. 2 desires a policy for $25,000, it is signed by each of the other 
 concerns under a final paragraph stating that the liability of each is $250. 
 If there are 412 subscribers and each limits his liability on a single risk to 
 $2,000, the largest policy that can be written is 411 times $2,000, or $822,- 
 000; on a policy for $25,000 the liability of each subscriber would be $25,000 
 divided by 411, which is $60.83. The amount of liability, $100, $250, $500, 
 $750, $1,000, $2,000, $2,500, or $10,000, which a subscriber will assume on a 
 single risk is specified in his power of attorney. 
 
 Subscriber's agreement and power of attorney .—It would be inconvenient 
 for each subscriber to receive and pass on every application for insurance. 
 Therefore each subscriber delegates the power to examine applications and 
 sign policies to the same person, the attorney-in-fact, who is the manager of 
 the exchange. The attorney is thus enabled to do business for all in one 
 place at one time. The instrument which each subscriber gives him is 
 called the “subscriber’s agreement and power of attorney.” The agreement 
 and the power may be separate, but usually they are together in one docu¬ 
 ment. This instrument specifies all the details of the method and prescribes 
 the duties that may be performed for the subscriber by the attorney-in-fact. 
 
 Premiums and expenses .—The premium which is paid in advance to the 
 manager is nearly always the same as is charged by the stock fire insurance 
 companies. The manager’s compensation is a commission on the premiums. 
 "This commission varies according to the character of the business of each 
 exchange. Many exchanges have it fixed at 25 per cent; a wholesale grocers’ 
 exchange operates at 20 per cent; department store exchanges get off at 
 15 per cent or even 10 per cent. What this compensation covers in addition 
 to the services of the manager is illustrated by this quotation from a sub¬ 
 scriber's agreement: 
 
 “It is expressly agreed and understood that they (the managers) shall, 
 out of said compensation, themselves defray all disbursements of every 
 character, except losses, counsel fees, costs and expenses of lawsuits, taxes, 
 legal assessments, expenses of fire control, fees of the advisory committee, 
 and all expenses incident to the investment and custody of funds and securi¬ 
 ties, and of the adjustment of losses.” 
 
 The manager himself pays for rent, salaries, traveling expenses, printing, 
 supplies, etc. All premiums after expenses and losses have been deducted, 
 belong to the subscribers. The most successful group of inter insurers hav£ 
 regularly saved for themselves 85 per cent of their premiums Another group 
 has returned amounts equal to 78 per cent of the premiums received. Some 
 exchanges report savings of 50 per cent, some 25 per cent, while others have 
 failed absolutely and produced net losses to their members. 
 
RISK AND RISK-BEARING 
 
 Separate accounts for each subscriber. —Since the premiums are the prop¬ 
 erty of the separate subscribers (every contract examined declares there 
 are no joint funds), separate accounts with each member are necessary. Two 
 different methods of accounting are used. Plan One. The premium of 
 each subscriber is held in trust for him. Each account is credited with the 
 premium received and with the earnings from the investment of the premium 
 and the accumulated surplus. Each account is debited with its share of 
 expenses and losses. The balance, if there is a credit balance, is the saving 
 of the subscriber from the premium paid. Plan Two. The premium paid 
 by a subscriber belongs pro rata to the other subscribers who have signed his 
 policy. Each account is credited with its share of every premium received 
 and with the earnings from the investment of the credit balances. Each 
 account is debited with its proper share of expenses and losses. The credit 
 balance, if there is one, is profit realized from the business of insuring fellow- 
 subscribers. By this method a subscriber who carries much less insurance 
 than his fellow-members may receive profits greater than his premiums. 
 
 Reserve against unusual losses. —It is a common rule to require that all 
 savings or profits be allowed to accumulate until a surplus equal to double 
 the subscriber’s risk on a single policy is provided. 
 
 Payment of excess losses. —If current losses are so great as to exceed the 
 amount of current premiums and accumulated profits,what is the liability 
 of each subscriber? Some reciprocals place no limit upon their right to 
 assess subscribers. Some provide that each insured shall not pay more 
 than his annual premium on any one risk; some that he shall not pay more 
 than one additional premium on any one risk. Such provisions still leave 
 no limit to the liability for aggregate losses. There is a type of agreement 
 in use, however, that attempts to restrict aggregate losses to the annual pre¬ 
 mium or deposit, by means of payments for reinsurance. The exchanges 
 writing the largest hazards provide that in case of one fire involving several 
 risks the insurance in force must be reduced to make the pro rata liability 
 of each subscriber no more than a multiple of, say, four or five times the 
 liability on each risk. The aggregate liability in the case of many single 
 fires is still, as it should be, unlimited. Usually the subscriber authorizes 
 the attorney, in the event that the surplus is insufficient to pa> losses, to 
 draw on him, and, if necessary, sue him for the amount, provided the maxi¬ 
 mum liability of the subscriber has not been reached. Sometimes the agree¬ 
 ment calls for a flat sum to be paid on demand in case of excess losses. It 
 is always possible to authorize the attorney to insure the subscriber against 
 excess liability. Some of the exchanges provide regularly for the deduction 
 of 5 per cent of the premiums to take care of this cost of reinsurance. Maxi¬ 
 mum liability is the knottiest problem of the reciprocals. Can you limit 
 liability and still have good insurance ? The proper solution is not to weaken 
 insurance by attempting to restrict liability by contract, but to lessen losses 
 bv sound underwriting, and not assume the hazard of conflagration. Here 
 
FIRE INSURANCE 
 
 309 
 
 is one such plan: “It is our policy not to write more than the equivalent 
 of one risk limit in any one city block or square, and not to write more than 
 the equivalent of five risk limits in any city.” When maximum ‘imits ace 
 involved the subscriber must know how many risks are about him. If his 
 contract limits his liability on a single risk to $1,000 and to four times that 
 on a single fire, and there are eight other risks in that area besides himself, 
 he is only one-half insured against conflagration. If there are only four 
 other risks in that area, he is insured to the face of his policy even if a. con¬ 
 flagration occurs. 
 
 Special class insurance .—The big advantage claimed for reciprocal 
 insurance is that it is more economical. How is it possible to insure for less 
 than is charged by the stock companies, the best of which lead the world 
 in insurance ability ? The factory mutuals of New England proved that if 
 only the highest class risks of one kind were studied and accepted the cost 
 could be reduced. This idea is characteristic of the best reciprocals. 
 
 An examination of the risks of reciprocals shows them to be certain 
 special lines such as bank buildings, steam laundries, steam bakeries, lum¬ 
 ber mills, wholesale houses, drug stores, hotels, and department stores. 
 An inter-insurer of hotels and drug stores says: “We write only upon build¬ 
 ings of brick, stone or fireproof construction and the contents therein, in 
 towns or cities with adequate fire protection.” One exchange advertises 
 the following safeguards: “Elimination of moral hazard; wide separation 
 of risks; rigid inspections; thorough equipment of automatic sprinklers— 
 no exceptions.” The manager of another exchange says: “The principal 
 features that make for the success of our insurance are the following: No 
 concern worth less than $125,000 is eligible on account of the assessment 
 feature; in other words, he must be strong enough financially to meet an 
 assessment of $20,000 without flinching, if called upon to do so (no assess¬ 
 ments have been made for twenty years). No application is approved 
 unless the concern is of the highest commercial standing in the community. 
 Our inspection department is a most important adjunct and we maintain a 
 corps of specially trained men at a very heavy expense, who do nothing but 
 inspect our risks from the Atlantic to the Pacific four times a year. Our 
 subscribers, who are not in business to burn, cheerfully cooperate with our 
 efforts to minimize the fire hazard.” 
 
 The writer went to a subscriber to this reciprocal and asked him if he 
 would show him the signatures to his insurance policy. As he read over the 
 names of America’s leading merchants, he realized the literal truth of what 
 the attorneys had written him and began to comprehend how it has been pos¬ 
 sible for this group during twenty-five years to have a loss record of only 
 $536,000 and to pay back to its members a total of $6,000,000 in cash refunds. 
 
 The advisory committee , or trustees .—The advisory committee is a part 
 of every reciprocal organization. In some cases it is a real power, though 
 in others the opponents of the method declare the members of the committee 
 
3 io 
 
 RISK AND RISK-BEARING 
 
 to be figureheads utilized by profiteering managers. This committee is 
 elected by the subscribers and has three, five, or seven members. 
 
 Objections to reciprocal insurance.— The chief objections to reciprocal 
 insurance have been summarized by John F. Ankerbauer 1 who has been one 
 of the leaders of those opposing the method. They are as follows: 
 
 1. Subscribers do not understand the nature of their obligations under the 
 subscriber's agreement; they have little or no knowledge of the obligations 
 incurred for them by their attorney-in-fact . This objection can be met by the 
 subscriber’s studying carefully his power of attorney, his articles of agree¬ 
 ment, and the reports of his attorney which every agreement should require 
 at frequent intervals. Such study should lead to care in the choice of a 
 reciprocal. 
 
 2. Reserves are inadequate. This has been true of some reciprocals. It 
 is true of every exchange that fails. A prospective subscriber should shun 
 a reciprocal unless adequate reserves as required of old-line companies are 
 maintained. He should make sure that there is both a premium reserve and 
 an accumulated surplus as a provision against unusual losses. He should 
 also find out whether a sound policy for investing reserves such as is com¬ 
 pulsory for stock companies is carefully followed. 
 
 3. The subscriber does not know the identity of his fellow-subscribers who 
 are insuring him. Unfortunately some exchanges are doing business in 
 such a fashion. They should be forced to change their method by lack of 
 business. Nobody should think of taking insurance from unknowns. 
 
 4. Some exchanges mix the business of separate industries when the insur¬ 
 ance by groups is supposed to be distinct. If steam laundries, bakeries, and 
 hotels insure each other at the same exchange, each insuring others of the 
 same industry only, it is a misrepresentation when the accounts of resources 
 and liabilities are not kept entirely separate and so reported. 
 
 5. If the attorney does not settle a loss satisfactorily , suit has to be brought 
 against too many persons in too many places. Most contracts provide that 
 the attorney shall accept process, permitting all suits to be brought in one 
 place. The prospect of legal trouble emphasizes the importance of dealing 
 oniy with a high-class exchange composed of manager and subscribers of 
 unquestioned responsibility and integrity. Legislation for reciprocal insur¬ 
 ance, as pointed out below, attempts to simplify the matter of bringing suits. 
 
 6 . It is beyond the power of a corporation to have such insurance unless 
 its charter gives it permission to engage in the insurance business; if such par¬ 
 ticipation is not legal, no liability can accrue. There have been some court 
 decisions supporting this view. In one state some large concerns have 
 withdrawn from reciprocal exchanges on account of the advice of counsel 
 that the above objection is well taken. 
 
 1 Inter-insurance Information , 32 pages. (Cincinnati: John F. Ankerbauer. 
 Not dated.) 
 
FIRE INSURANCE 
 
 3ii 
 
 Since authorities differ it becomes necessary in each state to discover 
 the weight of opinion and act accordingly. The uniform reciprocal law 
 which has been adopted in so many states clears up this problem by provid¬ 
 ing expressly: “Any corporation now or hereafter organized shall, in addi¬ 
 tion to the rights, powers and franchises specified in its articles of incorpora¬ 
 tion, have full authority and power as a subscriber to exchange insurance 
 contracts of the kind and character herein mentioned. The right to 
 exchange such contracts is hereby declared to be incidental to the purposes 
 for which such corporations are organized, and as fully granted as the rights 
 and powers expressly conferred upon the corporation.” 1 It is said that the 
 constitutionality of such a blanket addition to charters of all corporations 
 will be attacked. 
 
 7. Just as serious, in some states, as objection number 6 has been the 
 view of some state insurance departments that inter-insurance without a 
 license from the state department is contrary to law. 
 
 Before the passage of the reciprocal insurance law by Virginia in 1918 
 agents in that state were subject to arrest. Persons who wished such insur¬ 
 ance went to New York, Chicago, St. Louis, or Kansas City, Missouri, for 
 it, and became parties to agreements with firms and corporations not resi¬ 
 dent in Virginia. This practice was so general in states not providing by 
 law for reciprocal insurance, that a manager of a western exchange said that 
 he expected to write little more insurance in a certain state after the law was 
 passed than he had been writing before its passage. 
 
 8. A reciprocal insurance agreement forms a partnership; liability cannot 
 be restricted by contract , and each subscriber may be liable for the entire face of 
 the policy. This objection seems doomed, certainly in states where such 
 insurance is provided for by statute, and in any other state where such a 
 contract is not repugnant to its constitution or statutes. There seems no 
 doubt of the limited liability if the attorney signs each policy separately for 
 each subscriber, and specifies that the liability is several and not joint. If 
 every subscriber has made the same kind of usual agreement, there is no 
 partnership. Every subscriber possesses that agreement in duplicate, or 
 has seen it, so there are no innocent third parties. 
 
 9. The attorney-in-fact has too much intrusted to him; he is an autocrat. 
 There is great danger here. To safeguard against an incompetent or a dis¬ 
 honest manager, a strong advisory committee or board of trustees must be 
 provided. Unsafe underwriting and insufficient inspection are to be guarded 
 against. In practically every case the manager’s compensation comes from 
 a percentage of premiums. He is tempted to assume risks that are less 
 good and to give the applicant the benefit of the doubt. He is less likely 
 to yield if he realizes that, as losses increase, subscribers diminish; but the 
 
 1 Section 9, Ohio House Bill No. 325, 82 General Assembly, Regular Session, 
 1917. 
 
3 12 
 
 RISK AND RISK-BEARING 
 
 best restraining influence is to subject him to the control of the subscribers 
 acting through a committee. 
 
 io. The advisory committee does nothing; it trusts the attorney. Unless 
 the committee is annually elected by the subscribers, given authority over 
 the managers, and paid for their services, this is a real objection. While a 
 competent manager must have a free hand, certain exchanges have trustees 
 who really act as a board of directors. Within the past year the manager 
 of one exchange was retired. 
 
 Advantages of inter-insurance. —The advantages that are claimed for 
 reciprocal insurance are as follows: 
 
 1. The expenses of operation are less, due to dealing with a particular 
 class of risks, permitting specialized service, and the reduction of local commis¬ 
 sions to a minimum Many exchanges have no local commissions to pay. 
 Some exchanges operate at a low cost, but there are others that have saved 
 little or nothing for their subscribers. 
 
 2. All hut high-class risks are eluninated. This is true for some exchanges 
 and untrue for others. 
 
 3. Frequent inspections by trained inspectors. This is a great advantage 
 of some of the exchanges. There are others that do very little along this 
 line. 
 
 4. Consolidation of small policies into a large one. Many companies 
 will not write more than a small part of the insurance of a large concern. 
 The insurance obtainable by the reciprocal method in one policy runs all the 
 way from a small amount up to over one million dollars. 
 
 5. The probable large saving. Some people have not saved anything; 
 others save 25 per cent to 85 per cent of their premiums. 
 
 Legislation. —The sweep of legislation to favor reciprocal insurance and 
 to control it indicates that the states recognize both the strength of the 
 reciprocal method and the dangers of its misuse. The main features of such 
 legislation are: (1) to require reciprocals to file copies of their agreement. 
 pow r ers of attorney, and contracts; (2) to make complete reports of their 
 condition to the department of insurance; (3) to compel the maintenance 
 of premium reserves, a minimum amount of business, and the possession 
 at all times of such an amount of quick assets as to make certain their ability 
 to settle at once a heavy loss; (4) to enable a suit to be brought by a claim¬ 
 ant in his own county against the attorney, or any, or all of the subscribers 
 by serving process upon the state insurance commissioner who s declared 
 to be the representative for that purpose of the attorney and each of his sub¬ 
 scribers; and (6) to tax the business of reciprocals as other insurance is taxed. 
 
 Conclusions. —A study of the methods, advantages and disadvantages 
 of reciprocal fire insurance leads one to conclude that the principle is sound, 
 but that such insurance is neither incompetence-proof nor crook-proof. 
 In theory the attorney-manager is the agent of his principal, the subscriber. 
 
FIRE INSURANCE 
 
 313 
 
 That is proving to be the soundest practice. The attorney ought to be 
 subject to control by the subscribers. Just as directors are a real force in 
 the management of a bank or insurance company, so the advisory committee 
 ought to be in a position, if need be, to assert its authority over the attorney. 
 It seems contrary to good principle for an agreement to read as one did: 
 “Neither the subscriber or subscribers, has, have, or shall have, any owner¬ 
 ship or property interest in or to the business, plan of business, system of 
 indemnity insurance, office or office property of the attorney-in-fact, or any 
 property right in or to said exchange.” The manager must be a successful 
 underwriter and a man above reproach, committed to the welfare of his 
 principals, rather than a self-seeking adventurer. All but high-class risks 
 must be eliminated, and rigid, frequent inspection must be enforced. For 
 people who intend to adopt every means of preventing fire, who themselves 
 constitute no moral hazard, whose commercial integrity is the highest, whose 
 several properties are widely scattered, but whose interests draw them so 
 closely together that they have knowledge of each other’s integrity, there is 
 a profitable field for reciprocal insurance. For other people the range of 
 liability is so great that the value of the plan is doubtful. The business 
 man must proceed as carefully in its use as if he were buying stock in a corpora- 
 tion or extending a line of credit. Instead of getting insurance he may increase 
 his liabilities. Rockefeller’s success in oil does not foreordain the success 
 of every oil project. 1 
 
 V. RATES AND RATE-MAKING 
 
 The rate in fire insurance is quoted as the number of cents per 
 annum per hundred dollars insurance. Considerably lower rates 
 are granted on three- or five-year contracts, in some cases five years’ 
 insurance being sold for as little as three times the annual premium, 
 while on the other hand the “short rate” for less than one year’s 
 insurance is much higher than the annual rate. The practice of 
 extending much lower rates for long than for short contracts is due 
 to several causes. The burning rate is somewhat higher during 
 the earlier period of the life of the average policy, presumably on 
 account of greater moral hazard; the selling costs are less on long¬ 
 term than on short-term policies, and the office expenses connected 
 with the issuance of the policy are of course proportionately much 
 greater on short contracts; the excess premium on a long contract 
 is a clear gain in case a total loss occurs in the earlier period; and 
 the danger of losing a given piece of business to a competitor grows 
 less as the term of the contract increases. 
 
 1 Adapted by permission from J. Anderson Fitzgerald, “Reciprocal or Inter- 
 Insurance against Loss by Fire,” American Economic Review , X (March, 1920). 
 92-103. 
 
RISK AND RISK-BEARING 
 
 314 
 
 The determination of the proper level of insurance rates, as a 
 whole, is not an extremely difficult problem, but the proper apportion¬ 
 ment of the burden is a source of great perplexity and controversy. 
 The problem is not dissimilar to that which arises in connection with 
 freight rates, where the determination of the amount necessary to 
 maintain service and provide a fair return on capital is simple com¬ 
 pared to the problem of distributing this cost to the various kinds of 
 service rendered. In fire insurance, the difficulty arises from the 
 irregularity of the incidence of fire loss from year to year, and from 
 the extreme complexity of the factors which make one individual risk 
 greater than another. The total income of the insurance company, 
 if the business is to continue, must be great enough to provide for 
 normal losses, the expenses of carrying on the business, a contribution 
 to a conflagration reserve, the proper size of which is a matter of 
 conjecture, and a fair return on the invested capital. As the bulk 
 of the invested capital is in the form of income-bearing securities, 
 however, the necessary return to capital from the insurance operations 
 is quite Small. Aside from the small fixed assets and the money used 
 up in organization expenses, the capital pays its own way, except for 
 the return necessary to compensate investors for exposing their 
 capital to the hazard of loss through conflagration. In many years 
 the underwriting profit is quite small, but over a period of years the 
 business has proved very profitable for the majority of those engaged 
 in it. When returns are stated as a percentage on capital, the busi¬ 
 ness appears more profitable than it really is, because of the large 
 amount of invested capital which is carried as surplus. Much of 
 this is the result of the accumulation of past profits, but quite com¬ 
 monly part of the surplus represents capital obtained by selling stock 
 at a premium, a practice necessitated by the laws of certain states 
 which require the entire capital stock to be held in securities of a 
 specified character. 
 
 The adjustment of the rate to the individual hazard is much 
 more difficult in fire than in life insurance, because so much gieater 
 effort is made to take account of factors which cause variation in the 
 degree of risk. Whereas in life insurance it is practicable to draw a 
 line between the insurable and the uninsurable, and then subdivide 
 the insurable into groups according to age alone, in fire insurance the 
 rate on certain types of property is adjusted to take account of several 
 hundred different elements of variation in the risk. The resulting 
 groups of risks which are alike in all respects are too small to permit 
 
FIRE INSURANCE 
 
 3 J 5 
 
 statistical justification of any rate for each group separately. The 
 variations in rates on different kinds of property are expressions of 
 the judgment of experienced underwriters as to the effect which a 
 given difference in construction, occupancy, exposure, or protection 
 ought logically to exert upon the loss ratio. Each company is con¬ 
 stantly studying its experience to secure a better basis for rate¬ 
 making, but little has been done toward making their accumulated 
 experience common property, and until much more detail has been 
 made public, concerning the actual experience with different types 
 of risk, fire insurance rates will remain under the suspicion of arbi¬ 
 trariness. 
 
 In most parts of the United States, rates are made by associations 
 of insurers, which serve the double purpose of effecting an economy in 
 the work of inspecting properties, constructing fire maps, computing 
 rates, etc., and of eliminating any tendency toward cut-throat com¬ 
 petition. The rates made by these associations are subject to a 
 limited amount of supervision by the insurance authorities of the 
 various states, some states requiring merely the filing of rates, others 
 intrusting to their commissioners extensive powers of revision. In a 
 few states, the full power of making rates is lodged by law in the state 
 authorities. 
 
 In adjusting the rates on individual risks, two methods are in use. 
 In the case of farm buildings, dwellings, churches, and a number of 
 other classes of building, where the difference in individual hazard 
 is not great, the principle of classification is employed. Under this 
 plan, risks are thrown together into a few classes which are roughly 
 alike, and one rate is applied to the entire class, subject to a modifica¬ 
 tion in the case of city property based on a rating given to the city. 
 For instance, all three-story brick apartments in a given city may be 
 given one rating; all frame dwellings another rating; all brick churches 
 another; and so on. The second method, which is generally applied 
 to mercantile and industrial property, is known as schedule rating. 
 Under this system, no attempt is made to group together all risks 
 entitled to the same rate. Instead, the rate is built up by establishing 
 an arbitrary starting-point in a given combination of features of 
 hazard, then drawing up a detailed schedule of additions and deduc¬ 
 tions from a basis rate which is assumed to be applicable to this 
 standard. Manufacturing risks are rated under a great variety of 
 special schedules, while mercantile properties are generally rated 
 under some modification of one of two systems, the Universal Mer- 
 
3 l6 
 
 RISK AND RISK-BEARING 
 
 cantile Schedule, which is widely used in the East, and the Dean 
 Schedule, which is universal in the West. 
 
 The Universal Mercantile Schedule starts by defining a standard 
 building and a standard city, and fixes a basis rate of twenty-five 
 cents for the combination of these two standards. Next, the rate 
 for the individual city is determined by adding specific amounts to 
 the twenty-five-cent rate for specific deficiencies, such as narrow 
 streets, inadequate police service, extensive lumber districts, etc., and 
 making deductions for unusually favorable features. Then by a 
 similar schedule of additions and deductions, the rate for the standard 
 building in the given city is converted into the rate for the given 
 building. Successive modifications are then made for the character 
 of the occupancy, the individual fire protection, the exposure, and 
 the presence or absence of coinsurance. The rate on the contents 
 is built up in a similarly complicated manner from the rate on the 
 building, additions and deductions taking care of both the special 
 features of hazard connected with the building and those arising from 
 the character of the contents themselves. The following account of 
 the rating of a manufacturing building gives a good idea of the way 
 in which schedule rates are constructed: 
 
 This particular building has been inspected and surveyed by the rater. 
 The degree of municipal and local protection has been measured. This 
 establishes the basis rate of .40 which is a charge commensurate with the 
 degree of protection and covers all general hazards that cannot be segre¬ 
 gated and measured. In passing, let it be noted that the better the city 
 
 protection the lower will be the basis rate. 
 
 The rate is established as follows: 
 
 Basis rate. ....40 
 
 Area 15,800 sq. ft.04 
 
 (The standard unit area is 1,000 sq. ft., a proportionate 
 additional charge being made for larger areas.) 
 
 Parapet deficiency... .04 
 
 Skylights not standard. 02 
 
 Metal stacks through roof....06 
 
 Outside wood porches, cornices and wooden conveyor. . .06 
 
 Gallery decks... .. ..... .03 
 
 Occupancy.\ ... .92 
 
 Shavings allowed to accumulate.. 05 
 
 No waste cans. * ..„..05 
 
 Floor oil soaked. 05 
 
 No drip pans under machines .05 
 
 Total. 1.77 
 
 Credit for open finish.....08 
 
 Building rate unexposed.. 1.69 
 
FIRE INSURANCE 
 
 317 
 
 Exposure 
 
 From buildings No. 2 and No. 5 at 18 ft.34 
 
 From building No. 6 at 15 ft...02 
 
 From office at 23 ft..05 
 
 From buildings No. 9 and No. 10.07 
 
 Exposure charge.48 
 
 Total building rate. 2.17 
 
 The occupancy charge of 92 cents in the foregoing table is made up as 
 
 follows: 
 
 Grinding, machine shop, and blacksmith shop.06 
 
 Gas tempering furnace.01 
 
 1 brick forge and 1 movable forge.01 
 
 3 crude oil furnaces.02 
 
 High pressure steam boiler using shavings partly as fuel 
 and coal with an unapproved arrangement for shavings 
 
 in brick room.26 
 
 Inadequate ventilation.04 
 
 Gasoline automobile in building.12 
 
 Woodworking (1 pony planer, 1 rip saw, 1 cross cut)... .10 
 
 Wire room (2 auto, wire knotters, 4 wire cutters and 
 
 straighteners—all on wood using oil).24 
 
 10 hand knotting machines, additional labor, 28 hands. .06 
 
 Total occupancy charge.92 
 
 With this detailed information in the hands of the business man he 
 can figure exactly how to reduce his fire insurance rate and what the cost 
 of the changes will be. 
 
 Assuming that he carries a line of $65,000 on this building his annual 
 premium is $1,410.50. For each .01 reduction in the rate he is saving 
 $6.50 every year. 
 
 He finds that he can bring the parapet wall up to the standard require¬ 
 ment for $30.00. By this expenditure he lessens the hazard and reduces 
 the rate .04, thus saving in premiums $26.00 each year. He has the shavings 
 removed daily, installs waste cans, and drip pans under the machines at a 
 small expense. These improvements reduce the rate .15. He finds that 
 his automobile being stored in the building is costing him $78.00 a year in 
 increased premium. He puts the car in a small garage and reduces the 
 rate .12. 
 
 By comparing what the hazards are costing him with the expense of 
 correcting them he determines how much he deems it advisable to reduce 
 his own rate. As a matter of fact, the owner makes his own rate—the rater 
 simply measures the hazards in terms of rates. 
 
 The rate of $2.17 was reduced to $1.86 by a comparatively small out¬ 
 lay of money. In addition the liability to fire has been reduced. This 
 should be a stronger incentive than the saving of insurance premiums. 1 
 
 ‘Taken by permission from John J. Thomas, What the Business Man Should 
 Know About Fire Insurance , pp. 12-13. (Chicago, 1922.) 
 
RISK AND RISK-BEARING 
 
 318 
 
 The Dean Schedule presents several points of contrast to the 
 Universal Mercantile Schedule. The starting-point under this 
 system is a one-story brick building of ordinary construction, in a 
 town of the sixth, the lowest, class. No rate is prescribed for this 
 standard risk, the system being so constructed as to be applicable to 
 any base rate which the rating bureau may consider applicable to 
 the community. The additions and deductions, which adapt the 
 rate to the special features of the individual hazard, are made in the 
 form of percentages instead of flat charges. The theorv under¬ 
 lying this system is that a given defect of construction or protection 
 is more serious in a building which is otherwise a poor risk than 
 in the case of a building otherwise relatively safe. The system also 
 provides a much more careful analysis of occupancy and exposure 
 hazards than is attempted in the Universal Schedule. 
 
 Upon the whole, the schedule rates seem to be more equitable 
 than the classified rates, perhaps, however, because our knowledge 
 of the actual fire losses with different combinations of the elements 
 of risk is not sufficient to expose the shortcomings of the schedules. 
 As is to be expected in a task of such complexity, it is impossible to 
 secure a schedule which commends itself in all details to the judg¬ 
 ment of any one critic, and persons disposed to do so have no difficulty 
 in finding rather obvious flaws in the rating system. Until statistics 
 are available, however, for determining the loss experience on a large 
 number of classes of risk, we shall be obliged to content ourselves with 
 the sort of imperfection which the current schedules exhibit. The 
 most serious criticism is not the occasional absurdity in the relative 
 rates for given risks, but the tendency for certain rates to be warped 
 by the conditions surrounding the selling of insurance, conditions 
 which, as a rule, work to the disadvantage of owners of property 
 which falls within the classified groups. Manufacturers and mer¬ 
 chants scrutinize their insurance bills carefully and chambers of 
 commerce and manufacturers’ associations are effective means of 
 protest against rates deemed too high. Purchasers of insurance on 
 dwellings, school buildings, and churches, on the other hand, are less 
 effectively organized and are apt to regard their insurance as an item 
 of expense too small to be worth quibbling over, which indeed it 
 often is. So conspicuous has the resulting shift of the burden from 
 certain types of property become, that insurance companies have 
 created an informal classification of properties into preferred and 
 ordinary risks, the term “preferred risk” denoting, not a property 
 
FIRE INSURANCE 
 
 319 
 
 where the burning rate is low, but a property where the insurance 
 rate is high. 
 
 If rates were adjusted accurately in accordance with the consensus 
 of insurance opinion as to the hazards involved, even though that 
 opinion might involve a large degree of approximation, there would 
 be no such thing as a preferred risk; one risk would offer as much 
 prospect of profit as another. The notorious preference of insurers 
 for certain classes of business is sufficient evidence of the inadequacy 
 of present methods of apportioning the burden of insurance. 
 
CHAPTER XV 
 
 MISCELLANEOUS PROPERTY INSURANCE 
 
 Aside from contracts of life and fire insurance, there are innumer¬ 
 able similar arrangements by which the risks of business are eliminated 
 or reduced, through transfer to specialists and consequent combination 
 of risks or prevention of the event insured against. In general, almost 
 any risk is insurable, and will be insured by casualty companies if the 
 following conditions are present: (a) a body of experience sufficient 
 to afford a basis of judgment concerning the probable loss ratio; ( b ) 
 a loss ratio low enough so that rates need not be prohibitively high; 
 
 (c) a probability of individual losses large enough to make it worth 
 while for individuals to take the precaution of insuring against them; 
 
 (d) a loss ratio high enough so that individuals are alive to the hazard 
 and can be induced without excessive selling cost to provide against 
 it; (e) independence of the separate risks, so that the company can 
 secure a fair distribution of the hazard; (/) freedom of the event insured 
 against from complete control by the insured. 
 
 Of these many types of insurance, few present special features of 
 interest sufficient to warrant detailed study in a general survey of 
 methods of dealing with risk. The risks of labor and the insurance 
 devices for taking care of financial risks associated with the labor con¬ 
 tract will be considered in chapter xvii; other types of insurance 
 include the following: 
 
 Marine insurance comprises the whole field of insurance against 
 risks arising from the transportation of goods, and falls into two main 
 branches: ocean marine, which is what is ordinarily referred to as 
 marine insurance, and inland marine, which includes such forms of 
 protection as transportation, tourist baggage, parcel post, registered 
 mail, and motor truck contents insurance. 
 
 Ocean marine insurance is the oldest form of indemnity, of which 
 there is any record, and the policy usually written retains evidence of 
 its age in the quaintness of its wording. The perils insured against 
 are: 
 
 Of the seas, men-of-war, fire, enemies, pirates, rovers, thieves, jettisons, 
 letters of mart and countermart, surprisals, takings at sea, arrests, restraints, 
 and detainments of all kings, princes and people, of what nation, condition, 
 
 320 
 
MISCELLANEOUS PROPERTY INSURANCE 
 
 3 21 
 
 or quality soever, barratry of the master and mariners, and of all other perils, 
 losses, and misfortunes that have or shall come to the hurt, detriment or 
 damage of the said goods and merchandises and ship, etc., or any part 
 thereof. 
 
 Omitting reference to the items which enumerate hazards of war, 
 the clauses enumerating the hazards may be explained as follows: 
 “ Perils of the seas,” refers to damage from storm, collision, ice, strand¬ 
 ing, and such excessive action of the wind and waves as is not antici¬ 
 pated in the ordinary course of navigation. The line between ordi¬ 
 nary wear and tear and damage by storm is sometimes hard to draw, 
 but the principle involved is that the policy shall insure against losses 
 which may happen, not those which must happen. “Pirates, robbers, 
 and assailing thieves,” include all outside sources of loss through theft, 
 and “barratry” covers various unlawful acts of master and crew 
 (including mutiny, diversion of the ship from its course, scuttling, and 
 open robbery by the crew), but neither clause covers pilferage by the 
 ship’s company. “Jettison” means the throwing overboard of part 
 of the vessel’s cargo for the purpose of relieving the ship in distress. 
 
 The interpretation of an ocean marine policy is extremely technical, 
 as is indeed the whole of admiralty law, and into the intricacies of the 
 policy it is unnecessary for us to go. A few outstanding peculiarities 
 of this type of insurance, however, may be mentioned. In contrast 
 to fire insurance, the ocean marine policy is, in a great majority of 
 cases, a valued policy . 1 Another contrast with fire insurance is the 
 fact that under certain conditions a marine policy may be valid, even 
 though at the time it was taken out the insured had no insurable 
 interest in the property. This is the case where the property had 
 already been destroyed, but the facts were not known either to the 
 insurer or the insured. This is taken care of by the phrase “lost or 
 not lost,” included in the description of the property insured. 
 
 A third contrast with the usual practice in fire insurance is the 
 rule with regard to constructive total loss. A constructive total 
 loss occurs when the property insured is not physically destroyed, but 
 is so situated that the cost of rescue or repair would be greater than 
 the value of the property. Notice of intent to claim a constructive 
 total loss is given through “notice of abandonment,” an offer on the 
 part of the insured to abandon the property to the insurer in return 
 for payment of the face of the policy. Such notice does not obligate 
 the insurer to accept abandonment, nor does it release the owner from 
 
 1 See p. 293. 
 
3 22 
 
 RISK AND RISK-BEARING 
 
 the obligation to exercise reasonable care to preserve whatever value 
 may remain; it merely evidences good faith in claiming a constructive 
 total loss. 
 
 A very wide range of special clauses and special types of policy is 
 offered. “Voyage''’ policies cover a definitely described voyage; 
 “time” policies cover vessels for a stated period. “Fleet” insurance 
 covers a large group of vessels by a blanket policy. “Builders’ risk” 
 policies provide protection during the construction or repair of vessels. 
 Cargoes may be protected by “named” policies, which designate 
 the vessel to be used, by “floating” policies, which designate merely 
 the voyage and type of vessel, or by “open” policies which cover all 
 the shipments made by a given firm within the life of the policy. 
 
 The rates in marine insurance are highly unstandardized, competi¬ 
 tive, and unstable. There is no such thing as schedule rating. There 
 is a very limited body of statistical data from which to estimate the 
 risk, and such facts as have been gathered are closely guarded by the 
 individual companies as trade information. Moreover, the moral 
 hazard is very great, and even in the absence of fraud or deliberate 
 carelessness the loss experience of different operators varies widely. 
 Consequently, the element of judgment enters to a greater extent than 
 into almost any other type of insurance. 
 
 Tornado insurance is written in connection with fire insurance, 
 and is very popular in sections of the country which are subject to 
 disastrous wind storms. The general provisions are similar to those 
 of the standard fire insurance policy, but the contract is simpler for 
 the reason that there is no moral hazard, and no need of special pro¬ 
 vision to secure proper protective measures on the part of the owner 
 or tenant. Coinsurance is commonly required, where state laws per¬ 
 mit, as the proportion of partial losses is extremely high. 
 
 This type of insurance should always be written by a large stock 
 company covering a very wide territory. Local mutuals are in an 
 especially weak position with regard to this sort of coverage, for a 
 severe storm may cause partial loss on nearly every property in its 
 path, with numerous cases of total loss; an insurer must have a very 
 large field of business in order to secure an adequate distribution of 
 risks. 
 
 Automobile insurance.—The rapid increase in the use of the auto¬ 
 mobile, tor purposes both of business and pleasure, has created a 
 demand for this new type ol insurance. About 30 per cent of the 
 
MISCELLANEOUS PROPERTY INSURANCE 
 
 323 
 
 automobiles in the United States, it is estimated, are covered by one 
 or more of the standard types of policy, of which the most important 
 are the following: {a) Liability insurance; this policy protects the in¬ 
 sured against legal liability and damages because of personal injury to 
 others arising out of the use of an automobile. ( b ) Property damage 
 policies protect against injury to the property of others which may 
 result from accidents in connection with the use or ownership of an 
 automobile, (c) Collision insurance protects against injury to the car 
 owned by the insured, resulting from collision with other cars or with 
 any other object. ( d ) Fire insurance policies are very similar to those 
 written on buildings and other property, as described in chapter xiv. 
 ( e ) Theft insurance protects against loss of the car, or of its parts or 
 accessories. 
 
 In these types of insurance, there is a wide difference in the rates 
 charged in different territories, on different types of cars, and under 
 different conditions of use. For instance, the rate for public liability 
 insurance on a certain car ranges from $103 in the district rated highest 
 to $19 in the district rated lowest; theft insurance in one territory 
 ranges from $6.35 per $100 on one car to $25 on another. 1 
 
 Crop insurance is a highly speculative type, because of the extent 
 to which losses are likely to be coincident for a large number of policy¬ 
 holders; the insurer finds it difficult to secure a proper distribution 
 of the risk. Moreover, in the present organization of the business 
 there is a considerable moral hazard. The best established form is 
 hail insurance, which has been of considerable importance for the 
 past twelve or fifteen years. The total premiums paid for hail insur¬ 
 ance in 1919 amounted to $30,000,000; the total insurance in force 
 
 \ 
 
 to $560,000,000. 
 
 General crop insurance has been attempted in only a few instances. 
 During the war there were a number of cases of price insurance in New 
 England, but these were effected through associations of public-spirited 
 citizens as a means of encouraging increased agricultural production, 
 and not as a business carried on for profit. 
 
 In 1917, three insurance companies operating in the northwest 
 offered insurance against crop failure. This experiment turned out 
 badly for the insurers on account of drouth and failure to provide 
 properly against the assumption of risk after damage had already taken 
 place. 
 
 1 Riegel and Loman, Principles of Insurance , chap. xx. 
 
3 2 4 
 
 RISK AND RISK-BEARING 
 
 In 1920, two companies again offered crop insurance—one of 
 them including in its coverage protection against loss due to decline 
 in the market value of the crop, an experiment which proved very 
 costly on account of the slump in grain prices of that year. Various 
 forms of protection are now offered in limited territories, but this 
 form of insurance is still in its experimental stage and the outcome is 
 doubtful. 1 
 
 Credit insurance is a comparatively new type of indemnity, which 
 is offered by three leading companies. The object of this kind of 
 insurance, as its name indicates, is to protect business men (whole¬ 
 salers and manufacturers) against the risk of extraordinary losses due 
 to insolvency on the part of their debtors. 
 
 The policy offered contains a number of distinctive features. 
 In the first place, the insured must bear a stipulated initial loss 
 before the insurer has any liability. This amount is known as the 
 normal loss, and is figured on the basis of the average loss ratio to 
 gross sales for the preceding five years. Second, the maximum 
 amount which will be paid on account of a single loss is restricted 
 to an agreed percentage of the customer’s capital rating as supplied 
 by a reputable mercantile agency. Third, the principle of coinsurance 
 is applied, but in a manner somewhat different from that used in fire 
 insurance. In the case of customers who have first credit ratings, 
 the insured carries 10 per cent of the loss; in the case of those who 
 have a lower rating, 33J per cent. The insured cannot, as in fire 
 insurance, get rid of this residual risk by insurance with another 
 company. Fourth, the total liability of the company is usually, but 
 in the newer policies not always, limited to a stipulated maximum. 
 Fifth, the losses covered are those which arise from insolvencies 
 which occur during the life of the policy or within 15 days there¬ 
 after. Insolvency is defined very broadly for purposes of the policy, 
 however, including death or disappearance of the debtor, assign¬ 
 ment by the debtor, recording of a chattel mortgage on his 
 property, etc. 
 
 Judged by the total amount of losses incurred, the hazard of losses 
 through insolvency of debtors is comparable in importance to the fire 
 hazard, as is shown by the following table: 
 
 1 V. N. Valgren, “Crop Insurance,” Bull. U.S. Dept, of Agriculture , No. 1043, 
 January 23, 1922. 
 
MISCELLANEOUS PROPERTY INSURANCE 
 
 325 
 
 Failure and Fire Losses for 10 Years* 
 
 
 Failure Loss 
 
 Fire Loss 
 
 1921. 
 
 $750,200,000 
 426,300,000 
 115,500,000 
 137,900,000 
 166,600,000 
 175,200,000 
 284,100,000 
 357,100,000 
 292,300,000 
 198,900,000 
 
 $332,654,950 
 
 330,853,925 
 
 269,000,775 
 
 290,659,885 
 
 250,752,640 
 
 214 , 530,995 
 
 172,033,200 
 
 221 , 439,350 
 
 203 , 763,550 
 
 206,438,900 
 
 IQ20. 
 
 IOIQ. 
 
 1918. 
 
 1017. 
 
 1916. 
 
 IQI C. 
 
 IOI4. 
 
 IQI?. 
 
 IQI 2 . 
 
 Total. 
 
 $2,904,100,000 
 
 $2,492,428,170 
 
 
 * Huebner, Property Insurance, p. 526. 
 
 It is not sound to argue from these figures, as has sometimes 
 been done, that the business man’s need of credit insurance is com¬ 
 parable to his need of fire insurance. The test of the desirability of 
 any form of insurance is the unpredictable character of the loss, not 
 its total amount. Whereas the fire losses are concentrated in a very 
 high degree, so that only a small minority of business men suffer fire 
 loss in any given year, and that minority suffer very heavily, the risk 
 of loss from bad debts is widely distributed, falling in some degree 
 upon nearly everyone who extends credit, in every year. In so far 
 as the loss from bad debts runs the same from year to year, it can be 
 taken care of as one of the regular costs of doing business, and there 
 is no more need of insurance against it than against any other expense. 
 It is in recognition of this fact that the limitation of liability to loss 
 above a stipulated normal is included in the provisions of every credit 
 policy. Were this not done it would be necessary to increase the 
 premiums by a large fraction of the normal loss 1 and there would also 
 be a significant increase in the moral hazard. 
 
 The regularity of credit losses in the individual experience, as 
 compared with the experience with fire, arises from the fact that the 
 business man nearly always has a better distribution of his credit risk 
 than he has of his fire risk. With a few hundred accounts the opera¬ 
 tion of the law of large numbers assures a high degree of regularity 
 in so far as the risks are independent. The chief protection afforded 
 
 1 Not, however, as has sometimes been stated, by the full amount of the 
 normal loss. The added amount of claims to be paid would never equal the amount 
 of the normal loss on all the policies, as there arj always some policies on which 
 the loss in a given year is below the normal amount. 
 
326 
 
 RISK AND RISK-BEARING 
 
 by the policy is against the hazard of crisis, which corresponds in 
 credit insurance to conflagration hazard in fire insurance. The 1 busi¬ 
 ness man is really in the position of the small fire insurance company, 
 rather than in that of the holder of a few pieces of exposed property. 
 The insurance company reinsures if it has a few risks too large to be 
 carried safely in dependence on the working of the law of averages, or 
 if it gets too many risks exposed to the hazard of a single conflagra¬ 
 tion; likewise credit insurance is chiefly valuable in guarding against 
 the crisis hazard, or in protecting a line containing a few dispro¬ 
 portionately large risks. Whether the crisis hazard is great enough 
 to justify insurance of a well-balanced line of credit risks is'a question 
 in regard to which opinions may well differ, as the crisis hazard itself 
 changes from year to year. That the hazard is still far from negligible 
 is indicated by the experience of the leading credit insurers, which 
 showed losses amounting to 3 per cent of premiums in 1919 and 89 
 per cent in 1920. 
 
 Miscellaneous Property Insurance. Other standard types of 
 property insurance, which it is not necessary to describe in detail, 
 cover such varied hazards as personal accidents; burglary and theft 
 or personal property; breakage of plate glass (in this case the company 
 agrees to replace the glass or pay its actual value, so that there is no 
 limit to the company’s liability in case the glass advances in value 
 after the policy is written); steam boiler explosion (which involves 
 a much larger element of prevention of loss than do most types of 
 insurance); electric engine damage; water damage; sprinkler leakage, 
 etc. 
 
CHAPTER XVI 
 
 GUARANTY AND SURETYSHIP 
 
 V 
 
 I. INTRODUCTION 
 
 The type of specialization which involves the assumption of risk 
 by a specialist who believes that he can foresee the outcome of a 
 venture and decides that there is no risk, or a smaller risk than is 
 generally estimated, finds most of its illustrations in speculation. 
 Outside this field, illustrations are found in contracts of guaranty and 
 suretyship and in certain types of so-called insurance which are really 
 more properly considered as surety arrangements. For instance, a 
 title insurance company guarantees real estate titles, not by figuring 
 the percentage of losses and calculating a premium to cover the risk, 
 as is the insurance practice, but by searching the records until it is 
 satisfied that no risk exists. For the private individual who cannot 
 conduct this investigation for himself, the contract removes an impor¬ 
 tant risk; for the company the risk is negligible. 
 
 So with individual guaranties. When a friend signs a card to 
 enable one to draw books from a municipal library, he does not inquire 
 what per cent of guarantors are called upon to make good the losses 
 sustained by the library; he depends absolutely upon his friend’s per¬ 
 forming his obligations, though he is doubtless aware that some people 
 do not do so. He believes his friend is individually a safe risk, what¬ 
 ever the average may be. The library, not sharing this faith, considers 
 that the guaranty reduces a real risk. 
 
 In the same way, when A indorses B’s note as an accommodation 
 he may know perfectly well that i per cent of the business men in the 
 United States are likely to fail within a year, but he does not figure 
 that he is running a i per cent risk; he believes B is all right and will 
 not be among the i per cent. If he had any doubt about it, he would 
 probably decline to furnish the indorsement. A bank acceptance 
 is exactly the same sort of transaction. The bank accepts drafts 
 drawn on it on account of a customer, depending on him to provide 
 the necessary funds before the draft falls due. It does not charge 
 an actuarial premium based on statistics of risk; it merely charges a 
 commission for the service. Unless it considers itself safe it does not 
 accept the draft. To the drawer of the draft, who does not share the 
 
 3 2 7 
 
3 28 
 
 RISK AND RISK-BEARING 
 
 bank’s knowledge or its confidence in the customer’s reliability, the 
 bank’s acceptance makes the transaction less risky.. 
 
 In foreign-exchange transactions certain individuals or firms of 
 excellent standing buy the paper of small firms which have not estab¬ 
 lished their reputation, add their own indorsement and resell the paper 
 in the open market at a higher price. They know, or at least they are 
 convinced, that the less-known firms are sound; but the general public 
 not being so fully informed, the well-known indorsement adds to the 
 market value of the paper. Here again we have a reduction of risk 
 through specialization in securing more adequate information than 
 is generally available. 
 
 The ordinary practice of underwriting 1 security issues involves a 
 similar principle. An investment banking-house or a syndicate 
 guarantees the sale of an issue of securities, often knowing in advance 
 exactly where the buyers are to be found; and in other cases consider¬ 
 ing that there is no significant risk of failure to dispose of the issue. 
 The commission is indeed often in part an actuarial premium for risk 
 undergone, but it is chiefly a compensation for service rendered in 
 investigating the proposal and in facilitating the sale by its indorse¬ 
 ment. 
 
 Of the numerous ways in which business men transfer risk to 
 specialists who do not carry a corresponding risk, because of superior 
 knowledge or because of ability to prevent losses, two are selected 
 for detailed examination, corporate suretyship, and the protection 
 of buyers of real estate against defects in titles. 
 
 II. CORPORATE SURETYSHIP 
 
 Corporate suretyship has been described a? follows: 
 
 The business of suretyship as defined in the insurance law of New 
 York is: 
 
 1. Guaranteeing the fidelity of persons holding positions of public or 
 private trust. 
 
 2. Guaranteeing the performance of contracts other than insurance 
 policies. 
 
 3. Executing or guaranteeing bonds or obligations in actions or pro¬ 
 ceedings or by law allowed. 
 
 It will be seen from this that, in a general way, except as to insurance 
 policies, a surety company may, and generally will guarantee that a particu- 
 
 1 The term “underwriting” is here used in its narrower meaning of guaranteeing 
 1 sale, as distinguished from the loose usage of the term as equivalent to outright 
 purchase for resale. 
 
GUARANTY AND SURETYSHIP 
 
 329 
 
 lar principal will do any lawful thing specified, provided the security is 
 satisfactory to the surety company and a reasonable compensation is paid. 
 To really understand suretyship, one must separate fidelity insurance from 
 the other branches. Fidelity insurance is handled as any other line of casu¬ 
 alty insurance would be, and while reliance is placed upon salvage, neverthe¬ 
 less the real reliance is upon the fact that only a certain very small proportion 
 of men are likely to be dishonest. It is accordingly underwritten as an insur¬ 
 ance proposition. All the other lines, sometimes specifically spoken of 
 collectively as surety lines, are, however, underwritten upon the theory that 
 there is a sound and competent principal who will perform the condition of 
 the bond; and the surety does not seriously contemplate the possibility of 
 being required to pay the bond, but considers that what he furnishes in return 
 for the fee paid is merely a service. In other words, by signing the bond as 
 surety, he extends credit to the principal. Suretyship is just as much the 
 granting of credit as is banking, the only difference being that the bank 
 furnishes to its customer the use of current funds, while the surety furnishes 
 its customer with the opportunity to do something which he otherwise 
 would not be able to do, or enables him to avoid the necessity of doing 
 something until the contingency occurs which makes it certain he must do it. 1 
 
 Formerly, it was the custom for individuals who were called upon 
 to furnish bond for any purpose to make application to individual 
 friencjs and acquaintances, as is still the practice for the most part in 
 furnishing bonds for appearance of alleged criminals to answer charges 
 against them. For most purposes, however, the advantages of cor¬ 
 porate suretyship are so great that, within the fifty years since it was 
 introduced in this country, it has almost entirely supplanted the sys¬ 
 tem of individual suretyship except in criminal business and in the 
 furnishing of surety for the payment of small promissory notes. 
 
 Corporate suretyship offers several very distinct advantages over 
 the system of individual guaranties. In the first place, it substitutes 
 an impersonal business relationship for personal accommodation. The 
 result of this is that the assured is relieved of embarrassment and from 
 a sense of obligation to reciprocate. Moreover, especially in the case 
 of bonded public officials, individual suretyship may create an oppor¬ 
 tunity for the guarantor to exercise pressure in the direction of an 
 undesirable use of official discretion. Finally, the courts are prone 
 to be very lenient in interpreting responsibility of individual guaran¬ 
 tors when they are called upon unexpectedly to fulfil an obligation. 
 In the second place, corporate suretyship affords a better security, 
 
 1 Adapted from advertising literature published by the American Surety 
 Company, New York, 1919. 
 
330 
 
 RISK AND RISK-BEARING 
 
 for the resources of the insurer are much larger in proportion to the 
 requirements of any one bond than is likely to be the case with individ¬ 
 ual guarantors. 
 
 The types of bonds usually written by surety companies may be 
 described as follows: 1 
 
 Fidelity bonds protect employers against breach of trust and also 
 in some cases against negligence. In writing this insurance, great 
 emphasis is placed upon such factors as character, family connections > 
 income, standards of living and associates, yet the number of losses is 
 very great. Most of these losses apparently arise from one of three 
 sets of conditions: hrst, extravagance and dissipation; second, specu¬ 
 lation and gambling; third, loose accounting and mingling of 
 employers’ funds with personal funds. 
 
 Fiduciary bonds cover the liability of trustees. The most impor¬ 
 tant are those given in probate proceedings and in insolvency. In 
 these, as in most of the types of suretyship hereafter enumerated, the 
 moral risk is relatively small, but there are many opportunities for 
 the insurer to become involved in liability on account of carelessness 
 or ignorance concerning his very technical obligations. 
 
 Public official bonds are required in most cases where individuals 
 are intrusted with the care of public funds. The liability under this 
 form of suretyship usually extends to any responsibility which may 
 attach to the principal on account of negligence or ignorance, as well 
 as actual breach ot trust. 
 
 Judicial bonds are given chiefly by defendants to stay execution, 
 and pay judgments; sometimes to cover the liability of plaintiffs for 
 wrongful pursuit of a remedy to which they are not entitled. 
 
 Criminal bail bonds guarantee the appearance of a defendant for 
 trial. The moral hazard m this sort of suretyship is of course very 
 great. It is usual, therefore, to require that the principal deposit 
 collateral security with the insurer to cover its liability. In some cases, 
 the courts refuse to accept such bonds on the ground that a bondsman 
 who is fully secured has no incentive to produce his principal for trial: 
 hence the probability of forfeiture is too great to be consistent with the 
 public interest in securing the actual appearance of the defendant. 
 
 Admiralty bonds are given by owners of vessels to secure the pay¬ 
 ment of claims and damages, in order that the vessels may not have 
 
 1 The following description is based in part on Corporate Suretyship, an address 
 by First Vice-President R. R. Brown, of the American Surety Company of New 
 York, to the department of economics and social institutions of Princeton Uni¬ 
 versity (pamphlet, reprinted irom the Weekly Underwriter, New York, not dated). 
 
GUARANTY AND SURETYSHIP 
 
 331 
 
 to be held within the jurisdiction of the court while a case is awaiting 
 trial, and by the owners and consignees of goods which are likely to 
 be held liable for a contribution on account of the loss occasioned by 
 the jettison of other parts of the cargo or of parts of the vessel’s rigging 
 and equipment. 
 
 Depository bonds secure the repayment of deposits by banks; 
 usually deposits of public funds. 
 
 Customs and internal revenue bonds are written in many forms. 
 They secure the observance of revenue laws and regulations, or the 
 payment of customs duties on goods released from the control of 
 customs officials. Goods intended for re-export, for instance, may be 
 covered by a bond guaranteeing the payment of duties in case they 
 are not actually shipped out. 
 
 Warehouse bonds guarantee the performance of duties by ware¬ 
 housemen. Their purpose is chiefly to enable the owner of goods 
 in storage to secure credit on the security of the goods. 
 
 License , occupation , and permit bonds secure the observance of 
 law by persons engaged in regulated occupations, such as plumbers, 
 saloon-keepers, bonded abstracters, etc. 
 
 Contract bonds secure the performance of obligations under con¬ 
 tract. This is a very large and important class of surety obligations. 
 Bonds are required in connection with nearly all large construction 
 enterprises. Such bonds are very hazardous because of the numerous 
 circumstances which may occasion default on the part of a building 
 contractor, and the great expense involved securing the completion 
 of an unfinished contract. Bonds are also required by the United 
 States government in connection with the performance of mail service 
 and the furnishing of almost every kind of supplies. Supply bonds 
 involve chiefly the risk that the contract will become a source of loss 
 on account of advancing prices; contracts for the performance of mail 
 service are extremely hazardous, as specific performance is usually 
 required. 
 
 Lost security bonds indemnify a corporation in case of loss arising 
 from the replacement of a lost instrument which is later found. Such 
 bonds are always required when claim is made that a stock certificate 
 or bond has been lost or destroyed. This type of bond involves very 
 little risk to the bonding company. 
 
 m. INSURANCE OF REAL ESTATE TITLES 
 
 The title to real estate affords an excellent illustration of the possi¬ 
 bility of reducing risk through research. To the average man without 
 
332 
 
 RISK AND RISK-BEARING 
 
 expert assistance, the elements of risk involved in a purchase of real 
 estate on a simple warranty deed are very great. Years after the 
 property has been paid for and large sums have been spent in its 
 improvement, a defective title may result in an actual loss of posses¬ 
 sion, or, more frequently, a clouded title may necessitate expense in 
 order to clear up the doubt. On the other hand, if sufficient care is 
 taken it is almost always possible at any given time to discover all the 
 flaws in a title, and enable a purchaser to take the property with very 
 little risk. Three principal methods accomplishing this purpose are 
 in use in the United States. 
 
 Bonded abstracters .—The simplest system is the employment of a 
 bonded abstracter. Under this plan, the buyer or the seller of property 
 employs a professional abstracter to draw up an abstract of title, 
 which is then submitted to an attorney for an opinion. The abstracter 
 is legally liable if a loss occurs as the result of his failure so to prepare 
 the abstract as to show the facts of record concerning the title, and 
 is heavily bonded to insure the payment of such damages. 
 
 This system is widely used in the rural sections of the West and 
 works satisfactorily in the great majority of cases. (Indeed any sys¬ 
 tem works satisfactorily in the majority of cases for the reason that 
 there are usually no unknown defects of title which can cause trouble 
 no matter what system of protection is employed.) The system is 
 incomplete, however, for there are numerous possible defects which 
 are beyond the field of the abstracter’s investigation-—for instance a 
 forged deed may be recorded and the abstracter will have no way of 
 detecting the forgery, or there may be an undiscovered heir whose 
 rights are not a matter of record. Moreover, there is always the risk 
 that careless reading of the abstract or inefficient advisory work by 
 the attorney may cause a loss in cases where the abstract actually 
 discloses a flaw in the title. Finally, in the older sections of the 
 country, where transfers have been numerous, the mere physical labor 
 of searching records and copying abstracts makes this method unduly 
 expensive. 
 
 Title insurance .—In these older sections, especially in cities, the 
 most popular method of dealing with title, risks is through the services 
 of a title insurance company. Such a company usually has a virtual 
 monopoly of the business in a limited territory and therefore operates 
 on a sufficiently large scale to justify the expense of maintaining 
 elaborate files, from which the information necessary to pass on a 
 given title can be obtained quickly and economically. 
 
GUARANTY AND SURETYSHIP 
 
 333 
 
 The policy, which is perpetual in its force, insures not only against 
 the establishment of an actual defect in the title, but also against any 
 expense which may be involved in defending title, and against any 
 damage which may be sustained because of the refusal of a buyer to 
 accept the property on account of alleged defects in the title. 
 
 Before issuing such a policy, the insurer makes a careful examina¬ 
 tion of the records and lists in the policy all known defects, and also 
 certain possible unknown defects which are not matters of record. 
 Loss from these listed defects is then excepted from the protection of 
 the policy. Thus the policy serves the double purpose of a report on 
 the existing state of the title and a guarantee against loss due to error 
 and omission in the report. 
 
 The essential difference between the protection afforded by such a 
 policy and that afforded under the bonded abstracter system is that 
 in the latter case protection extends only to the result of negligence 
 or wilful error on the part of the abstracter, while in the case of the 
 title quarantee company it extends to numerous potential defects 
 which are beyond the possible knowledge of any of the parties to the 
 contract. The more important of the possible flaws which are not 
 discoverable through searching of the records are excepted from the 
 provisions of the policy, however, so that the risk actually taken by 
 the company is very small. 
 
 The following quotations from the form used by a prominent 
 title insurance company indicate the character of the protection 
 afforded: 
 
 The X Title and Trust Company shall have the right to, and will, at its 
 own cost and charges, defend the party guaranteed in all actions of eject¬ 
 ment or other action or proceeding founded upon a claim of title, incum¬ 
 brance or defect, which existed or is claimed to have existed prior in date to 
 this policy and not excepted herein; reserving, however, the option of set¬ 
 tling the claim or paying this policy in full. 
 
 Loss or damage by reason of special taxes or special assessments which 
 have not been confirmed by a court of record, conveyances or agreements 
 not of record at the date of this policy, or mechanics’ liens when no notice 
 thereof appears of record are not covered by it. 1 
 
 In addition to the limitation of liability just quoted, each policy 
 contains a special schedule of “estates, defects or objections to title, 
 and liens, charges and incumbrances thereon, which do or may now 
 
 1 The quotations are from the form used by a western company. For full 
 standard form adopted by the New York Board of Title Underwriters, see Huebner, 
 Property Insurance (revised), pp. 513-19. 
 
334 
 
 RISK AND RISK-BEARING 
 
 exist, and against which the Company does not guarantee.” The fol¬ 
 lowing quotations from this schedule in a recent policy are typical: 
 
 1. Conditions contained in the deed made by John E. Brown and wife 
 to Margaret A. Short dated November 5, 1894, and recorded November 5, 
 1894, as document 218475, that no building shall be placed on the east 
 thirty-five feet of the premises in question. 
 
 2. Party wall rights, if any. 
 
 3. Special assessment warrant 36783 for paving Johnstone Avenue, 
 confirmed March n, 1919, for $108.63 on premises in question, payable in 
 five installments, the last four unpaid. 
 
 4. Taxes for the year 1920. 
 
 Title policies are not assignable, except when issued to protect 
 mortgages. At each transfer a new policy is issued to protect the 
 new buyer. The cost of subsequent policies is considerably less than 
 that of the first, as little work has to be done to bring the record down 
 to date. 
 
 The losses paid by title insurance companies are far smaller than 
 is the case with any other type of insurance; indeed in many cases 
 purely nominal losses are sustained for years at a time. The premium 
 is based on the service rendered in searching the title rather than on 
 the risk assumed. Nevertheless, though the amount lost on account 
 of defects which are not discovered through searching records and are 
 not excepted (such as forged deeds, spurious powers of attorney, deeds 
 executed by lunatics, undiscovered heirs), the loss in the few instances 
 where such flaws exist is likely to be very serious for the persons con¬ 
 cerned, and a system by which such risks are transferred at small cost 
 to a responsible insurer provides a real social gain. 
 
 The Torrens system .—A third method of furnishing security against 
 defects in title, which has been introduced in recent years in certain 
 parts of the United States, is. the so-called Torrens system. This is a 
 system of public registration whereby at each transfer of title the pur¬ 
 chaser is given either an indefeasible title or a guarantee of reimburse¬ 
 ment in case the title proves defective. 
 
 In the original Torrens system, which was established in Australia 
 in the latter fifties, an administrative body was authorized to search 
 the title, and in the event that no defect appeared, the claimant in 
 actual possession was given a certificate entitling him to absolute 
 ownership. A small assessment on all property registered under this 
 system provided a fund from which compensation was made to any 
 holders on unsatisfied claims who might be deprived of their rights 
 through such registration. 
 
GUARANTY AND SURETYSHIP 
 
 335 
 
 The system has had a limited application in England and a con¬ 
 siderable popularity in Canada, and within the last few years has been 
 adopted in modified form in about a dozen American states. Under 
 the law of some of these states, registration does not give an inde¬ 
 feasible title, and the fund provided by registrants is used to compen¬ 
 sate holders of the registration certificates, in case error is discovered, 
 instead of previous holders of title as under the original Torrens sys¬ 
 tem. In other states, the registrant is given an indefeasible title, but 
 this is done through a formal suit to clear the title, and not through 
 the action of administrative officers. 
 
 In theory, the principle of the Torrens law provides a distinct 
 improvement over any of the other systems. It does not seem neces¬ 
 sary that in a community where land has been held by private individ¬ 
 uals for many generations, investigators should at every transfer 
 review the entire history of the title and reopen the question of the 
 validity of each alleged transfer, as is the practice under the bonded 
 abstracter system. Nor does it seem an ideal system that the com¬ 
 munity should depend for so essential a service upon the preservation 
 of the records of a private company and the maintenance of its ser¬ 
 vices, as is the case where the title insurance system is used. The 
 Torrens system, by clearing the slate at each transfer, greatly sim¬ 
 plifies the whole question. 
 
 In most cases, the initial expense of registration is somewhat 
 greater under the Torrens system than in the guarantee of title by a 
 title insurance company, and this cost falls upon a seller who has no 
 interest in the economy which will result in connection with future 
 transfers. For this reason, possibly also because of the influence of 
 the title companies, and also because of administrative weaknesses 
 and doubts in some quarters as to constitutionality, the progress of 
 the Torrens system in America has been slow. The only places in 
 which it has apparently had a significant development are Cook 
 County, Illinois, and the state of Massachusetts, and even there, so 
 far as volume of business is concerned, it is overshadowed by the title 
 insurance companies. 
 
CHAPTER XVII 
 RISKS OF LABOR 
 
 I. INTRODUCTION 
 
 As was indicated in chapter iii, the present industrial organization 
 contemplates the transfer to the business man of certain of the risks 
 associated with production, and a corresponding increase in the secu¬ 
 rity of the other factors in production. Under all ordinary circum¬ 
 stances, the laborer can count on receiving his pay for his co-operation 
 in an enterprise quite regardless of the ultimate success of the enter¬ 
 prise. Not only does the employer’s capital stand between the laborer 
 and the risks which beset the productive process, but to a large extent 
 those who extend credit to the business manager in any other way have 
 their claims subordinated to those of the laborer. 
 
 Nevertheless, the position of the worker is never free from certain 
 elements of risk. This arises in part from the impossibility of framing 
 a labor contract in such a way that all the risk of the business is borne 
 by the management, and secondarily from the fact that the worker 
 must himself carry the risk of being unable to find continuously an 
 opportunity to enter into an advantageous contract for the selling of 
 his labor. A group of students of the labor problem have summarized 
 the situation as follows: 
 
 To carry the analysis into the field of labor, the worker, if he learns a 
 trade, takes the risk that the demand for his services will be inadequate to 
 give him full-time employment at a living wage; he takes the risk that there 
 may be more workers in the trade than can be employed; he takes the risk 
 of changes in the technique of production eliminating the need for his skill 
 and throwing him into competition with myriad unskilled workers; he takes 
 the risk of being injured or becoming infected by occupational disease; he 
 takes the risk of being made a nervous wreck by the “roar and rhythm" 
 of the machine; and always there is the risk that public demand for the 
 product in the manufacture of which he is engaged may cease and leave him 
 out of a job, unfitted to do the work demanded in other lines of industry 
 
 Labor trouble is a source of danger to the business manager, but it also 
 threatens the worker. If he goes on a strike to better wages or working 
 conditions he runs a chance that the organization of which he is a member will 
 not be strong enough to win the strike or that strike benefits will be insuffi 
 
 336 
 
RISKS OF LABOR 
 
 337 
 
 dent to keep himself and his family alive. If the strike arouses public ill will, 
 anti-labor legislation may limit freedom of action on the part of labor organi¬ 
 zations thus tending to perpetuate the uncertain conditions against which he 
 went on strike. 
 
 And so it goes. Inadequate income whether due to unemployment, 
 industrial old age, sickness, accidents, industrial conflict, or low wages bring 
 risks of undernourishment which brings the risk of impaired efficiency which, 
 if it occurs, increases the risks of accident, disease, and low wages. Children 
 brought into the world may have to grow up under the handicaps imposed 
 by such risks and this adds another risk to the already heavy load of uncer¬ 
 tainty which the worker has to bear. 
 
 Indeed it can be said with a certain degree of accuracy that the worker 
 assumes all the risks of the employer and in addition bears some unique 
 to himself. In common with all individuals he runs the risk of death, acci¬ 
 dent, fire, war, disease, etc., the risks due to his carelessness which includes 
 many accidents and deaths, and the risks due to the dishonesty on the part 
 of the worker or others; as a member of the working class he bears the unique 
 risks of unemployment, underemployment, or overemployment, long hours, 
 the risk of inadequate wages, the risks arising out of the antagonism between 
 specialists, the risks of specialization, the risks due to the characteristics of 
 the machine, the risks of anti-labor legislation, and the risks of competition 
 from his fellows; in particular industries he runs the risk of seasonal employ¬ 
 ment, of occupational disease, of sweating, of accidents, or moral devolution. 1 
 
 The risks which the laborer shares with the rest of the race we 
 may well leave without detailed consideration. Our particular inter¬ 
 est is in the risks which arise directly from his connection with the 
 economic process. Of these by far the most important are the risks 
 of unemployment and of industrial accident and occupational diseases. 
 
 II. UNEMPLOYMENT 
 
 Exact figures for the volume of unemployment are not available , but 
 the estimates made by competent investigators agree in showing, first, 
 a high degree of variability in the amount of unemployment, and, 
 second, an appreciable amount of unemployment at the busiest sea¬ 
 sons of the most prosperous years. Omitting agricultural labor from 
 consideration, it appears that during the last twenty years the amount 
 of unemployment in the United States has fluctuated from a probable 
 minimum of 1,000,000 to a possible maximum of 6,000,000, out of a 
 total number of workers estimated as about 30,000,000 during the 
 latter part of the period. To some extent, the significance of the 
 
 1 From Douglas, Hitchcock, and Atkins, The Worker in Our Modern Economic 
 Society (preprint, chap. v). The University of Chicago Press, 1923. 
 
33 § 
 
 RISK AND RISK-BEARING 
 
 maximum figures is reduced by the probability that a considerable 
 expansion of agricultural employment coincided with the minimum 
 of industrial employment, but the extent of this absorption of the 
 unemployed has not been estimated. 
 
 The distribution of the cost of unemployment is very uneven.--In the 
 case of approximately half the working group, the loss due to this cause 
 is negligible, while within the other half there are very wide individual 
 variations. 
 
 Unemployment is a market risk. —Each manual laborer has to sell 
 a definite amount of labor service, each item of which represents an 
 irreplaceable impairment of his stock in trade. At the outside, the 
 manual laborer can rarely sell more than twelve thousand days’ 
 service during his working life; the average figure is probably 
 nearer six thousand. Unemployment is simply the failure to market 
 a part of his stock in trade. The seriousness of this hazard arises 
 fundamentally from the fact that his labor is a “perishable com¬ 
 modity.” Every day’s service must be sold at a given time or not 
 at all. 
 
 The difficulty is aggravated by the inelastic character of the price 
 of labor. In times of slack demand, it would frequently be to the 
 laborer’s immediate interest to sell his time at a cut price, just as a 
 merchant finds it advantageous to clear his shelves by bargain sales, 
 but the market is so organized that, as a rule, the laborer cannot, by 
 price-cutting, stimulate an increase in demand for his services. He 
 can sell his time at the going rate demanded by his competitors or he 
 cannot sell it at all. Some decline of wages takes place in time of 
 declining demand,but to a large extent labor is “deflated” in periods 
 of depression by a decrease in the amount of labor sold rather than 
 by a decline in its price . 1 
 
 1 This is much less true of agricultural than of industrial labor. Independent 
 farmers lose by the decline of the price of their products, and the relationship 
 between the employing and employed groups in agriculture is so close that even 
 the hired laborer in this field of employment is relatively free from the risk of 
 unemployment, and finds his wage fluctuating rather sharply with the level of 
 prices for the products of the farm. 
 
 Whether labor, as a whole, gains by this custom of holding up wages in times 
 of dull business and accepting unemployment is doubtful. There can be little 
 doubt that a sharp readjustment of wages downward, in times of liquidation, would 
 contribute greatly to the shortening of the ensuing depression. Laborers who are 
 most certain of employment would lose; those who bear the burden of unemploy¬ 
 ment would gain; the net result for the time being would probably be a gain. 
 Whether this gain would be offset by the difficulty of gettiig wages up again as 
 
RISKS OF LABOR 
 
 339 
 
 In any discussion of the causes of unemployment, a distinction 
 should be maintained between the conditions which determine the 
 amount of unemployment at any given time and those which deter¬ 
 mine the selection of individuals to bear the burden of the unemploy¬ 
 ment. The amount of unemployment in any industry is determined 
 chiefly by conditions for which the workers in that industry are indi¬ 
 vidually responsible to a trifling extent. 
 
 Unemployment arises chiefly from six causes: ( a ) seasonal fluctua¬ 
 tion in the activity of specific industries; ( b ) cyclical fluctuation in the 
 activity of business in general, as well as of specific industries; (c) the 
 necessity of maintaining a reserve of unemployed labor in order to 
 insure the smooth working of the industrial machine, as was pointed 
 out in chapter ii; (d) labor troubles; (e) interruption of production 
 from causes peculiar to the individual establishment, such as fire, 
 bankruptcy, consolidation of plants, shutdown for lack of transpor¬ 
 tation or of raw material, overstocking with finished goods, and similar 
 causes; (/) personal incapacity and inefficiency, and shiftlessness. 
 
 The factor named last is not co-ordinate with the other five, how¬ 
 ever, but overlaps them. The first five causes determine how much 
 employment there shall be at a given time; the sixth helps to determine 
 which individuals shall be left out. Assuming that the economic 
 situation is such as to dictate the unemployment of io per cent of the 
 labor supply, what determines which of the laborers shall make up 
 this io per cent? In part, the answer is, chance. Shutdown on 
 account of fire, for instance, affects the efficient and the inefficient 
 alike. Reduction of forces on account of decline in the volume of 
 orders, on the other hand, gives opportunity for a sifting of the labor 
 force, especially where the number of employees is large, with the 
 result that personal characteristics play a very large part in determin¬ 
 ing where the ax shall fall. Moreover, even in cases where the unem¬ 
 ployment arises from conditions which affect a whole group of workers 
 alike, the personal efficiency, the energy, and the co-operative spirit of 
 the laborer determine in large part what shall be the duration of his 
 unemployment. For the best workman, a position is usually to.be 
 found quickly; for the mediocre and the low-grade worker the loss 
 
 business revived one can only conjecture; it is a question of the relative importance 
 of bargaining power and actual productive value in determining wage scales. A 
 system of very elastic wage scales would make it possible for industry to pay higher 
 average wages than it can now pay; the inelastic system makes it somewhat easier 
 to compel industry to pay as much as it can. 
 
340 
 
 RISK AND RISK-BEARING 
 
 of a job is much more likely to mean serious loss of time before employ¬ 
 ment can once more be obtained. 
 
 Not all the unemployment represents waste, either from the social 
 standpoint or from that of the laborer. From the standpoint of soci¬ 
 ety, the loss of time incident to maintaining an adequate reserve of 
 labor, the unemployment incident to shifting laborers from time to 
 time to more productive employment, and the time necessarily lost 
 on account of seasonal fluctuations in business, are all parts of the 
 cost of running the industrial machine, and are no more to be accounted 
 wastes than is the time of laborers engaged in eating and sleeping. 
 
 From the laborer’s standpoint, also, the loss of time incident to 
 seeking and obtaining better conditions of work must be regarded as 
 an investment rather than a waste. 
 
 In like manner, the unemployment which is the result of labor dis¬ 
 putes represents, from the standpoint of the laborer, an investment 
 intended to increase the selling value of part of his labor time by sacri¬ 
 ficing the income from a smaller part. If the labor market were 
 perfectly fluid, such dissipation of labor power would represent a sheer 
 waste, for it would be practicable for anyone who was dissatisfied with 
 the conditions of his employment to transfer himself to another field 
 where the compensation and conditions of work were more satisfactory. 
 The labor market, however, is an imperfect market; it is not practi¬ 
 cable for the laborer who believes himself ill paid to transfer himself to 
 another employment without loss of time, direct money cost, and con¬ 
 siderable risk. Consequently, the effort to improve those conditions 
 by interruption of service may well be, from the individual standpoint, 
 profitable. From the social standpoint, it represents a waste just in so 
 far as there exists a better method of insuring the adjustment of wages 
 to changing conditions of demand and supply in the labor field. Cer¬ 
 tainly it is a cumbersome and expensive method of maintaining the 
 relationship between wages in a given industry and the conditions 
 which determine a fair wage in that industry; yet this loss cannot be 
 labeled a complete waste till a better method of accomplishing its 
 purpose is demonstrated to be practicable. 
 
 Of the causes of unemployment enumerated, the seasonal fluctua¬ 
 tion is the most important, so far as numbers indicate importance, but 
 the significance of this factor is greatly lessened by the extent to which 
 it is compensated, either by wage rates or by the possibility of making 
 profitable use of the idle time. The extent to which dovetailing of 
 employment is possible depends chiefly on the technique of the indus- 
 
RISKS OF LABOR 
 
 341 
 
 try, and on the extent to which the amount and time of the employ¬ 
 ment is known in advance. Some occupations, such as coal-mining, 
 unfit the laborer for the most accessible alternate employments; others, 
 such as farming, do not interfere directly with the laborer’s fitness for 
 a variety of other employments, but coincide in their slack and busy 
 seasons with most of the occupations in which alternative employment 
 could otherwise be secured most readily; others, such as teaching, 
 dovetail well with numerous other occupations which furnish profitable 
 employment during the slack season. 
 
 The extent to which the rate of pay in any occupation adjusts itself 
 to the worker’s necessity of losing time, on account of seasonal fluctua¬ 
 tions, depends on two factors, namely, the extent to which dovetailing 
 is usually practicable, and the degree of certainty in the unemployment. 
 Any condition limiting the total amount of employment, if it is cer¬ 
 tain, is fairly sure to be compensated for in the wage, but competition 
 is not so effective in compensating for the uncertain but probable losses. 
 Even if the wage in a given occupation adjusts itself so that the average 
 compensation for a year’s service is sufficient to cover idle as well as 
 working time, it would still be true that many individuals would suffer 
 from less than average employment. Moreover, if the amount lost 
 by each individual is highly uncertain, it is much more likely to be 
 under- than over-compensated for the average worker. The effect of 
 the unemployment hazard on wages is merely to keep them high 
 enough so that workers are willing to take the risk; if even a minority 
 of workers overestimate the amount of employment they are likely to 
 have, the wage adjustment may be such as to leave the average worker 
 the loser. In practice, the adjustment of wages to irregularity in the 
 volume of employment seems to vary widely from industry to industry, 
 being most accurate in cases like teaching where the idle time is known 
 accurately in advance, and least satisfactory in cases where a high 
 degree of irregularity combines with a low standard of life and inade¬ 
 quate appreciation of the risk on the part of the worker. 
 
 Ways of dealing with the risk of unemployment are numerous .— 
 Private employment agencies and newspaper advertising serve to 
 shorten the interval between jobs by reducing the amount of work 
 necessary for worker and employer to get in touch with one another. 
 Scientific labor administration, including such devices as job analysis, 
 rating cards, and all administrative methods and policies which aim 
 at the creation of harmony and a spirit of co-operation within an indus¬ 
 trial organization—all these serve to reduce the turnover of labor, and 
 
342 
 
 RISK AND RISK-BEARING 
 
 incidentally the risk of unemployment. Public employment agencies 
 aim to effect a more economical adjustment of demand and supply in 
 the labor field than that effected by the private agencies. All plans 
 for the stabilization of industry (with primary reference to the reduc¬ 
 tion or elimination of the cyclical fluctuation) include, among their 
 objectives, the reduction of the amount of unemployment which char¬ 
 acterizes the depression stage. Diversification of one’s preparation, 
 so as to make possible the dovetailing of employment, aids individuals 
 to meet the exigencies of the situation. 
 
 Finally, it remains to consider the possibility of dealing with this 
 risk through insurance. In most respects unemployment presents a 
 good example of the kind of risk for which insurance offers a satisfac¬ 
 tory palliative. The incidence of unemployment is frequent enough 
 to keep the laborer alive to the importance of provision against it; it 
 is not so great in amount that insurance against it involves a prohibi¬ 
 tive cost; it affects different individuals at different times and from 
 different causes, so that (in spite of the concentration of losses occa¬ 
 sioned by a downswing of the business cycle) the catastrophe hazard 
 is not a serious bar to the underwriting of the risk. The moral hazard 
 would be very great if full protection were offered, but the insurer 
 could be protected against this danger, as in credit insurance, by 
 requiring the insured to bear a fixed “normal loss” and to coinsure for 
 a fixed percentage of the remainder. Insurance to the amount of 50 
 or 60 per cent of wages for unemployment beyond a certain number of 
 days (the number varying with the industry) would hardly stimulate 
 a significant amount of deliberate unemployment. 
 
 The chief obstacle to the writing of such insurance arises from the 
 wide variation in the hazard on different individual risks; the difficulty 
 in measuring this difference; and the certainty of serious adverse 
 selection in case such measurement is not effected and utilized in rate¬ 
 making. If flat rates were charged, without attention to individual 
 variations in employability, there would undoubtedly be a tendency 
 for poor risks to insure and the good risks, the men who rarely have 
 trouble in finding jobs, to carry their own risk. There is also to be 
 considered the possibility that kind-hearted employers, confronted 
 with the necessity of reducing forces, would deliberately select for 
 dismissal those who were protected by insurance against unemploy¬ 
 ment. For these reasons, the ordinary form of insurance, which looks 
 to the self-interest of each individual to induce him to take out such 
 insurance as he needs, does not meet the situation. 
 
RISKS OF LABOR 
 
 343 
 
 On the other hand, some method by which whole groups of laborers 
 might be insured, without opportunity for adverse selection, might 
 serve a very useful purpose. One device, which has been used for the 
 purpose in a number of cases, and appears possible of wider service 
 in this way, is insurance through the trade union. Membership in a 
 union depends primarily upon other considerations, so that there is 
 no tendency for the poor risks to predominate among the insured; the 
 amount paid is small enough so that there is no incentive to malinger¬ 
 ing, and the organization has better than average facilities for deter¬ 
 mining the genuinemess of claims against it. 
 
 The weakness of this method consists in the fact that the insurance 
 feature of trade union policy is subordinate to other features, and is 
 therefore likely to be sacrificed to attain some other end. In almost 
 every instance where insurance benefits are offered by a trade union, 
 the funds contributed by members for that purpose are commingled 
 with those collected for other purposes, and are likely to be used for 
 the promotion of ends which have no relation to insurance. From 
 the typical trade-union official viewpoint, the insurance feature is a 
 means of obtaining and keeping members, or collecting additional 
 revenue from them, rather than a primary purpose of the organization. 
 Were an attempt made to collect from the membership sufficient funds 
 to cover adequately the risk of unemployment, the insurance feature 
 would become so expensive as to weaken rather than strengthen the 
 organization. 
 
 It does not seem probable that the risk of unemployment can be 
 removed by voluntary insurance, paid for by the workers, either 
 through the trade union or through a commercial insurance company. 
 There remain the possibilities of insurance at the cost of the state, of 
 the employer, or of some combination of these with one another or 
 with insurance at the cost of the worker. Subsidized public insurance, 
 both voluntary and compulsory, has been tried in a number of Euro¬ 
 pean countries, the most notable experiment being that now carried 
 on by the British government under the Unemployment Insurance 
 Act of 1920 (an extension of the National Insurance Act of 1911). 
 Under this system, the cost of insurance is borne jointly by the 
 employer, the employee, and the state. This joint support removes, 
 in large part, the fundamental objection to a system of insurance 
 which does not adjust the premium to the known difference of hazard 
 in the individual case. With about 60 per cent of the cost borne by 
 the state and the employer, even the individual who believes himself 
 
344 
 
 RISK AND RISK-BEARING 
 
 to be a high-grade risk will not be so likely to complain of being over¬ 
 charged when he is required to pay at the same rate as is charged his 
 less employable fellow-worker, though in the case of the best workmen 
 even 40 per cent of the average loss is probably an overcharge. The 
 compulsory feature secures for the insurer a proper distribution of 
 the risk. The contribution of the state is offset, in part at least, by 
 the saving in poor relief, both public and philanthropic, which results 
 from the operation of the insurance fund, and the effect of public 
 relief extended in this way is perhaps less demoralizing than would 
 be the case if it were extended directly as poor relief. The compulsory 
 contribution of employers is defended on the ground that the cost of 
 unemployment incident to the operation of a given industry is a part 
 of the cost of running the industry, and ought to be so assessed as to 
 appear in the price of the product, or in the profit account of the 
 employer. 
 
 The weakness of the plan, aside from serious administrative diffi¬ 
 culties, lies in the absence of any plan of merit rating by which the 
 employer may be given an incentive to stabilize his operations, or the 
 employee an incentive to increase his own employability. An insur¬ 
 ance system which merely equalizes burdens is useful, but it falls short 
 of its highest possibilities unless it does something to reduce the total 
 amount of losses. It may be too much to expect that any practicable 
 system of rating individual risks will give the worker more incentive 
 than he now has to rise into the class of steady workers who are 
 relatively free from the risks of unemployment, but in the case of the 
 employer there seem to be distinct possibilities of gain in this direction. 
 In the light of the great progress which has been made ii. recent years 
 in the elimination of irregularities in the operation of industrial plants, 1 
 compulsory unemployment insurance which fails to reward or penalize 
 marked departures from the usual proportion of idle time fails of its 
 highest potential usefulness. 
 
 It may be added that the political organization of the United States 
 makes it more difficult here than abroad to maintain a national system 
 of unemployment insurance, with its necessarily minute research into 
 local conditions; while state organization presents very undesirable 
 aspects on account of the extent to which the employers of one state 
 are in direct competition with those of another, while their employees 
 are drawn from a common source and move freely from one state to 
 
 1 For example, in this country by the Dennison Manufacturing Company 
 and by the Joseph and Feiss Company. 
 
RISKS OF LABOR 
 
 345 
 
 another. Unemployment insurance under political control does not 
 appear to be a probable development of the immediate future, in the 
 United States. 
 
 Another possibility of the reduction of unemployment is the delib¬ 
 erate expansion of public works in times of depression. This plan 
 offers the double advantage of equalizing the incomes of laborers, con¬ 
 tractors, and others by furnishing them employment during periods 
 of dulness in industry, and of offering a probability of economy, con¬ 
 struction costs being lowest at such times. In so far as public works 
 promise to serve a real social need when completed, and are at the same 
 time not of so urgent a character as to make it inadvisable to wait for 
 depression eras in order to undertake them, this plan is thoroughly 
 sound. The chief difficulty in its practical application arises from 
 circumstances similar to those which interfere with the concentration 
 of construction work by corporations in times of low cost, namely the 
 difficulty of financing enterprise at such times, or securing authorization 
 to carry them forward. A time when general business is very slack 
 and employment scarce is fairly certain to be a time when the burden of 
 taxation is felt to be abnormally heavy, and legislatures and electorates 
 are prone to economize at such times. Proposals to undertake heavy 
 expenditures for purposes that are not urgent receive grudging 
 support. 
 
 m. ACCIDENT AND OCCUPATIONAL DISEASE 
 
 The risk of industrial accident and occupational disease presents a 
 problem both in social policy and in individual financial management 
 which is very similar to that presented by unemployment. In each 
 case there is a considerable element of risk which cannot be eliminated 
 by preventive measures, and another considerable element which can 
 be eliminated if proper incentives are given those who are responsible 
 for the conditions under which industry is carried on, both employers 
 and laborers. In each case the hazard varies greatly from one industry 
 to another; and in each case the financial loss is divided between the 
 employer, the public, and the laborers themselves. In each case the 
 financial loss inflicted upon the majority is small enough so that no 
 serious problem exists, while the loss in individual cases is so great as 
 to make the hazard very serious. The variation of the risk from one 
 individual to another, under like conditions of employment, is not 
 as great as in the case of unemployment hazard, but is neverthe¬ 
 less so great that it is necessary to take account, in the determina- 
 
346 
 
 RISK AND RISK-BEARING 
 
 lion of a wise policy, of the effect on the worker’s incentive to exercise 
 his best efforts to reduce the hazard. 
 
 The statistics of industrial accident are more complete than those 
 for unemployment, and the loss shows a much greater degree of regu¬ 
 larity from year to year. The number of fatal industrial accidents in 
 the United States has been estimated at 25,000 for 1913, and 23,000 
 for 1919; those involving four weeks or more of disability at 700,000 
 for the former year and 575,000 for the latter. 
 
 The burden of the loss from personal accidents is distributed in 
 various ways. Much of it falls directly on the workers affected; 
 another portion probably falls initially on the employer through the 
 necessity of paying higher wages in the more dangerous occupations; 
 another part is assumed by the public in the form of poor relief, and 
 through the cost of maintaining machinery for adjudicating claims 
 arising out of accidents; another part is shifted to employers and 
 others who may be responsible through voluntary or compulsory pay¬ 
 ment of damages, through payments under compensation laws, and 
 through insurance against liability; some small part is distributed 
 over the working group through the medium of private insurance. 
 Some of these methods are of sufficient importance to warrant detailed 
 examination. 
 
 There is no evidence that wage rates adjust themselves accurately to 
 the risk of accident. —It has been argued that there is little need of 
 public action with a view to allocating the burden of accidents more 
 equitably, for the reason that competitive wages can be depended upon 
 to equalize this, as it does other differences in the attractiveness of 
 different forms of employment. The weakness in this form of argu¬ 
 ment is the assumption, first, that in practice the degree of risk asso¬ 
 ciated with any form of accident is known to the parties to the wage 
 contract well enough to make it a reasonable basis of adjustment of 
 wages, and, second, in the assumption that even if such adjustment 
 were effected the result would be to equalize the burden. It may be 
 granted that if the number of accidents which will occur in each 
 establishment could be predicted accurately, and were known to all 
 prospective applicants for such employment, and all such appli¬ 
 cants were rational in their choices, the wages paid would have 
 to compensate the group as a whole for the total loss due to acci¬ 
 dents, and the burden would fall either on the capitalists employing 
 them, the consumers of the product of' the industry, or, conceivably, 
 on the public at large. Even then, as was pointed out in discussing 
 
RISKS OF LABOR 
 
 347 
 
 a similar situation in connection with the risk of unemployment, the 
 result, in the absence of an effective system of insurance, would be to 
 bestow extra compensation upon the majority who escape the hazard, 
 and not to remove the burden from those who now suffer it. 
 
 But the outstanding characteristic of the situation is the absence 
 of certainty concerning the amount of loss which will be incurred, and 
 the certainty of selection adverse to the workers. For if some workers 
 overestimate and others underestimate the risk, it matters not whether 
 the average estimate is too high or too low. The effective amount of 
 risk is the risk as estimated by those who, in numbers sufficient to man 
 the industry, are disposed to rate it lowest. Familiarity breeds 
 indifference, so that those who best know the risks of a trade are most 
 apt to ignore them. Notoriously, many men have an unintelligent faith 
 in their own good luck; others shrink from being thought afraid; and 
 many are ignorant of the hazards involved in the pursuits which they 
 choose. These are the men whose choices determine the excess of 
 wages to be paid in dangerous occupations; the services of the timid 
 or even the intelligently cautious worker are rarely needed in occupa¬ 
 tions where danger is really great. 1 
 
 The accident risk is rarely covered by personal insurance by workers .— 
 The same factors which obstruct any tendency for wages to adjust 
 themselves to the hazard of a given employment also obstruct the 
 progress of private insurance as a palliative. If workers underesti¬ 
 mate the degree of risk in a given trade, they are not likely to pay the 
 premiums demanded for insurance by an insurance company which 
 must figure the risk conservatively high and add a loading for expense 
 and profit. Moreover, in the absence of a definite assurance that 
 wages are high enough to compensate for the risk undergone, the 
 effect of insurance at the expense of the workers is merely to equalize 
 the burden they are assuming without adequate compensation; it 
 increases the burden for the group as a whole. Casualty companies 
 do write a considerable amount of personal insurance to protect against 
 the risk of accidents, but this is carried chiefly by professional and busi¬ 
 ness men rather than by laborers. 
 
 Liability. —It was noted above that a part of the accident hazard 
 is transferred to employers, or other responsible persons, through the 
 
 1 Cf. A. S. Johnson, Introduction to Economics , pp. 205-7. A careful theoret¬ 
 ical analysis of this question is found in R. M. Woodbury, Social Insurance, an 
 Economic Analysis, pp. 56-70. Mr. Woodbury has also examined the statistical 
 evidence, and concludes that the data are entirely inadequate either to prove or to 
 disprove the existence of any tendency for wages to adapt themselves to the degree 
 of risk. 
 
348 
 
 RISK AND RISK-BEARING 
 
 medium of voluntary or forced settlement of claims for damages. The 
 original theory of the common law does not distinguish the responsibil¬ 
 ity of employers from that of others; that is, they are responsible for 
 such damages as may be caused directly by their fault or negligence. 
 
 This liability was, during the course of the nineteenth century, 
 subjected to further limitation on account of the application, in cases 
 involving claims for damage done to workmen by their employers, 
 of defenses which would not be available in similar cases where the 
 plaintiff was not an employee. These are, first, the defense of con¬ 
 tributory negligence, the essence of which is that in cases where negli¬ 
 gence on the part of both employer and employee is shown to have con¬ 
 tributed to bring about the accident, no damages can be collected; the 
 fellow-servant doctrine, which holds that an employer is not respon¬ 
 sible for damage done to his employees through carelessness of other 
 employees; and the doctrine of assumption of risk, by which the 
 laborer is held to have waived his claim to damages if he can be shown 
 to have had knowledge of the special hazard and accepted employ¬ 
 ment without a special agreement guaranteeing him compensation 
 for such accidents as might result. The cumulative effect of these 
 defenses was to make it extremely difficult and expensive for an 
 employee to obtain compensation in such cases as make up the major 
 portion of the accidents to w hich the laborer is exposed, and to place 
 upon him the financial cost of numerous accidents which he could in 
 practice do little to prevent. 
 
 During recent years, the situation has been changed through the 
 general adoption of one or the other of two reforms, known respectively 
 as employers’ liability laws and workmen’s compensation laws. 
 
 Employer’s liability legislation (widely adopted between 1885 and 
 1910) is simply legislation designed to modify the liability of the 
 employer, without abandoning the fundamental rule that the employer 
 is responsible, just as anyone else is responsible, for the results of his 
 own negligence. Some states have abolished the fellow-servant doc¬ 
 trine; others limit its application to certain industries or exclude from 
 its operation injuries due to the fault of certain classes of employees. 
 There have been also various modifications of the doctrine of contribu¬ 
 tory negligence, some states providing for a division of the financial 
 responsibility, in cases where negligence is shown on the part of both 
 parties; others placing the burden on the employer to prove contribu¬ 
 tory negligence instead of requiring the employee to prove its absence, 
 as was the case under the common law. 
 
RISKS OF LABOR 
 
 349 
 
 The chief criticisms of the system of employers’ liability as modi¬ 
 fied by legislation are, first, that it is unduly expensive in administra¬ 
 tion (on account of the necessity of suits to establish responsibility 
 in a large proportion of cases); second, that it fails to place properly 
 the cost of the accidents for which neither employer nor employee is 
 directly responsible; third, that it has in practice provided compensa¬ 
 tion for only about one accident in eight so that the bulk of the cost 
 of accident has remained with the working group, where its incidence 
 has been most burdensome, and its effect least effective in stimulating 
 remedial and precautionary effort. 
 
 Workmen’s compensation .—During the years since 1910 a new 
 principle has come to be widely accepted for dealing with this type of 
 risk, known as the principle of compensation. The features which 
 differentiate the compensation plan from the systems which preceded 
 it may be summarized as follows: First, under compensation the pre¬ 
 sumption is in favor of assessing the cost of an accident on the employer 
 instead of on the employee. In cases where neither the employer nor 
 the employee is guilty of negligence, employers’ liability places the 
 cost on the employee; workmen’s compensation places it on the 
 employer. Second, workmen’s compensation aims to provide, so far 
 as possible, a fixed scale of benefits for each type of injury, the amount 
 depending on the character of the disability, the amount previously 
 earned by the injured worker, the existence or non-existence of depend¬ 
 ents, and similar considerations. Third, compensation benefits are 
 frequently made payable in the form of annuities, in order that the 
 loss due to the death or permanent disability of the injured worker 
 may be reduced by the replacement of his wages by a similar type of 
 income; liability insurance, since it contemplates payment fora spe¬ 
 cific wrong already committed, favors immediate payment of damages 
 in a lump sum. Fourth, compensation plans frequently recognize 
 the desirability of requiring employers to protect their employees 
 from the risk that the purpose of compensation may be defeated by the 
 employer’s bankruptcy or withdrawal from business. 
 
 Beginning in 1910, the principle of compensation found very rapid 
 acceptance, and only five states, together with the District of Colum¬ 
 bia, 1 now have no compensation laws. In many of the states listed 
 as having compensation, however, the number of occupations excluded 
 and in the few cases the existence of optional substitutes, reduce con¬ 
 siderably the significance of these figures. The following recent 
 
 1 In private employment. 
 
3So 
 
 RISK AND RISK-BEARING 
 
 summary indicates the wide dissimilarity between the plans now in 
 use, the differences extending to almost every point where a difference 
 is possible: 
 
 Compensation laws may be either compulsory or elective. A com¬ 
 pulsory law is one which requires every employer within the scope of the 
 compensation law to accept the act and pay the compensation specified. 
 An elective law is one in which the employer has the option either of accept¬ 
 ing or of rejecting the act, but in case he rejects the customary common-law 
 defenses are abrogated. Of the 45 compensation jurisdictions (43 states, 
 Alaska, and Hawaii), 14 are compulsory and 31 are elective as to compensa¬ 
 tion provisions. 
 
 Scope or coverage. —No state compensation act, even when full use of 
 the elective provisions is taken into account, covers all employees. The 
 principal exemptions, in the order of their importance, perhaps, are: non- 
 hazardous employments; agriculture; domestic service; numerical exemp¬ 
 tions, i.e., excepting employers having less than a specified number of 
 employees; public employees, casual laborers or those not employed for the 
 purpose of the employer’s business; and employments not conducted for 
 gain. 
 
 Occupational diseases. —Eleven states and the Federal Government now 
 include occupational diseases among the list of compensable injuries. In 
 most of these states all occupational diseases are compensated, but in some 
 the coverage is limited to certain specified diseases and processes. 
 
 Waiting period. —In most of the states an injury to be compensable must 
 cause disability for a certain length of time, no compensation being paid 
 during this time. This noncompensable preliminary period is known as 
 the “waiting period.” The most common provision is that disability must 
 continue for more than one week, this being found in 25 states. 
 
 Compensation scale. —In all but two states the amount of compensation 
 is based upon wages. A number of states, however, provide fixed lump 
 sums or pensions for certain injuries, but apply the percentage system to all 
 others. A few states have varying percentages for different types of injuries, 
 and in several states the percentage varies with conjugal condition and num¬ 
 ber of children. In 19 states the amount of compensation is 50 per cent of 
 the employee’s wages: in 3 states, 55 per cent; in 9 states, 60 per cent, in 
 3 states, 65 per cent; and in 9 states and the Federal Government, 66§ per 
 cent. 
 
 The compensation benefits are usually modified by weekly maximum 
 and minimum limits which may materially affect the amounts. It is 
 undoubtedly true that under no state compensation law does the employer 
 bear 50 per cent of the cost of industrial accidents and in most states he bears 
 but 20 to 35 per cent. 
 
RISKS OF LABOR 
 
 35 1 
 
 The benefits for death in most cases approximate three or four years’ 
 earnings of the deceased employee. Twenty-three states place a limit upon 
 the maximum amount payable in any one case. These maximum amounts 
 range from $3,000 to $6,000. 
 
 Most states recognize the fact that a permanently disabled workman is a 
 greater economic loss to his family than if he were killed outright at the time 
 of the accident, and consequently provide greater benefits than in case of 
 fatal accidents. Eighteen states and the Federal Government provide that 
 for permanent total disability compensation payments shall continue for 
 the full period of the injured workman’s life. Twenty-one states place a 
 limit upon the maximum amount payable in any one case; these maximum 
 amounts range from $3,000 to $10,000. 
 
 Partial disability .—Two methods for compensating partial disabilities 
 are generally provided for. One method is based upon the percentage of 
 wage loss occasioned by such disability, payments continuing during inca¬ 
 pacity but subject to maximum limits. The second method is the adoption 
 of a specific schedule of injuries for which benefits are awarded for fixed 
 periods, the payments being based upon a percentage of wages earned at the 
 time of the injury. Usually both methods of payment are provided for. 
 The practice in most states is to pay a percentage of the wage for fixed periods 
 for certain enumerated injuries and for all other injuries a percentage of the 
 wage loss during disability. 
 
 Medical benefits .—Three states furnish no medical service except that in 
 fatal cases involving no dependents the expenses of last sickness shall be 
 paid by the employer. Seven states and the Federal Government provide 
 unlimited service. Nine laws place no limitation upon the period during 
 which medical treatment shall be furnished, but do limit the amount; while 
 seven limit the period, but do not limit the amount. 1 
 
 It remains to consider the extent to which the risk of industrial 
 accident is reduced through the operation of insurance. Insurance to 
 cover this risk has two quite distinct purposes. It may be taken out 
 for the purpose of protecting the employer against the hazard he carries 
 under either employers’ liability or workmen’s compensation, or it 
 may be required by the state in order to protect workmen against loss 
 from inability of the employer to meet his responsibilities under the 
 law. 
 
 Liability insurance is voluntary .—Before the liability of employers 
 was generally increased through the passage of the limiting legislation 
 to which reference was made above, few employers felt it necessary 
 
 1 Adapted from Carl Hookstadt, “Workmen’s Compensation and Social Insur¬ 
 ance,” Monthly Labor Review , XVI (January, 1923), 158-69. 
 
352 
 
 RISK AND RISK-BEARING 
 
 to protect themselves by insurance against the hazard of incurring 
 liability for damages on account of industrial accident. With the 
 passage of laws abrogating the customary defenses, however, the risk 
 became so serious that liability insurance became very common, and 
 it still is valuable in states where compensation systems have not been 
 introduced, and also in the case of the numerous occupations to which 
 compensation requirements do not apply, and in the cases where indi¬ 
 vidual employers elect to refuse to come under the provisions of 
 optional compensation arrangements. This form of insurance is 
 written chiefly by stock companies. 
 
 Compensation insurance is in many cases compulsory .—Some form 
 of guarantee of financial ability is required in nearly all the states 
 which have adopted the principle of workmen’s compensation. The 
 most common requirement is that all employers who are subject to 
 the provisions of the compensation law shall either insure with licensed 
 insurance carriers, or else provide what is called “self-insurance,” 
 that is, satisfy the proper administrative body of their ability to. carry 
 the risk. Only eight or ten states make insurance absolutely compul¬ 
 sory, while four make no provision for guaranteeing the payment of 
 compensation in case the employer becomes bankrupt or retires from 
 business. In view of the long period during which compensation 
 liabilities persist, some provision to assure the continuance of pay¬ 
 ments is highly important. 
 
 Three principal types of insurance are in use, namely, state funds, 
 stock company insurance, and mutual insurance. In seven states, 
 an exclusive fund is maintained by compulsory contributions from 
 employers, and all compensation payments are made from this 
 fund. In nine others, state funds compete with private agencies, 
 and in the remaining states the field is occupied only by the private 
 agencies. 
 
 Workmen’s compensation is so new that it is hazardous to venture 
 an opinion as to the relative desirability of the three plans. In theory, 
 a monopolistic state fund, if efficiently managed, should be able to 
 furnish the service more economically than a private carrier, with its 
 large selling costs and limited volume of business. The state funds 
 actually in operation have made an excellent showing. Such data as 
 have been published (and several of them have been subjected to care¬ 
 ful investigation) indicate that the cost of administration of accident 
 insurance is lower in the mutual than in the stock companies, lower 
 
RISKS OF LABOR 
 
 353 
 
 still in the competitive state funds, and lowest in the exclusive state 
 funds. 1 
 
 The effectiveness of public administration varies so widely from 
 state to state, however, and also from time to time within the same 
 state, that the present body of experience is hardly sufficient to over¬ 
 come the hesitancy of many students of public affairs to indorse an 
 enlargement of the scope of state administrative responsibility. Where 
 state funds compete with private funds, the private carriers succeed 
 in obtaining a large volume of business, in spite of higher costs. 
 
 From the standpoint of the employer, the great advantage of the 
 stock insurance company contract is its definiteness. The object of 
 insurance is to remove uncertainty; a contract which relieves the 
 employer of his responsibility in return for a contractual premium does 
 this more effectively than does a mutual or state fund with its assess¬ 
 ments dependent on the loss experience, so that many employers are 
 willing to pay a somewhat higher average cost for the sake of greater 
 freedom from uncertainty. 
 
 Rating in compensation insurance .—The systems used in making 
 rates for insurance in compensation insurance are very complex. They 
 involve the application of all three of the leading principles of rating 
 which were discussed in chapter xiv in connection with fire insurance, 
 namely, classification, schedule rating, and experience rating. 
 
 The starting-point in the determination of an individual rate is 
 the manual rate, which is determined by a study of statistics of the 
 accident rate for a given type of labor in a given industry, modified 
 bv differences of experience in different states, differences in the 
 liberality of different state systems of compensation, catastrophe 
 hazard, current state of business activity or depression, and profit 
 to the insurer. 
 
 Such a manual rate, if scientifically calculated, should serve the 
 double purpose of producing a sufficient amount of revenue to meet 
 the requirements of compensation, and of distributing the cost as 
 equitably as it can be distributed by advance calculation, without 
 inspection of the individual establishment. It fails, however, to 
 accomplish one purpose which it is very desirable to keep in the fore¬ 
 ground of attention in all discussions of policy with regard to accident, 
 
 T Cf. Commons and Andrews, Principles of Labor Legislation, pp. 411-13 
 (Harper & Bros., 1920); Carl Hookstadt, Comparison of Workmen's Compensation 
 Insurance and Administration, p. 97 (Government Printing Office, April, 1922). 
 
354 
 
 SOCIAL ASPECTS OF RISK-BEARING 
 
 namely to encourage activity designed to reduce the number of acci¬ 
 dents. 
 
 Schedule rating is a system of individual debits and credits for 
 favorable or unfavorable features of the individual risk. This type 
 of rating does much to encourage the introduction of safety devices 
 and the elimination of unnecessary elements of hazard in the physical 
 surroundings of the workers. 
 
 Physical surroundings, however, are responsible for only a minor 
 part of the preventable accidents; morale and discipline count for 
 more than do any features of plant and equipment which can be listed 
 in a schedule and checked up by the inspector. To take account of 
 this factor, experience rating is sometimes used. This is a system 
 whereby employers, who have a sufficiently large body of employees 
 to establish a probability of uniformity in the loss experience, receive 
 a modification of the insurance rate in the light of any marked depar¬ 
 ture of their individual experience from the general experience of the 
 industry in which they are engaged. The obvious advantage of this 
 system is that it gives a direct incentive to individual effort to reduce 
 the accident loss; an incentive surpassed only by that which is present 
 under so-called self-insurance. The disadvantage is that there is 
 always present the possibility that an unusual run of good or bad luck 
 will result in an adjustment of rates which is not justified by the actual 
 conditions of operation. 
 
CHAPTER XVIII 
 
 SOCIAL ASPECTS OF RISK-BEARING 
 
 In this chapter attention is directed to the question of the social 
 usefulness of certain institutions, whose uses in connection with the 
 transfer and reduction of risk have been discussed in the pre¬ 
 ceding chapters. In this survey we shall consider, first, the social 
 utility of the system of free appropriation of profit by private indi¬ 
 viduals. Next, we shall consider the ethical significance of three 
 specific devices for dealing with risk, namely, gambling, insurance, 
 and speculation. Finally, the whole system of modern industry and 
 trade will be compared briefly with two other systems in the light of 
 its tendency to increase or decrease the risk element in the lives of 
 those who live under it. 
 
 I. SOCIAL ASPECTS OF PROFIT-TAKING 
 
 The profit system is so integral to the present organization of 
 economic life that a discussion of its merits really involves the whole 
 question of the merits of a capitalistic society, to which attention is 
 given in a later section of the chapter. The present section does not 
 consider possible substitutes for the profit incentive, but rather 
 certain points at which that system is susceptible of modification 
 without the abandonment of any of the major features of the economic 
 order under which we live. 
 
 In chapter iii we indicated the relationship which exists between 
 risk and profit. Profit, it was there shown, arises from the fact that 
 the amount of capital which seeks employment in certain industries, 
 or other opportunities for investment, is smaller than the amount 
 which could be so employed in them as to earn for itself the usual 
 return. The most frequent cause for such restriction of investment 
 in certain lines is the existence of risk. We have not, in our previous 
 survey of this topic, raised the question of th e justification of the profit 
 system. What we have done is to indicate in a very broad way the 
 conditions which make it possible for the individual owner-manager 
 to collect a profit. Socially speaking, there can be only one justifica¬ 
 tion for profit, namely, its service as an incentive to individuals to 
 undertake ventures where the outcome is uncertain. There is perhaps 
 
 355 
 
356 
 
 RISK AND RISK-BEARING 
 
 dC 
 '.l £, 
 
 /✓/ 0 
 
 no phase of our modern industrial organization which has been more 
 acutely criticized of late years than this reliance on the motive of 
 private profit. To many students the system seems calculated to 
 foster the worst conceivable distribution of the world’s goods—exces¬ 
 sive wealth for the few and correspondingly meager returns for the 
 many, while the service it renders as an incentive to productive effort 
 seems unreal or at best of secondary importance. Is the criticism 
 valid ? 
 
 As with most questions of social policy, no final and absolutely 
 conclusive reply to this question is likely to be formulated, for it 
 involves comparing the partly known with the unknown, but we may 
 find a basis for a judgment of probability in regard to it. In the first 
 place, it seems clear that a limited amount of profit is socially useful, 
 indeed if we are to continue the system of individual enterprise at all, 
 is necessary. For unless those who place their capital in a position 
 of hazard have some hope of making more than a normal rate of 
 interest, capital for hazardous investr^ nt cannot be expected to 
 appear. And in this sense almost all new enterprise and much of the 
 extension of old and successful enterprise through new investments 
 is to be classed as hazardous. Capital cannot all be put at interest. 
 The existence of a “normal rate of interest” presupposes a guaranteed 
 return on capital, and a guaranty on some capital is impossible 
 unless there is other capital interposed between the guaranteed 
 capital and the hazards of the business. 
 
 It does not follow, however, that because some profit must be 
 anticipated, it must necessarily be realized in any given case, nor does 
 it follow that the whole amount of the return above current interest 
 must even be held up before the prospective investor as a possible 
 reward for putting his capital at risk. Some oil wells would doubt¬ 
 less be drilled under a system of taxation which confiscated half the 
 profits of the successful driller, without relieving him of any of his 
 risk of failure, for the rewards of success in a limited number of 
 cases are great enough to secure the capital, even though the odds 
 against the investor should be greatly increased. 
 
 This is the theory of the excess profits tax, to permit a tax-exempt 
 return high enough to compensate for the use of capital and take a 
 large share of any excess, leaving the owner, however, some share 
 of the excess return from risks successfully undertaken as an incentive 
 to his further efforts. The graduation of the tax, so as to take a 
 larger percentage of very high returns, while quite justifiable from the 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 357 
 
 standpoint of ability to pay, fails to take account of the probability 
 that high returns are associated with high risk. An enterprise offering 
 a high return and a high risk, if taxed at the same rate as another 
 offering a low return and a low risk, may be equally attractive, but 
 if the unsafe enterprise is taxed heavily on its successes, and gets no 
 compensation for its failures, more conservative investments are 
 encouraged at the expense of risky ones. An ideal, but probably 
 impracticable, application of the principle would involve the adjust¬ 
 ment of the rate of excess profits taxation so as to leave the owner a 
 larger percentage of his profit in cases where the risk appears in 
 < advance to be larger. 
 
 Interference with monopoly profits is quite practicable and from the 
 public standpoint desirable. —For instance, government has largely 
 interfered with profit in the field of public utility service, where again 
 and again the principle of a limited return has been imposed in place 
 of the principle of individual freedom in the pursuit of profits, and 
 industry has not been stifled. Here, however, it should be noted 
 that the success of the limitation has arisen from the slight amount of 
 risk involved in the furnishing of public services under conditions of 
 monopoly coupled with steady and strong demand, and that in the 
 fixing of a “fair return” due regard has been given, in form at least, 
 to the degree of risk. 
 
 In this connection an interesting question arises relative to the 
 method of calculating the investment upon which a fair return is to 
 be allowed. Should the investor be allowed a fair return upon the 
 amount he has actually invested in the public utility property, or 
 should his return be figured upon the amount which it would cost to 
 reproduce that property at present price levels ? Both views have had 
 numerous adherents, although it appears that, to a large extent, the 
 position taken by advocates of both plans has been determined by the 
 immediate situation rather than by any well-defined convictions, 
 on the principle involved. In a period of rising prices, the friends 
 of the public utilities are apt to be convinced that reproduction cost 
 is a very legitimate basis of calculation, and defenders of the public 
 interest to favor original cost, while in periods of falling prices, opposite 
 points of view prevail. 
 
 The question is too large a one for complete discussion here, but 
 its connection with the problem of risk reduction makes it necessary 
 to consider certain angles of it. The following discussion brings out 
 an aspect of the problem which has often been overlooked: 
 
35* 
 
 RISK AND RISK-BEARING 
 
 An even more serious objection to reproduction cost, or reproduction 
 cost new, as it is sometimes called, is that it tends when applied to put 
 public utilities in the class of speculative enterprises. The valuation used 
 as a rate base, the “value” fixed by law upon which earnings may be made, 
 when found by this method depends, among other things, upon the price- 
 level. If a utility company can get its property valued by a commission 
 using this method when prices are high it may reap great profits and at the 
 same time conceal them from the public. If the valuation be made when 
 prices are low, the company may suffer great loss and at the same time 
 be thought by the public to be earning current returns upon investment. 
 Suppose that a utility company assembled its plant in the late eighties of 
 the nineteenth century, and that a valuation was made in 1894 or 1895. 
 Prices had fallen in those years until it would have cost much less to 
 reproduce a plant than to build it a few years before. A “fair return” 
 upon the reproduction cost in 1895 would not represent the current return 
 upon actual investment made a few years earlier. Again, suppose a plant 
 assembled in the winter of 1914, and that valuation by reproduction cost 
 new was made in 1920. It would, in 1920, cost to reproduce the plant about 
 double the amount actually invested in 1914. A “fair return” at interest 
 current in 1914 upon such a valuation made in 1920 would give the investors 
 an enormous profit. Let us say that the plant in 1914 cost $1,000,000. 
 Net earnings of 6 per cent on the amount would be $60,000. In 1920 the 
 same property could be reproduced or duplicated at about $2,000,000. 
 Six per cent on this sum would be $120,000. But since interest rates have 
 also advanced, the company might insist upon and obtain permission to 
 fix rates to yield 8 per cent. Eight per cent on a valuation of $2,000,000 
 would be $160,000, that is to say 16 per cent on the amount actually invested. 
 By this simple expedient of a valuation, made to protect the public, the 
 public would be called upon to pay a return upon twice the amount invested 
 in the property, to tax itself in rates to give reality to this estimated value, 
 and enable the owners to show a commercial value double the principal 
 sum actually invested. Under a government control making use of repro¬ 
 duction cost new to find the value, the commercial value of a utility property 
 would fluctuate with the rise and fall of prices. A certain sum would be 
 put into the property, but how much the owners could earn upon it, the 
 commercial value of their investment, would depend upon all the complex 
 forces which are reflected in the price-level. How much the investment 
 would be worth ten years after it was made would not depend altogether 
 upon honesty and ability of management and confidence and support of 
 patrons, but even more upon unforeseeable contingencies, forces beyond 
 control of the management, all those accidents in different parts of the 
 world which influence the movement of prices. Under such a control 
 effectively applied, an investor in a public utility would gamble on the 
 rise and fall of prices. Instead of utility properties attracting careful 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 359 
 
 investors, they would appeal more to that class who speculate in mines and 
 oil propositions. A business owned by speculators is more apt to be 
 “skinned” for the sake of immediate returns, than one owned by investors. 
 It is to the public interest that utility properties be owned by those looking 
 for a moderate and regular return upon investment. In the long run the 
 public will get better service, if the utility properties can be developed so 
 as to draw this class of investors. Reproduction cost new tends to defeat 
 this end, and to make' utility properties highly speculative ventures . 1 
 
 While the main point in this argument is well taken, it should be 
 noted that the speculative element which is introduced by the use of 
 reproduction cost is a speculative element which is present in all 
 ordinary competitive business. If the cost of building shoe factories 
 goes up, existing plants can presently charge prices based on the 
 competition of newer factories built at higher costs, and if the cost of 
 constructing such factories goes down the older plants must sooner 
 or later meet the competition of the new low cost plants, even though 
 it involves the writing off of a large part of their investment . 2 
 
 The purpose in the use of reproduction cost is simply to put 
 monopolized business as nearly as possible in the position of competi¬ 
 tive business, to gain for the public the rates the public would have to 
 pay under conditions of competition. The case for the use of original 
 cost, so far as considerations of risk are concerned, must rest on the 
 contention that it establishes a better situation than would maintain 
 under competition, better both for the investor and for the public 
 because, while the average result in periods of rising and falling prices 
 taken together should be the same, the amount of uncertainty would 
 be greatly reduced under the original cost plan . 3 
 
 1 W. M. W. Splawn, “Reproduction Cost as a Basis of Valuation,” Journal of 
 Political Economy, XXIX, 162-63. 
 
 * It is of course not implied that the cost of building factories is an all sufficient 
 explanation of a given level of shoe prices. All that is involved of price theory 
 is the assumption that (a) a rise in building costs will retard the construction of 
 factories till prices of shoes reach a level which justifies such investment; ( b ) a 
 fall of building costs will correspondingly encourage building, so long as shoe prices 
 remain high, and (c) the number of factories actually built is a direct factor influen¬ 
 cing the output and hence the price at which shoes can be sold. 
 
 s If the difference between reproduction cost and original cost is due to a change 
 in the general level of prices, the reproduction cost basis might lead to less uncer¬ 
 tainty. Cost of service to the public and return to investors in dollars would fluc¬ 
 tuate, but the fluctuation would be offset by changes in the purchasing power of 
 the dollars. 
 
360 
 
 RISK AND RISK-BEARING 
 
 It is dangerous to limit profits if risks are great .—The fallacy 
 involved in reasoning over from monopolistic to competitive condi¬ 
 tions is well illustrated by the difficulties which have been met recently 
 in controlling rents. Within the last few years, numerous attempts 
 have been made to apply the principle of a fair return on original 
 costs to the rental of dwellings, particularly apartment houses, in a 
 period when the cost of construction had greatly advanced. The 
 difficulty in applying this principle to such an investment is that 
 while the government can restrict the investor to a fair return on his 
 original investment in a period of advancing costs, it cannot guarantee 
 him that return in a period of falling costs, or at least has not proposed 
 to do so. Hence, the builder is confronted with the dilemma that if 
 prices advance, he will not be allowed to increase rents above the 
 level of a fair return on his investment, while if costs go down, he 
 will have to meet the competition of new buildings constructed at a 
 lower level and take a loss as a result. Hence, the construction of 
 apartment houses has been discouraged by the application of the 
 principle of a fair return on original cost, while the application of this 
 principle in the field of monopolistic public utilities has not had a 
 similarly discouraging effect. 
 
 What is a fair return ?—A question which arises in connection 
 with the regulation of profit relates to the allowance to be made 
 for risk. If we are to set limits to a fair profit, determining those 
 limits by a consideration of the degree of risk involved, at what time 
 is the risk to be estimated ? Much of the current discontent with the 
 profit system arises from the obvious fact that the businesses which 
 are now most profitable are being operated, to all appearances, with 
 a minimum of risk and, hence, with a minimum need for managerial 
 ability. An old railroad or bank is an illustration. Should the 
 maximum profit accrue to the old established successful business, 
 whose managers have fewest risks to worry them? This attitude is 
 expressed by two students of labor problems, as follows: 
 
 Do the owners and borrowers of capital assume all the risk? Profits 
 accrue to them today because it is conceived that they are the initiators, 
 responsible agents, and, if necessary, the losers in industrial development. 
 That this is true as a general proposition seems plausible. And in certain 
 fields, particularly in marketing new commodities, there is a risk that none 
 but relatively few in the community are willing to assume; and the extension 
 of industrial activities is at present wholly dependent upon their assuming 
 it. But these cases can fairly be left out of consideration because of their 
 relatively small number in proportion to the total production. Setting 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 3 61 
 
 aside these exceptions, and viewing the problem as industry exists today— 
 not as it has been developed but as it stands today—the extent to which 
 investors and enterprisers in industry assume risk is a matter as to which 
 each case must be considered separately. The risk is one thing in a highly 
 competitive business where the demand is new and destined to rise; it is 
 another in a monopoly; it is still another in a declining business doomed to 
 disappear. 1 
 
 What is overlooked in this sort of reasoning is that every old 
 conservative business was once a new and speculative enterprise, 
 and the large and certain returns which these old strong businesses 
 . now collect are made possible by the risks they have already run, 
 as well as by the risks others must now run to oust them from their 
 position. Should they now be limited to a fair return upon their 
 capital, they would doubtless continue to function, since the capital 
 sunk in them cannot be recovered without loss, and since it is now 
 exposed to comparatively little risk. Once the capitalist has success¬ 
 fully run his risk, he is at our mercy, and we can, if we will, reduce his 
 return to correspond to the risks he still has to run, disregarding those 
 that are past. But can we do this continuously and still secure new 
 capital for enterprises which have yet to prove their merit? As 
 Professor W. H. Lyon puts it: 
 
 How about an established business? Should the government be per¬ 
 mitted to take advantage of “hindsight,” and after the event has proved 
 of a business that its promoters were justified in undertaking it, step in 
 and say that the measure of return shall be the measure of risk now 
 apparent ? Or should the government make what we may call a retroactive 
 estimate of the risk, and, from the standpoint of the present, attemot to 
 measure the risk originally assumed ? Human judgment cannot be counted 
 on to be fair under such circumstances. It is so easy now to look baciv and 
 feel sure that the telegraph, the telephone, the Union Pacific Railway, in 
 fact, practically any established business, was bound from the start to be 
 successful in a large way. Yet at the beginning of all these things there 
 were more thousands who believed that the anticipated profits did not 
 justify the risk to be taken than tens who believed that they did. It is 
 impossible from the standpoint of the present to get the same view backward 
 that the standpoint of twenty-five or fifty years ago presented forward. 
 It is unfair to get the measure of reward for a risk assumed in the past by 
 a present estimate of the risk now existing. 2 
 
 1 R. G. Valentine and O. Tead, Quarterly Journal of Economics (February. 
 1919), p. 248. 
 
 ' W. H. Lyon, Corporation Finance, pp. 229-30. 
 
3 62 
 
 SOCIAL ASPECTS OF RISK-BEARING 
 
 Not only is it unfair, but as a general policy it seems certain to be 
 disastrous, though it may take many years for the evil results to 
 become evident. Nevertheless, it does not seem necessary to leave 
 untouched every accumulation of profit, which either foresight or 
 good luck has created. Nor is the question primarily one of the size 
 of the profits. The limits of social interference (aside from monopo¬ 
 lies) depend chiefly on the question whether the profits arise in a 
 way which might reasonably have been anticipated when capital was 
 invested , or are of an unpredictable character. The former cannot be 
 attacked with impunity unless we provide some other incentive to 
 capitalists to undertake enterprises where there is an appreciable risk 
 of loss. The latter can frequently be confiscated or prevented without 
 such discouragement to future enterprise, simply because they are 
 recognized as being interferences of such an exceptional character as 
 not to constitute a ground for fear of similar interferences in the 
 future. 
 
 For example: if a British importer of wheat is not allowed his 
 profit on wheat which he has already imported before the price rises 
 on account of a crop failure in Minnesota, or a rise in ocean freight 
 rates, he is likely to be deterred from making similar importations in 
 future years when an exceptionally good harvest or a decline in freight 
 rates may bring a loss from his operations. But if an extremely 
 successful submarine campaign cuts off a supply of wheat which would 
 ordinarily come into competition with his importations, and forces 
 competitive prices in England to unheard of levels, government or 
 public opinion may safely step in and deprive him of his fortuitous 
 gain. The chance of a profit on account of the change in freight rates 
 or a change in crop conditions entered into his calculations and will 
 enter into them in the future. The possibility of profit from the total 
 interruption of commerce with the outside world did not enter into 
 his calculations and will not enter into his future calculations whether 
 he is deprived of it on this occasion or not. Such profits are free 
 gifts, and are at the mercy of society to deal with in such manner 
 as expediency in the short run seems to dictate. 
 
 Profiteering is collecting profits which are socially unnecessary .— 
 This distinction between the cases where interference with profits 
 is to be justified by extraordinary circumstances and cases where such 
 interference involves, or is likely to involve, an undermining of the 
 incentive to further productivity on the part of capital, is at the basis 
 of the concept of profiteering, of which we have heard so much in 
 
RISK AND RISK-BEARING 363 
 
 recent years. To understand this concept it will be helpful to review 
 its history. 
 
 In the medieval system of social philosophy, the place of profits 
 was perfectly defined. Everything had its “just price” and anyone 
 who made a profit must do so either by buying below the “just price ” 
 or by selling above it. Hence, all profit was illegitimate, and the 
 middleman was necessarily a profiteer and a parasite. Necessarily 
 an exception to this doctrine was allowed in the case of foreign trade 
 because it was impossible for producer and consumer to meet, but 
 such trade was regarded as exceptional. With the development of 
 ' commerce in the later Middle Ages, and the increasing importance of 
 capital in manufacture and the great expansion of opportunities for 
 individual initiative in the early modern period, ‘this doctrine of the 
 immorality of profits disappeared. Public opinion swung to the other 
 extreme, and profit came to be thought of as the inevitable, the just, 
 and the socially beneficial reward of enterprise. The “business man” 
 became the social leader. 
 
 With the development of monopoly in numerous fields in the 
 latter part of the nineteenth century, the doctrine of the just price was 
 partially revived in the form of the concept of a “fair return” to which 
 reference has been made. Finally, during the Great War the old 
 doctrine reappeared in another form, the social condemnation of 
 excessive profit-taking as profiteering, and this sentiment found 
 expression in numerous types of legislation and the other restrictive 
 action both in America and Europe. The concept, however, was, 
 and remains, an extremely vague one. Current literature abounds 
 in the denunciation of the profiteer, but tests by which he is to be 
 distinguished from the wholly estimable “successful business man” 
 are almost entirely lacking. 
 
 Our ideals are changing, and change requires some groping in the 
 dark, but the key to the problem is to be found in the distinction drawn 
 between ordinary profits, that is, profits which were, or could have 
 been, anticipated with sufficient clearness to constitute a motive for 
 venturing into a risky field of investment, and extraordinary profits. 
 If profits are attacked only rarely, and under color of public necessity, 
 or are justified by their unusual size or their extraordinary origin, 
 future enterprise may not be discouraged. If they are confiscated 
 persistently and as a matter of public policy, some method of pro¬ 
 tecting investors against risk must be provided, or risky enterprises 
 will be avoided. 
 
364 
 
 RISK AND RISK-BEARING 
 
 Must risk and control be closely associated? —In chapter iii the 
 effect of risk in the distribution of wealth has been discussed on 
 the tacit assumption that the two functions of carrying risk and 
 appropriating profit are in fact closely associated with a third, the 
 exercise of control. The term owner-manager was used throughout 
 the chapter instead of the term entrepreneur , generally used by econo¬ 
 mists, in order to keep this assumption from being overlooked. This 
 assumption, which is an original basic theory of the modern type of 
 private ownership in the means of production, underlies most of our 
 law of property and also runs through most of our orthodox economic 
 theory. In fact, the whole modern organization of production through 
 a separation of “entrepreneurs” from capitalists and laborers is 
 grounded on the assumption that the risk of loss from any under¬ 
 taking can best be carried by those who are directly responsible for 
 the policies which may bring about the loss, and conversely that the 
 responsibility for control can best be exercised by those who carry 
 the burden of risk. Our whole tradition of the right of the individual 
 business manager to freedom from outside interference is derived 
 from this conception, just as is our traditional acceptance of his 
 claim to the entire profits of the enterprise. “Whatsoever a man 
 soweth, that shall he also reap,” is in theory the essence of the whole 
 system of private property and free initiative. Partly because men 
 are believed to work more efficiently when they themselves profit 
 or lose as their enterprises prosper or decay, partly because we have 
 felt it unjust for one man to suffer from the results of another’s mis¬ 
 management, control of business has been delegated to the risk¬ 
 bearing factor rather than the lending or laboring factor in the joint 
 enterprise. 
 
 To a considerable extent, however, opinion has recently drifted 
 away from this point of view. On the one hand it is recognized 
 that the specialization of owners in carrying risk is at best only partial; 
 that the laborer and the capitalist are exposed to certain risks because 
 the entrepreneur is unable to bear the full amount of the possible loss. 
 Hence, the theory that control logically associates itself with risk seems 
 to demand a partition of control as a recognition of the extent to which 
 risk is divided. For instance, the demand for “ industrial democracy,” 
 in the sense of a share for labor in the management of industry, is in 
 part a recognition of the extent to which labor shares in risk. Like¬ 
 wise the custom of placing bankers on boards of directors of corpora¬ 
 tions to whom the banks extend credit is a recognition of the extent 
 to which lenders share in risk. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 365 
 
 In the next place, it is recognized that there are limits to the 
 extent to which the bearing of risk carries with it as a logical corollary 
 the actual assumption of control, for the reason that the risk itself 
 may be reduced by transferring control away from the risk-taker to 
 a hired manager whose greater expertness offsets his lack of direct 
 personal interest in his results. This situation, in large part, accounts 
 for the tendency to increased complexity of organization, which has 
 accompanied the development of large-scale business. In small-scale 
 business it is still true that most investors insist on having either 
 control or protection from the risk of unfortunate control by someone 
 else, but there are many who in large-scale operations are willing as 
 common stockholders to subject their capital to the major risks of 
 business while retaining only the merest shadow of control. 
 
 In legal theory, of course, the common stockholders are the 
 ultimate owners of the business, assuming the primary burden of 
 risk and exercising the final control, but in the case of large corporations 
 whose stock has been distributed among investors the control exercised 
 by most of these investors is wholly imaginary. Actually the control 
 is exercised by the relatively small group—officers, creditors, or active 
 stockholders, who are interested enough and have ability enough to 
 exercise it, and the results of the control exercised by this group fall 
 only slightly on themselves. The investor’s reliance is primarily 
 on their good faith and ability as witnessed by past performance, 
 not on any close association between the control and its consequences. 
 
 One important result of this dissociation between control and risk 
 has been the wide spread of the practice of limited liability. An 
 investor does not hesitate to intrust a definite sum of capital to 
 another’s control, but he will rarely accept the full responsibility of 
 ownership in an enterprise, with resulting liability for its debts, 
 unless he has a real voice in its management. Hence for enterprises 
 too large to be financed by those who actually control them, the 
 corporation and the limited partnership are devised. The investor 
 in stock limits his liability to the amount he actually invests, or to a 
 stipulated sum in excess thereof. The risk of which he divests himself 
 by this means is scattered among the creditors . 1 
 
 ‘Texts in elementary economics sometimes contain the question: “In a cor¬ 
 poration, who is the entrepreneur?” It may not be amiss, therefore, at this point, 
 to call attention to the impossibility of applying the concept “entrepreneur” to 
 any part of a corporate organization (except in a close corporation which is managed 
 like a partnership). The essence of entrepreneurship is the union of control and 
 risk-bearing; in a public corporation these are not united 
 
366 
 
 RISK AND RISK-BEARING 
 
 Another modification of our traditional policy of uniting control 
 and risk is found in the numerous safeguards which have been erected 
 for the protection of debtors. Bankruptcy laws, exemption of home¬ 
 steads, of the proceeds of insurance policies, of the tools of a trade, 
 and of minimum earnings from attachment for debt, all are ways of 
 transferring part of the risk of business from the owner-manager to 
 his creditors, in recognition of the fact that the enterprise is in fact a 
 co-operative one, in which all have an interest and in the results of 
 which all may be required to share, if a strict enforcement of the full 
 responsibility of the owner-manager results in hardship. 
 
 The test of a wise social policy in this matter seems to be much 
 the same as in the converse case of limitation of profits, to which 
 reference was made above (pp. 362-63). What is the effect on 
 incentive? The object of placing the responsibility on business 
 men for loss of property intrusted to them by their creditors is to 
 secure a maximum of interest and effort on their part and to induce 
 lenders to part with their capital; if the proposed interference follows 
 such exceptional circumstances that it will not enter seriously into the 
 calculations of lenders or business men, and either retard the financing 
 business or lead to wasteful management, it may be judged by its 
 immediate value in relieving distress; if it extends to normally 
 anticipated situations it will probably do more harm than good. 
 
 President David Friday has made an interesting suggestion looking 
 to the elimination of the waste incident to the curtailment of produc¬ 
 tion for business reasons, especially in times of failing prices. 1 He 
 proposes that the government should establish an insurance fund to 
 protect business men from the loss of their capital. 
 
 His argument, in brief, is as follows: The recurrent curtailment 
 of production by business managers is to be explained primarily in 
 terms of fear of loss rather than greed for high profits. Business men 
 are willing to continue operation of their enterprises at times when 
 the prospect of profit is small, provided they do not by so doing incur 
 too great a risk of loss. To insure to each entrepreneur his actual 
 costs, obtaining the necessary funds by taxation of successful businesses, 
 would remove the incentive to stop production, and thereby prevent 
 wastes of such enormous magnitude as would more than compensate 
 for the social costs of administration. 
 
 1 “Maintaining Productive Output,” Journal of Political Economy, XXVII 
 (January, 1919), 117-26. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 367 
 
 Into the administrative difficulties involved in this proposal we 
 shall not carry our criticism. The social waste of underproduction 
 (estimated by President Friday at $10,000,000,000 per annum) is 
 large enough to justify vast expenditure on any experiment which offers 
 a reasonable chance of success in eliminating it. We can even afford 
 to face the certainty of numerous individual cases of abuse, if the 
 general result is to increase the national dividend by half of the sum 
 involved. 
 
 More fundamental than the administrative difficulty, however, 
 is the question of the ultimate social gain to be derived from the 
 operation of the scheme, assuming that the difficulties of administra¬ 
 tion were overcome. Proposals to relieve the business man from the 
 risk of losing his out-of-pocket costs assume that these risks have no 
 social value; are they not on the contrary as essential in maintaining 
 a proper balance in production as are the hopes of profit ? It is quite 
 true that it is the fear of loss rather than the smallness of profit that 
 induces the suspension of production in periods of falling prices and 
 diminishing demand, but such curtailment is a belated recognition 
 that production in certain lines has gone too far. The elimination of 
 the risk, would, it appears, tend to aggravate the tendency to follow 
 the lure of immediate profit by producing to excess those commodities 
 of which at the preceding moment there has seemed to be a deficit. 
 
 For example, it is now perfectly clear that at the close of 1919 
 the world had been producing too much of certain perishable consump¬ 
 tion goods, notably sugar, textiles, and rubber tires, and not enough 
 of such durable goods as houses, street cars, and bridges. This is 
 the natural tendency of production at times when it is anticipated 
 that over a long period the tendency of prices will be downward. 
 Men are willing to pay high prices for the goods which they buy for 
 the immediate future, but balk at paying peak prices for permanent 
 construction. Everyone recognized that the nation was understocked 
 with buildings and public utility properties, long before it was clear 
 that it was overstocked with perishables. 1 
 
 When the latter fact became clear, production slackened, in the 
 one field, then gradually revived in the other. If the result of a 
 
 1 It is not implied that this was the only factor involved. Another factor, for 
 instance, was the great difficulty in getting higher prices out of the public for such 
 staple necessities as transportation, rent, and gas. It does not appear likely that 
 this situation would have been alleviated by public knowledge that the corpora¬ 
 tions and individuals furnishing these necessities were protected by insurance 
 against business losses. 
 
368 
 
 RISK AND RISK-BEARING 
 
 guaranty of costs would have been to divert productive energy sooner 
 from the field that was overdone to the neglected field, a great national 
 gain would have resulted from its adoption. It is clear that this would 
 not have been true, however. As things actually stood till the end 
 of 1919, the risk of producing sugar seemed less than that of producing 
 street cars; if this risk had been removed by social insurance it would 
 still have been true that the prospective profit of producing perishables 
 would have been greater than that of producing durables. Might 
 not the result of insurance of costs have been to prolong the maladjust¬ 
 ment by removing the fear that actually brought about the readjust¬ 
 ment, leaving us with a still greater overstock of sugar and understock 
 of trolley cars when the readjustment finally came ? 
 
 Insurance of costs seems to look to the immediately disastrous 
 effects of readjustment of malproduction; a sound social policy 
 should look to a prevention of the maladjustment, and in the author’s 
 opinion, is to be secured rather through the development among 
 business men of an appreciation of the risks involved in following 
 blindly the guidance of prices, advance orders and profit margins, 
 rather than through the elimination of those risks. 
 
 The interest of society is not merely to secure the maximum 
 expenditure of energy by productive agents; it is to direct those 
 agents to the creation of the goods which satisfy a real need, and it 
 does not seem probable that the assumption by a government agency 
 of the risk of loss, leaving undisturbed the forces which fix the relative 
 profit margins in various lines of business, will notably improve the 
 apportionment we now secure. For it will very frequently be true 
 that the line of activity which seems to offer a prohibitive risk of 
 loss, and therefore is neglected, will also offer the minimum opportunity 
 of profit, and therefore be neglected even though the risks are /emoved. 
 Such an arrangement would favor the highly speculative undertaking, 
 by giving the entrepreneur a chance at a very high profit without a 
 corresponding risk of loss; otherwise it is not clear that it would have 
 any marked effect on the distribution of social energy. 
 
 Finally, the effect of subjecting investment and operation to such 
 a degree of public control as the insurance program would involve is 
 dubious. President Friday believes that the government would 
 refuse to permit suspension of operation and consequent unemploy¬ 
 ment if it were in the position of a guarantor of cost; is it not on the 
 other hand probable that the insurance bureau would be inclined to 
 demand the suspension of production whenever it appeared probable 
 
SOCIAL ASPECTS OF RISK-BEARING 369 
 
 that such operation would result in loss, thereby aggravating the evil 
 against which a remedy is sought ? 
 
 II. THE ETHICS OF GAMBLING 
 
 An estimate of the social significance of the group of institu¬ 
 tions through which the transfer of risks is accomplished may con¬ 
 veniently proceed by a consideration of certain aspects of gambli ng, 
 o f insurance, and of speculation. These three types of activity have 
 this much in common, that all consist of the transfer of wealth from 
 one person to another in a way which is contingent upon an un¬ 
 known, usually a future, event. Between a short sale of wheat and 
 a bet that the price of wheat will fall, or between a fire insurance 
 policy and a bet that a certain house will burn, there is superficially 
 a close resemblance; an analysis of the difference between them 
 must get back of the form to the social and individual consequences. 
 
 In chapter vii, we gave attention to opportunities of profit involved 
 in gambling, without consideration of the social and moral aspects 
 of the question. It remains to consider the justification of the tra¬ 
 ditional condemnation of gambling as immoral. Is it purely a ques¬ 
 tion of balancing the risk of loss against the individual’s enjoyment 
 of the excitement, or are there more important social considerations ? 
 The following points are suggested as having a bearing upon our answer: 
 
 a) The gambler is in an antisocial position. —The whole drift of 
 social evolution throughout the recorded history of the race has been 
 toward the development of moral standards, of legal and political 
 institutions, and of other agencies of social control to enforce co-opera¬ 
 tion; that is, to induce or compel the individual to seek his own 
 advancement through activities which tend to the advancement 
 of other members of his group. The gambler, however, gains only as 
 others lose. The traditional attitude of hostility toward the gambler 
 rests, therefore, on much the same ground, though its expression is 
 less extreme, as our hostility toward the confidence man and the 
 burglar. The more efficient any of these become, the poorer the rest 
 of the world becomes, and the more surely the rest of the world must 
 organize to restrain the antisocial activity. 
 
 b) Energy devoted to the improvement of the gambler's technique is, 
 socially speaking, wasted. —A universal energizing of gamblers or a 
 general introduction of scientific management among them would 
 leave them and the world no better off, for one gambler’s gain in 
 efficiency would be offset by another’s. In this respect the gambler’s 
 
370 
 
 RISK AND RISK-BEARING 
 
 position is analogous to that of the militarist, the political stump 
 speaker, and the proselyting apostle . 1 
 
 c) Gambling tends to disqualify one for work. —On the one hand the 
 successful gambler finds money coming so easily through the pursuit 
 of chance that it seems a waste of time and energy to hammer out an 
 income by the slow and painful processes by which most of the world 
 makes its living. On the other hand, the unsuccessful gambler finds 
 the fruits of his labor slipping away from him and becomes discouraged 
 and is apt to pin his fate to a turn in luck rather than to a return to 
 productive employment. So long as the world’s business cannot be 
 conducted without work, any institution which tends to reduce the 
 number of competent workers is socially undesirable. In this respect 
 gambling is comparable to the institution of inheritance . 3 
 
 d) The sum total of gambling transactions involves a net social loss , 
 for it tends to increase inequality of wealth, and unequal distribution 
 of wealth decreases its utility. Suppose A and B bet counters on the 
 toss of a fairly balanced coin. If they play a long time the most 
 probable theoretical result is that they win the same number of tosses 
 and quit as they began. But, if the number of counlers they hold is 
 small, the chances are that before they toss a thousand times one of 
 them will be out of counters and the game will stop. If they start 
 even it is of course as likely that one will survive as the other, but if 
 one has more counters than the other the game is loaded in his favor. 
 If A, for instance, starts with ioo counters and B with io, the chances 
 are that before they make a thousand tosses B will run out of counters 
 and have to quit. If he has to reserve some of his counters for some 
 other purpose, he is so much the more certain to quit a loser, though 
 his loss will not be so great. If he reduces his stakes when his fund 
 begins to get low and increases them as it grows, as he is very likely 
 to do, the odds are against him still more, for every run of luck against 
 
 1 These analogies are of course imperfect, for the increased zeal and efficiency 
 of rival propagandists does tend to bring out the truth, however much they may 
 as individuals seek to obscure it. 
 
 a For more emphatic statement of this point cf. “The Social Evil,” Outlook , 
 June 28, 1912, p. 246. “Gambling likewise isolates the risk and excitement that 
 are found as an element in all legitimate enterprise; and by artificial devices pro¬ 
 vides for the constant recurrence of that excitement apart from any useful work or 
 worthy undertaking. Nature retaliates by taking from the man who tries to cheat 
 her the inclination and the power of steady industry; the true sense of social value; 
 and makes of him a burden to his family, an irritable and worthless parasite upon 
 the industrial order.” 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 371 
 
 him will have to be made up by a longer run in his favor, while a run 
 in his favor will be wiped out by a shorter run against him. 
 
 This is probably the most important reason for the very large 
 percentage of failures not only in gambling but in all speculative 
 enterprises where the duration of the individual transaction is short 
 and the scale of operations can be increased readily. For instance, 
 note the cases in industry and trade in which one year of depression 
 has taken away the profits of several years of prosperity. The 
 expansion of operations made possible by the war profits makes the 
 scale of losses on the way down bigger than the scale of profits on 
 the way up. 
 
 e) A perfectly fair gamble is bad economics .—Say A, having 
 $1,000 stakes $100 against $100 on a fair and legitimate 1:1 
 chance. He is balancing the chance of increasing his fortune to 
 $1,100 against the chance of reducing it to $900. But in accordance 
 with what economists call the “law of diminishing utility,” he will 
 lose more if his wealth is cut to $900 than he will gain if it is increased 
 to $1,100, for the tenth hundred provides for more urgent needs or 
 wants than does the eleventh. So with each addition to one’s wealth. 
 The more he has, the less the importance of one more unit; the 
 unit the gambler may lose is of greater importance than the one he 
 may win. 
 
 The larger the unit staked in proportion to the total owned, the 
 more important this point becomes. Loss of one’s entire fortune 
 causes a far more important change of status than does doubling it. 
 On the other hand, if the unit staked is relatively small the point is of 
 no importance. The difference between the utility of the 999th and 
 that of the 1,oooth dollar is entirely negligible. Indeed, in some cases 
 the argument may be turned the other way. Suppose A buys a 
 lottery ticket for ten cents, which gives him one chance in 5,000 of 
 winning $500. Mathematically the bet is an even one; economically it 
 may be in his favor, for the dime he will probably lose represents no 
 perceptible impairment of his capital or lowering of his income, while 
 the prize he may possibly win will bring him a perceptible benefit. 
 This will hold even if he pays fifteen cents for the ticket. The bar¬ 
 gain is now a good one for both the buyer and the seller (indirect 
 moral and social losses being disregarded). The lottery thus affords 
 a means of collecting from a great number of persons amounts so small 
 that their psychological cost is negligible and combining them into 
 units large enough to give a few people a perceptible addition to their 
 
372 
 
 RISK AND RISK-BEARING 
 
 material welfare. The advantage of this sort of gamble to the buyer 
 of the small chance depends on his rigidly limiting not only the size 
 but the number of his purchases to such an extent that the loss, which 
 is overwhelmingly probable, will mean nothing in his standard of 
 living. This is very difficult to do, but if he succeeds the real odds are 
 distinctly in his favor. 
 
 /) Nothing that has been said should be applied to the case of the 
 professional gambling-house keeper. He is not necessarily a gambler 
 at all; he is a business man selling entertainment and taking his pay 
 through a percentage in his favor in the arrangement of odds. His 
 risk is not the gambling risk at all, it is the risk common to all lines 
 of business of failing to get enough business to cover overhead costs, 
 with the added necessity of getting a certain volume in order to insure, 
 the working of the law of averages on which he depends for his income. 
 
 g) Against these clear costs and dangers of gambling there can 
 be set simply the fact that a very large proportion of the race in all 
 ages have found it enjoyable, and have been willing to pay the cost of 
 supporting an expensive body of devices and organizations to enable 
 them to gratify their taste for this form of excitement. The foregoing 
 of this enjoyment may be a necessary part of the cost of building an 
 organization in which men can live together with the minimum fric¬ 
 tion and maximum satisfaction, but it is none the less a cost. 
 
 In summary: the moral condemnation of gambling must rest 
 not on its economic irrationality, for it may in many cases be defended 
 as rational, either on the ground that the stake is so small as to involve 
 no real loss, or on the ground that the amusement is worth the cost. 
 The final condemnation or indorsement of this practice must rest on 
 our judgment of the importance of the effects it produces on men’s 
 ability and willingness to co-operate in the building and maintenance 
 of a better social structure. 
 
 In the author’s opinion, the weight of the argument rests with the 
 opponents of gambling; the traditional condemnation of the practice 
 as immoral reflects a sound judgment of the social issues at stake. 
 Whether, however, gambling belongs in the list of immoralities which 
 an intelligent social policy seeks to prohibit by legal enactment, or 
 whether it is one of the far more numerous types of antisocial conduct 
 which can more wisely be discouraged by education and moral suasion 
 only, is an entirely different question. Any attempt to answer this 
 question would take us too far from the field of the present study, into 
 considerations of the limits of effective coercion in human conduct. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 373 
 
 III. THE ETHICS OF INSURANCE 
 
 As was stated above, an insurance contract is not dissimilar in 
 form to a wager. The insured pays a small premium, which he may 
 lose or may receive again multiplied many-fold, in accordance with 
 the outcome of an uncertain event. But, though the form is the same, 
 the moral aspects of the question, provided a genuine risk is insured, 
 are exactly opposite. The insurance contract serves to decrease risk, 
 to substitute a small but certain loss for a large uncertain one. Thus a 
 net gain results, parallel to the net loss involved in a gambling con¬ 
 tract. We noted above that a perfectly fair gamble is economically 
 unsound for the reason that the gain, if one wins, is smaller than the 
 loss if he loses, because of the operation of the principle of diminishing 
 utility. The case of the insurance contract is just the opposite. 
 Ignoring insurance company expenses and profits, let us assume that 
 A pays $10 for $1,000 of fire insurance, knowing that the chance of 
 his suffering a loss of $1,000 is exactly T ^. Mathematically, his 
 bargain is neither good nor bad; economically, it is good because the 
 $1,000 he may lose represents more in real sacrifice than one hundred 
 times the loss of the $10 involved in the payment of the premium. 
 
 Likewise most of the other arguments advanced in the preceding 
 section to show the antisocial character of gambling, have no applica¬ 
 tion, or a negative application, to insurance which covers a genuine 
 risk. Neither the insurer nor the insured puts himself in a position 
 where his gain depends on the other’s loss; rather they have a common 
 interest in the non-occurrence of the event insured against. Energy 
 devoted to the improvement of the insurance technique is not wasted, 
 as is energy devoted to the improvement of the gambling technique; 
 insurance does not tend to disqualify one for work, but rather encour¬ 
 ages one to labor in the confidence that he will not be deprived of the 
 fruits of his labors by some accidental circumstance; insurance does 
 not tend to create inequality of wealth. 
 
 On the other hand, whenever there is no genuine risk to be hedged, 
 as is the case in overinsurance, and in the case of insurance on the life 
 of persons who have no producing power, the arguments cited against 
 gambling have full force. The following account of the early history 
 of life insurance illustrates the possibility of using the insurance con¬ 
 tract for purely gambling purposes. 
 
 The distinguishing feature of the age was the “Gambling” tendency of 
 nearly all the Offices. Under the title of “Insurance Wagers,” every con¬ 
 ceivable description of speculation was entered into. The duration of the 
 
374 
 
 RISK AND RISK-BEARING 
 
 lives of persons believed to be on their death-bed, was a common hazard, 
 and the author of Every Man His Own Brother was not far wrong when he 
 said the dissolution of persons, who saw themselves insured in the public 
 papers at 90 per cent, was, not unlikely, hastened by such announcements. 
 
 Even the morality of the newspapers of that day was shocked by such 
 proceedings; we find the London Chronicle of 1768 thus declaiming, “The 
 introduction and amazing progress of illicit gaming at Lloyd’s Coffee-house 
 is, among others, a powerful and very melancholy proof of the degeneracy 
 of the time. Though gaming in any degree is perverting the original and 
 useful design of that Coffee-house, it may in some measure be excusable to 
 speculate on the following subjects:—Mr. Wilkes being elected member for 
 London: which was done from 5 to 50 guineas per cent.:—Mr. Wilkes being 
 elected member for Middlesex, from 20 to 70 guineas per cent.; Alderman 
 Bond’s life for one year, now doing at 7 per cent.:—On Sir J. H. [mark the 
 modesty!] being turned out in one year, now doing at 12 guineas per cent.; 
 —On John Wilkes’ life for one year, now doing at five per cent. N.B. 
 Warranted to remain in prison during that period:—On a declaration of war 
 with France of Spain in one year, 8 guineas per cent.” “But,” continues 
 the sensitive journalist, “when policies come to be opened on two of the 
 first peers in Britain losing their heads at 10s. 6d. per cent, or on the dissolu¬ 
 tion of the present parliament within one year at 5 guineas per cent., which 
 are now actually doing, and underwritten chiefly by Scotsmen, at the above 
 Coffee-House, it is surely high time to interfere.” 
 
 In the Public Advertiser of Dec. 6, 1771 [then the leading newspaper], 
 we find the following paragraph:—“We have the pleasure to assure the pub¬ 
 lic, from the most undoubted authority, that the repeated accounts of her 
 Royal Highness the Princess Dowager of Wales being very ill, and her life 
 in great danger, are entirely false; such reports being only calculated to pro¬ 
 mote the shameful spirit of the gambling by insurance on lives !” 1 
 
 IV. THE ETHICS OF SPECULATION 
 
 The case for organized speculation is midway between that for 
 insurance and that for gambling. The speculative contract which 
 transfers to speculators the risk which some one must carry anyway 
 is analogous to insurance in that it relieves one party of risk and enables 
 him to do business more economically and efficiently. It is inferior 
 to insurance in that the insurer does not as a rule get rid of the risk 
 by combination. The total amount of uncertainty-bearing is not 
 reduced, but the incidence is shifted to those who voluntarily elect 
 to carry it. Incidentally, as was noted in chapter xi, the service of 
 
 1 Walford, Insurance Guide and Handbook , pp. 27-28. (4th ed.; Charles & 
 Edwin Layton, London, 1901.) 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 375 
 
 risk-bearing, so far as the whole group of speculators are concerned, 
 is probably uncompensated, so that society as a whole gains at the 
 expense of the speculative group. 
 
 If the personnel of the futures market were made up entirely of 
 hedge buyers and sellers, it would not be a speculative market at all; 
 it would be simply a convenient device by which, on the one hand, 
 industries using grain or cotton as raw materials, and, on the other 
 hand, dealers in those commodities, could trade with one another, the 
 needs of the one group for protection against falling prices being offset 
 by the need of the other group for protection against rising prices. 
 Unfortunately, the needs of dealers in raw materials and those of 
 manufacturers who need to buy hedges do not coincide in time nor 
 necessarily in volume. Consequently, a futures market without 
 speculators could only be run through some such process as this, that 
 if at a given season there was an excess of supply of hedging contracts 
 from producers of, or dealers in, the raw materials, over the number 
 required as hedging purchases by manufacturers, the price would be 
 forced so low that manufacturers would be induced to contract in 
 advance for their supplies of raw material, thus taking the load off 
 the market. Vice versa, if there were an excess of demand for hedges 
 from industries and a consequent high price, prospective sellers of 
 hedges might be induced to sell their contracts in advance. Such 
 a development would not mean the elimination of the speculator 
 however; it would merely mean that dealers and manufacturers had 
 been given an inducement to become speculators themselves. To a 
 large extent, something like this does happen, but it is not at all clear 
 that there is any social advantage in having the speculating done by 
 people who are also dealers in raw material or products rather than 
 by specialists in speculation. Certainly the presence of a group of 
 speculative traders who are ready on occasion to take either side of 
 the market, facilitates the hedging process by making the market 
 broad and continuous enough 30 that the hedger is able to make his 
 trades with confidence that a contract once opened can be closed out 
 again without breaking or “bulling” the market. As a practical 
 issue, there can be no hedging without speculation. 
 
 It is undoubtedly true, however, that in a large number of trades 
 neither party is hedging; there are only two speculators, one trading 
 for a rise and the other for a fall. If all the trades were of this char¬ 
 acter, the social results would be exactly the same as those outlined 
 in the case of gambling contracts. There is in speculation the same 
 
376 
 
 RISK AND RISK-BEARING 
 
 unwholesome dissociation of income from useful work as in gambling; 
 the same consequent undermining of the sense of the values of money 
 and of work; the same eagerness to profit by another’s misfortunes; 
 and the same temptation to risk more than one can afford to lose, and 
 to seek to recoup one’s fallen fortunes by dishonest means. 
 
 The question whether a speculative market serves to increase or 
 decrease the net amount of uncertainty resolves itself into a question 
 concerning the proportion of trades which are purely speculative in 
 character. No data bearing directly on this question are available, 
 but the indirect evidence indicates that a very large part of the trades 
 on the American exchanges are purely speculative . 1 But it must be 
 remembered that a hedging trade may be made between two specu¬ 
 lators, neither of whom has any idea of ever owning anything to hedge. 
 Suppose that A, a flour-miller, buys a line of May wheat from B, a 
 speculator, in order to cover a forward contract for the delivery of 
 flour; then gradually sells out the contracts as he delivers the flour. 
 Some of his contracts may remain open for five or six months. But B 
 has no intention of staying “short” for such a length of time. He 
 buys in his contract from C, and forgets all about the transaction long 
 before A is ready to close it out. C, in turn, buys tire contract in 
 from D, D from E, and so on, the “short side” of the contract passing 
 from hand to hand till finally it is bought in from a grain house which 
 remains short till delivery date and then fulfils the contract by delivery. 
 In the meantime, however, A may have decided to close out his last 
 remaining contracts. He sells to X; X sells to Y, and so the “long 
 side” of the contract passes from hand to hand till it reaches someone 
 who is willing to accept delivery, or possibly is bought by a speculator 
 who has already sold it short at the other end of the line, and so is can¬ 
 celed out. Most of the intermediate holders of the contract were 
 speculators, not hedgers, yet each played an essential part in the hedg¬ 
 ing transaction by carrying for a part of the time the risk which had 
 to be carried by someone all the time. It is difficult to see how the 
 situation would be better, from the social standpoint, if one speculator 
 carried the risk clear through than it is with a succession of speculators 
 
 1 Arthur Richmond Marsh estimated some years ago that not over 25 per cent 
 of the trades made through the cotton futures market were speculative. (Annals 
 of the American Academy of Political and Social Science, XXXVIII [September, 
 iq 11 ], 276.) But the estimates given in chap, xi, concerning the volume of futures 
 trading, indicate that even if it is figured that every bushel of grain is hedged three 
 times on its way from the farmer to the baker the number of direct hedging trades 
 is a minor fraction of the total volume of exchange trading. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 377 
 
 each carrying it for a short time. Certainly it is much easier to find 
 someone able and willing to carry the load when facilities are offered 
 for getting out of the trade at will . 1 
 
 To summarize this discussion: the same possibility of using a 
 contract either for the purpose of hedging a legitimate risk or for the 
 purpose of creating a gambling risk which we saw in the Lloyds con¬ 
 tracts arises in connection with “future contracts” on the produce 
 exchanges. When a grain merchant sells a future contract to hedge 
 against a fall in prices while he is marketing his purchases of cash grain, 
 or a flour-miller buys a future contract to protect himself against loss 
 while he is manufacturing flour which he has agreed to deliver, he is 
 securing protection against a definite risk in much the same way that 
 one secures protection against an incalculable hazard through a Lloyds 
 policy, but in both cases the only way that the insuring or hedging 
 individual gets rid of his risk is by transferring it to someone else who 
 assumes it as a speculation. The whole machinery of the produce 
 exchange finds its justification in the facilities which it affords for 
 carrying on certain types of business with a minimum risk and conse¬ 
 quently at a minimum cost. There is no question that it is sound 
 business policy to make use of the hedging market whenever a hedging 
 contract can be secured on reasonable terms, but the existence of a 
 hedging market presupposes the existence of a group of speculators 
 who take the risk off the business man’s shoulders, and there has as 
 yet been found no way to prevent these contracts being bought and 
 sold in a purely gambling spirit. A, the speculator, in relieving B of 
 risk certainly performs a valuable service for society, but A does not 
 know whether he is relieving B of risk or buying contracts from C who 
 is speculating on the opposite side of the market, and if the result is 
 to impoverish A or to bring him unexpected “easy money” the effect 
 is quite as demoralizing as when similar occurrences take place through 
 the medium of the race course or the roulette wheel. 
 
 In any case it is clear that the mixing of speculation with other 
 types of business is likely to be bad for the other business. No busi¬ 
 ness man thinks of employing his surplus funds during a slack season 
 in writing insurance policies on his friends’ property, and the employ¬ 
 ment of surplus funds in speculation by business men in general in 
 
 1 The reader will not fail to notice the parallel between this process of passing 
 on the risk of price changes and the practice at Lloyd’s by which underwriters 
 reinsure all or part of a marine risk when they apprehend that a loss has taken 
 place. 
 
37 » 
 
 RISK AND RISK-BEARING 
 
 order to furnish other business men with protection against price 
 
 V 
 
 fluctuations is quite as unsound. This is true, not so much because 
 the man who speculates as a side Kne lacks expert knowledge, but 
 simply because it diverts energy and time from the principal business 
 into the side line, and, more important, creates a new and unnecessary 
 hazard affecting the working capital of the principal business. Society 
 needs speculators, but the proper source for speculative funds is the 
 accumulation of surplus funds in the hands of those who are not 
 
 actively engaged in other business and can afford to take a series of 
 
 / 
 
 losses without flinching in the expectation of making it back in the 
 long run. The great weakness of present-day speculation is that there 
 are too many people furnishing speculative contracts who, either on 
 account of the needs of their other lines of business or on account of 
 absolute limitation of funds, cannot stick through the long run and 
 are “wiped out” by the first or second unexpected turn of the market. 
 
 So much emphasis has been laid upon the service of exchanges in 
 making hedging possible, that there is danger of overlooking the fact 
 that an exchange is a market, and as a market has a function to per¬ 
 form in bringing about such an adjustment of prices as will, on the 
 one hand, clear the market within a crop year of substantially the 
 entire crop, and, on the other hand, stimulate an increase or decrease 
 of supply by producers in harmony with changing conditions of con¬ 
 sumers’ demand. As was pointed out in chapter xii, such adjustment 
 is effected in part through manipulation of the carry over, but this 
 method is effective only for absorbing minor fluctuations in demand. 
 Both the adjustment of the carry-over and the slower but more effec¬ 
 tive adjustment of production and consumption are effected chiefly 
 through the agency of price; the question whether organized specula¬ 
 tion assists in such adjustment is therefore of primary importance. 
 
 The tests of a satisfactory price level are, first, does it adjust 
 itself quickly and smoothly to changes in the demand or supply situa¬ 
 tion as such changes become known, and, second, is it relatively free 
 from fluctuations which are not the result of such changes. On the 
 one hand, it is desirable that any change, whether an increase or a 
 decrease, which is to be caused by a given condition, shall take place as 
 soon as possible after that condition becomes known. If, for instance, 
 a crop shortage necessitates a decrease in consumption, it is better 
 that such decrease shall be brought about as early in the preceding crop 
 year as possible, in order that the carry over from the fat into the 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 379 
 
 lean year may be large enough to equalize the consumption. In 
 general, the sooner a change in price occurs the less violent it need be; 
 the price-making function of the speculator is to anticipate changes 
 of price-making conditions, and by his purchases and sales expedite 
 the adjustment of prices to them. If his anticipations are correct, his 
 purchases will be made in advance of increases in price which would 
 ultimately occur anyway, and his profit may be regarded as a compen¬ 
 sation for facilitating the adjustment; if his anticipations are wrong 
 his losses are the penalty he pays for obstructing the adjustment. 
 The amount of the profit or loss in the individual case bears no relation 
 to the value of the social service or damage rendered, but as the most 
 of the profits of the successful come out of the losses of the unsuccess¬ 
 ful, society, outside the group of speculators, has no direct concern 
 with the size of the individual profits and losses . 1 
 
 It may be added that the operations of a skilled group of fore¬ 
 casters, whose purchases and sales hasten the adjustment of prices 
 to their normal level, tend to reduce the risks of trade, for the reason 
 that buyers of grain and other speculative commodities, even if they 
 do not hedge, carry a somewhat smaller risk of adverse changes in 
 price if the market is so organized that prices at any given time reflect 
 the consensus of skilled and informed judgment concerning the demand 
 and supply situation. This point is of more importance, however, in 
 connection with stock speculation, and will be discussed in that con¬ 
 nection in a later paragraph. 
 
 The conclusions just set forth, in regard to the tendency of specu¬ 
 lation to reduce the fluctuations of price by hastening their approach, 
 rest entirely upon theoretical reasoning. It would be desirable, if 
 possible, to fortify them with statistical evidence, but the facts avail¬ 
 able are entirely inconclusive. So many other factors enter the situa¬ 
 tion alongside the influence of speculation that it is impossible to 
 isolate the effects of this particular factor . 3 
 
 1 Cf. Lavington, “The Social Interest in Stock Exchange Speculation,” 
 Economic Journal, XXIII, 36-52. Professor Lavington correctly indicates that 
 in specific cases the speculator’s services are enormously overpaid, but does not note 
 that the rewards of successful prognostications, which promote the adjustment of 
 prices to their theoretically correct level, are chiefly paid in the form of penalties 
 by those whose unsuccessful prognostications retard such adjustment. 
 
 3 The possible methods of approach seem to be four: to compare prices of the 
 same commodity at the same time in different places; to compare prices at the 
 same market, or in similar markets, at different times; to compare prices of different 
 grades of the same commodity during the same period in the same market; and to 
 
380 
 
 RISK AND RISK-BEARING 
 
 One other point must be considered, the ethics of short selling. 
 Frequently the short seller is condemned for “selling what he does not 
 own”; “causing depreciation in the value of other people’s property”; 
 and “dealing in fictitious commodities.” Analysis of what the short 
 seller does fails to sustain the attitude which is expressed in these 
 invectives. Inherently it is no more evil to cause a decline in the value 
 of other people’s property than it is to cause an increase, if the decline 
 or increase is caused by a change in the condition of the market and 
 not a change in the usefulness of the property itself. The price of 
 anything represents a compromise between the interests of the buyer 
 and of the seller. If a short seller forces prices unduly low, he may 
 injure those who have occasion to sell during the time of his influence, 
 but he correspondingly benefits those who buy during the same period. 
 Moreover, whatever he sells he must later buy, so that the net effect 
 of his sales and purchases is neither to increase or decrease prices; it 
 is merely to increase the turnover, just as is the case with the specula- 
 
 compare prices of different commodities whose markets are in most respects similar 
 except that some have and some have not facilities for speculative trading. None 
 of these methods is satisfactory. If we compare prices of the same commodity in 
 different parts of the world, we meet the difficulty that the prices in the non- 
 speculative market are directly influenced by those in the speculative market, 
 and vice versa. If we compare the prices of different grades of the same com¬ 
 modity, we meet the same difficulty; the prices of the grades deliverable on con¬ 
 tracts and those not so deliverable are interdependent. If we compare the range 
 of fluctuation of prices before the introduction of future trading with the range 
 since, we meet the difficulty that the introduction of organized speculation has 
 been accompanied by other changes, such as the introduction of telegraphic com¬ 
 munication, the establishment of grading systems, the improvement of transporta¬ 
 tion and storage, and the auction system of buying and selling, which collectively 
 far outweigh in importance the advent of the speculator. Comparisons of the 
 price fluctuations of similar commodities, such as wheat and rye, present the 
 difficulty that the prices are not entirely independent of one another. It is quite 
 probable, however, that some light may be thrown on the question by more care¬ 
 ful study of this last kind of evidence than has yet been made. For a recent 
 attack on the question, cf. Boyle, Speculation and the Chicago Board of Trade, 
 pp. 122-24, 219, criticized by the author in Journal of Political Economy , XXIX 
 (January, 1921), 82-83. Brace, Value of Organized Speculation , p. 58, and Emery, 
 Speculation on the Stock and Produce Exchanges of the United States, p. 127, conclude 
 from rather scanty evidence that speculation has probably increased the stability 
 of prices. Usher, “The Influence of Speculative Marketing on Prices,” American 
 Economic Review, VI, 49-60, concludes that the problem is not susceptible of direct 
 statistical solution. Cf. Chapman and Knoop, “Effects of Anticipation in the 
 Cotton Market,” Economic Journal, XIV, 541-54. 
 
RISK AND RISK-BEARING 
 
 381. 
 
 tive buyer who later sells all that he buys. What really breaks a 
 market during a bear raid is the selling of weak and timid owners who 
 do not reappear as buyers. 
 
 If the short seller can frighten real owners into selling out at the 
 bottom, he is enabled to cover his sales at a profit; unless they do so 
 he can never profit by a fall in prices of his own making. The prac¬ 
 tices of buying on narrow margins, placing stop-loss orders, and trad¬ 
 ing on market gossip and surface indications are responsible for much 
 imre weakness of markets and artificial depression of values than is 
 short selling . 1 
 
 The other criticisms of short selling need no extended refutation. 
 “ Selling what one does not own,” in order to profit by a fall in price, 
 is no more intrinsically immoral than is buying what one does not want 
 to own in order to profit by a rise. “ Dealing in fictitious commodi¬ 
 ties,” as has been shown in chapter xi, expresses a misconception of 
 what actually takes place in a futures market. The popular distrust 
 of the short seller is a good example of our tendency to distrust the 
 mysterious. Short selling is as useful as speculative buying. Both 
 are useful just in so far as they express an intelligent judgment of the 
 probable trend of prices. 
 
 Speculation in securities .—The case for organized speculation in 
 securities presents quite different features from those with which we 
 have just been dealing. The advantages of this sort of speculation 
 relate not to the maintenance of facilities for the direct shifting of 
 risk to specialists, as is done in hedging and in insurance, but to the 
 maintenance of a broad market through which securities may readily 
 be bought and sold without the necessity of bidding them up in order 
 to purchase or offering them down in order to sell. As was shown in 
 chapter vii, such a broad market makes possible the elimination of an 
 important kind of risk, namely the risk that the investor will not be 
 able to get his money back when he needs it; and at the same time 
 makes it possible for the corporation which uses the capital to remain 
 free from the risk which would result from an agreement to repay it 
 on demand. The free shifting of investments through a stock market, 
 or for that matter through an active “ over-the-counter ” market, is 
 facilitated by the presence of a body of speculators who stand ready 
 
 1 This argument is much more significant in the case of speculation in securities 
 than in the case of commodities, as the investment buyer is much more responsible 
 for the price level in the security market* 
 
382 
 
 RISK AND RISK-BEARING 
 
 to buy or sell on slight changes of price, though their services are not 
 as essential as they are in a commodity exchange. 
 
 Speculation in securities, whether organized or unorganized, 
 affords an illustration of specialization in risk-bearing much more 
 complete and minute than that which is secured through the produce 
 exchanges. Each individual carries securities involving the amount 
 and kind of risk he prefers; as securities change in character they are 
 passed on from one group to another. Normally, as a corporation 
 grows older its securities grow less speculative; the exchange facilitates 
 the process of passing them on, till they reach the status of high-grade 
 investments and leave the speculative market to rest in the strong box 
 of the conservative investor. The most conservative investments 
 have usually passed through a speculative stage, and there are only 
 two ways in which they can be carried through this period—either by 
 speculators and speculative investors, or else in the hands of a com¬ 
 paratively small group of persons close to the management who have 
 more faith in the enterprise than the general public has any cause to 
 display. 
 
 Short selling is not as essential to the work of a stock exchange 
 as it is to a commodity exchange, but its effect is, on the whole, to 
 facilitate the adjustment of market price to the known elements of 
 value. As was noted in connection with a similar feature of the 
 commodity markets, such an adjustment decreases the risk of the 
 investor. Most buyers of securities are not able to inform themselves 
 thoroughly in regard to the stability of the corporations whose securi¬ 
 ties they buy, and must, to a large extent, rely on the price itself as a 
 guide in determining their selections. Many buyers establish a 
 definite policy of buying no securities whose yields do not fall between 
 certain fixed limits. They make their selections in large part on the 
 basis of the risk indicated by the yield, assuming that if the yield is 
 very high or very low there must be some good reason for it. 
 
 This is far from being an ideal method, but it is probably one of 
 the best which is available to the average investor, provided the yields 
 are determined in a genuine competitive market. Unless such a 
 market exists, however, the method breaks down completely. Short 
 selling makes it much more difficult for anyone to maintain an artifi¬ 
 cially high price for a security, and then sell it to investors on the 
 strength of the apparently favorable market rating evidenced by the 
 price itself. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 383 
 
 The value of this protective feature of the security markets 
 would be much greater if some method were devised by which short 
 sales could be made safely in a larger number of securities. As the 
 case stands now, a speculator may be quite right in his judgment 
 that a certain security is selling at too high a price, and must sooner 
 or later decline, yet it may be unsafe for him to sell it short because 
 of the risk that the floating supply will be bought up by someone 
 who will then refuse to make loans of stock for the use of short sellers . 1 
 
 The cases where the services of the short seller would be most 
 useful are those where securities are being distributed by under¬ 
 writers at what the informed know to be unduly high prices, yet the 
 most of the certificates are still in the hands of the underwriters, so 
 that it is impossible for short sellers to break the market down to its 
 proper level. The uninformed are permitted to buy the security 
 on the strength of the high quotations established by manipulation. 
 Short selling is practically confined to a few active securities. 
 
 In the light of the considerations set forth above, we may agree 
 with the judgment of a leading economist that speculation has both 
 benefits and evils, but the benefits accrue chiefly to the general public, 
 while the evils accrue to the speculators themselves. One adverse 
 feature of the situation, however, remains to be considered. 
 
 We have emphasized above, and economists generally have 
 emphasized, the service of a body of expert speculators in studying 
 the indications of coming change, and expressing their judgments in 
 purchases and sales which tend to bring the level of prices as soon as 
 possible into line with all the known facts. Economists have not, 
 however, generally recognized the opposite tendency involved in the 
 fact that speculation, especially organized speculation, gives these 
 same students a financial incentive to conceal the facts of which they 
 become cognizant. 
 
 Suppose a certain speculator obtains advance information of 
 facts, which when made public will inevitably raise the price of certain 
 commodities or securities. He cannot take advantage of his knowl- 
 
 1 As this is being written, the Piggly Wiggly case furnishes an excellent illustra¬ 
 tion. Stock which could be bought for December delivery at $55 was selling in 
 March, 1923, around $75, obviously an artifically high price. Yet short sellers 
 who attempted to take advantage of this situation suffered severely because they 
 found themselves unable to get a sufficient supply of loanable certificates to keep 
 themselves ‘‘short” until the partial payment stock could be secured. 
 
3^4 
 
 RISK AND RISK-BEARING 
 
 edge except by purchases, and purchases tend to cause the rise to 
 occur at once, which is socially desirable. But if he can induce 
 others to sell freely until he has completed his purchases he can make 
 them more advantageously; thus he has a financial incentive to keep 
 his news secret, and to do what he can to stimulate a belief that prices 
 are actually going down. This direct incentive to speculators to 
 become spreaders of darkness instead of light goes very far to offset 
 the social advantage of having prices influenced by the judgment of 
 special students of the market outlook. 
 
 Finally, there can be no doubt that from the social standpoint 
 much of the energy which is spent by speculators in study of the 
 behavior of organized markets, and much of the time of brokers and 
 their employees, represents sheer waste. The function of scrutinizing 
 the news for indications of coming change in the security markets is 
 valuable, but it is greatly overdone, and too largely intrusted to those 
 who have no qualifications for doing it well. 
 
 Land speculation .—The case of land speculation is worthy of 
 special attention because there is a very widespread belief that the 
 land speculator is especially deserving of condemnation as a parasite. 
 There seems to be no basis for the assumption that the land specula¬ 
 tor’s social significance is particularly different from that of any other 
 speculator, or that he can make a profit out of price changes except 
 by promoting those uses of land which are socially most desirable. 
 
 In the case of land which can be rented and fully utilized during 
 the time it is being held by a speculator, as is generally the case with 
 farm land, there is no waste of social resources; the rental value of the 
 land is no greater and no less than it would be if the land were held by 
 a permanent investor. The social problems involved are those 
 generally associated with tenancy. 
 
 In the case of land which cannot be put to productive use till it 
 is improved and is being held unimproved by a speculator, there is 
 apparently a waste of resources, and it is in connection with this type 
 of land speculation that the system of free buying and selling has been 
 most condemned. Yet no speculator has any incentive to hold land 
 out of service any longer than is necessary in order to reserve it for 
 its most productive use. If a speculator believes that ten years from 
 now his lots will be worth enough to justify putting a $100,000 building 
 on them, he cannot afford to put a $10,000 building on them now, 
 unless the smaller building will pay for itself in ten years so that it 
 can be scrapped without loss to make way for the more productive 
 
SOCIAL ASPECTS OF RISK-BEARING 385 
 
 use. In such a case it is socially desirable to hold the land out 
 of use. 
 
 In general, if the speculator is right in his judgment that his land 
 will be worth enough more some years hence to pay interest on what 
 he could get for it now, plus a profit, society gains by having the land 
 held out of use till that time. If, on the other hand, the most profitable 
 way to use the land, in the long run, is to improve it at once, and then 
 scrap the improvements later to make way for better ones, it is to the 
 speculator’s interest to do so or to sell to someone who will. Here, 
 as in other types of speculation, the line of greatest profit coincides 
 with the line of social interest. Speculators may, and often do, retard 
 the use of land for purposes for which it is desirable that it be used, 
 but they lose money by so doing. 
 
 Of course, what has been said above concerning the possibility 
 of profiting by dissuading others from following the line of their 
 best interests, withholding from them valuable information, and 
 disseminating errors, applies here, but it is probably of less importance 
 than it is in the case of the organized markets. 
 
 V. RISK-BEARING AND THE SOCIAL ORDER 
 
 In any evaluation of our social machinery for dealing with 
 uncertainty, the largest question involved is the rating which is to 
 be given the present economic order as a whole, from the standpoint 
 of its tendency to reduce or increase the element of risk. One of the 
 chief objects at which men are aiming in their economic efforts is the 
 attainment of security. Does the economic system they have 
 established promote this purpose reasonably well ? 
 
 The question is not answerable, even in theory, unless it is so 
 restated as to involve a direct comparison between the economic 
 order under consideration and some other order, either historical or 
 hypothetical. Viewing the economic system of free enterprise merely 
 as an isolated phenomenon, without consideration of any possible 
 alternative system, the observer is equally justified in rendering a 
 verdict highly favorable or highly unfavorable. One man is filled 
 with amazement and admiration that the system works as well as it 
 does; another is aghast that it does not work better; there need be 
 no difference of opinion between them as to the actual facts of the 
 case at all. Their difference of attitudes is merely aesthetic. As soon, 
 however, as a comparison is attempted between the present order and 
 some other order, we have some chance of reaching a rational judgment. 
 
386 
 
 RISK AND RISK-BEARING 
 
 Practically speaking, there are only two bases on which a judgment 
 of any interest concerning the efficiency of the modern capitalistic 
 organization can be formulated: namely, a comparison with the 
 medieval small-scale non-competitive and non-speculative economy; 
 and secondly, a comparison with the socialized large-scale non¬ 
 competitive, non-speculative economy which, in some form, is preferred 
 by most radical critics of our present-day organization. 
 
 As compared with the situation which prevailed before the 
 introduction of the machine technique, corporate organization, 
 extensive commerce, and complex finance, the case is far from clear. 
 In relation to the hazards which arise from man’s ignorance of the 
 workings of nature, the average man is more secure than were his 
 ancestors. Public and private facilities for the maintenance of health 
 are far better than ever before in the history of the world; weather 
 forecasting has greatly reduced the hazards of storm and flood; 
 dangerous animals have been driven far from the homes of most men; 
 better food, better clothing, and better shelter make man independent, 
 as never before, of the powers of physical nature. The hazards of 
 war also, in spite of the formidable evidence to the contrary, are 
 probably less than was the case when our scientific knowledge and 
 economic interdependence was less. War grows more spectacular, 
 but less frequent, and though the weapons of war grow more deadly, 
 the diseases of the camps kill fewer and fewer. 
 
 Let us consider next the risks of maladjustment of production 
 and marketing. It is obvious that modern methods of production 
 involve a great deal more uncertainty with regard to the exact coin¬ 
 cidence of desire and supply than did the simpler type of organization. 
 When the medieval gildsman made a pair of shoes for his neighbor, he 
 knew before beginning work that a market existed for the shoes. 
 And even earlier when he was acquiring his skill or establishing his 
 shop, he knew pretty accurately the course of demand for his product 
 during the period when the acquired skill and capital were to be used. 
 
 When goods are made by the modern factory process, on the other 
 hand, there is no exact knowledge of the coincidence of the productive 
 effort and the desire for its fruits. When the clothing manufacturer 
 starts the process of making a suit of clothes, he does so in the faith 
 that somewhere in the world is a man of the size and shape to fit that 
 suit, and that the paths of the suit and the man will cross at the 
 exact moment when the man desires to purchase a new suit of clothes. 
 Viewed from the standpoint of the single transar-tion, such an effort 
 'ooks hazardous in the extreme. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 3^7 
 
 The degree of hazard is not to be estimated, however, on the basis 
 of the probability of the single transaction’s turning out well, but on 
 the basis of the average result as estimated in accordance with the 
 law of large numbers. And from this standpoint the broader the 
 market, the less the risk. If of 5,000 suits that were sold last year, 
 9 per cent were of a certain size and 17 per cent of another size, there 
 is slight probability that the proportion of men of these sizes in the 
 next group of 5,000 buyers will differ widely from the preceding 
 result. As the number of cases grows larger, the percentage of error 
 grows smaller. The individual varies, the crowd remains the same. 
 It is only the exceptional individual, who in size or shape fails to 
 conform to the mass, whose wants cannot be supplied by the method 
 of mass production. 
 
 Most problems of risk reduce themselves finally to these two 
 types: Does the increase in the value of a commodity, which will 
 result from its being transported to another point in space, promise 
 to offset the costs and risks of the undertaking? Does the increase 
 in value anticipated from transferring a commodity by storage to a 
 remote time promise to offset the costs and risks involved in the 
 undertaking ? In the case of transportation, the direct and calculable 
 cost is the more serious factor; in the case of storage the risk element 
 is more likely to control, but in both cases the principle is the same; 
 the anticipated increase in value must equal the actual known costs 
 of the operation, plus the probable cost or loss multiplied by the frac¬ 
 tion which represents its probability. What communication is to the 
 difficulties of space, forecasting is to the difficulties of time; what 
 transportation is to the difficulties of space, storage is to the difficulties 
 of time. 
 
 One of the first effects of the expansion of business into its modern 
 form was a great increase in the space area involved within the cal¬ 
 culations of the single unit. In the beginning this expansion of space 
 involved an increase of risk. When wool was raised in northern 
 England to be woven into cloth in Belgium, and worn as clothing in 
 London, Paris, Spain, and Denmark, it was impossible for an indi¬ 
 vidual who was responsible for the early stages of the productive 
 process to know the conditions at the point where the later stages 
 would be carried through, and the result was the injection of a large 
 element of risk into men’s calculations. 
 
 The later course of capitalistic development, on the other hand, 
 has been in the direction of eliminating space risk. Rapid transporta- 
 
388 
 
 RISK AND RISK-BEARING 
 
 tion and improved communication through postal, telegraph, tele¬ 
 phone, and radio service have made a continent, so far as effect of 
 space upon risk is concerned, smaller than an old-time county. The 
 trader buying wheat in New York for export has Liverpool quotations 
 no more than ten minutes old, and even in markets for less stand¬ 
 ardized commodities and in dealings with remote parts of the world, 
 the factor of ignorance due to distance has been reduced to a fraction 
 of its former importance. 
 
 On the other hand, the risk from the other type of extension of 
 the market has tended to grow more and more important. The 
 modern productive processes not only involve a wider range of ter¬ 
 ritory but a greater scope of time. Between the opening of an iron 
 mine in Minnesota and the purchase of the resulting needle by a 
 housewife in Texas, much time must elapse, and the effect of time is 
 to multiply the possibilities of miscalculation. And our technique 
 of reaching into the future to secure a basis for our calculations is 
 vastly inferior to our technique of reaching across space, with the 
 added complication that, whereas goods shipped in error from one 
 point to another can generally be shipped back, goods carried through 
 in error from one point of time to another can never be returned. 
 
 To these considerations two others must be added. The risk of 
 loss in a given undertaking depends not only upon the amount of 
 hazard to which the capital or acquired skill invested in it will be 
 exposed before the normal completion of the undertaking; it depends 
 also upon the completeness and rapidity with which the investment 
 can be rescued in case the adverse conditions appear. This is chiefly 
 a question of the degree of specialization. The capital invested in an 
 office building or a building suitable for light manufacture can be 
 utilized without tremendous loss if the enterprise in connection with 
 which it was originally invested proves a failure, whereas the capital 
 invested in a steel plant, a stock of pogo sticks, or an equipment for 
 manufacturing five-inch shells can be utilized for few other purposes in 
 case the calculations of the investor prove false. It is at this point 
 that the indictment of insecurity against the modern organization 
 has most force, with reference both to the investment of capital and 
 the investment of time in fitting one’s self for a particular type of 
 labor. The unskilled laborer is dependent for his support not on the 
 continuance of the particular industry in which he is employed, but 
 on the continuance of activity of business in general. But the pastry 
 cook must lose his investment of time in acquiring skill in manu- 
 
SOCIAL ASPECTS OF RISK-BEARING 389 
 
 facturing a given type of dessert as soon as public taste turns to a 
 rival delicacy. 
 
 Finally competition may bring loss to the individual even when 
 it brings gain to the group. All competitive business involves in¬ 
 eradicable elements of risk. We improve the merchant’s technique 
 of studying the market, and we increase correspondingly the number 
 of things he must know. We may develop a technique of forecasting 
 price changes, but if we share the technique with those to whom we sell 
 and those from whom we buy, the difficulty of squeezing a living out 
 of price fluctuations remains unchanged. If we establish a hedging 
 system to relieve the merchant of the risks of price changes, presently 
 competition narrows his margin of profit so that his certainty of an ade¬ 
 quate return for his efforts is again removed. If we make the trader’s 
 lot more secure by creating insurance companies, police forces, and 
 other agencies for relieving him of risk, we attract more traders into 
 competition with him. Efforts to make competitive business safe 
 for all who engage in it are like efforts so to improve the standards of 
 athletic coaching in a community that no one will lose any more 
 contests. 
 
 It is a striking fact, however, that the number of persons subject 
 to the risks of the market and of competition has vastly expanded. 
 We release the farmer from the grip of manorial custom, and leave 
 him free to experiment with new methods which may greatly increase 
 his income, but which may ruin him. We free the peasant from the 
 soil and send him out to seek his fortune; he may rise much higher 
 than his ancestors ever dreamed of rising, but he may also much 
 more easily sink to pauperism. In granting opportunity, we have 
 imposed risk. The average standard of living of the agricultural 
 laborer has advanced greatly, but the variation in status has increased 
 still more. 
 
 In other departments of life the same thing is true. The guilds- 
 man, the monk, and the soldier of the precapitalistic era all found 
 their place in life as members of organizations; they rose or fell chiefly 
 as those organizations rose or fell. Modern individualism has cut 
 the bonds between individuals, and given them the possibility of 
 choice , and with free choice goes increased risk. 
 
 The question of the relative value of medieval and modern organi¬ 
 zations, from the standpoint of the risk involved, is therefore an open 
 one. The range of uncertainty has for most men increased, but the 
 uncertainty arises largely from the possibility of better things; whether 
 
390 
 
 RISK AND RISK-BEARING 
 
 these possibilities are worth the risks they entail is largely a matter 
 of the individual’s preference as to the kind of world he wants to 
 live in. 
 
 The question of the incidence of risk in a socialist state, as com¬ 
 pared with that in a capitalist state, is too large for complete analysis 
 here, because of the extent to which a final conclusion in regard to it 
 depends on estimates of such unknown variables as the effect of the 
 abolition of independent business opportunities on the caliber of men 
 offering themselves for public office, and the effect of the socialization 
 of productive property on the individual’s feeling of responsibility 
 to do faithful work. All that we shall attempt is a consideration of 
 the direct effect of the change to a socialist organization on the amount 
 of uncertainty involved in the productive and distributive processes. 
 
 Clearly, a well-organized socialist state could remove much of the 
 uncertainty in man’s life. It could, as a military organization does, 
 place men in definite positions from which there would be little chance 
 of their escaping either for better or for worse. The risks of production 
 and of the commodity market would be borne by the group as a whole, 
 and in large part eliminated by combination; the risks connected 
 with the market for one’s individual skill and energy could, if the 
 controlling minds desired, be eliminated by cutting the connection 
 between the demand for one’s service and the rate of one’s wage. 
 
 On the other hand, such an organization might as readily operate 
 on the basis of an unequal distribution of the community income to 
 laborers of various kinds, with free competition between individuals 
 for the higher paid and more difficult positions. If this latter method 
 were followed, the uncertainty of the individual’s economic future 
 might be little less than it is at present. 
 
 Or, quite possibly, a compromise might be effected whereby the 
 amount of individual liberty and consequent individual risk would be 
 less than it is at present, yet greater than it would be if all tasks 
 were apportioned solely by political methods, and income was divided 
 equally or by some method not directly connected with the scarcity of 
 the kind of service which the individual could perform. Our own 
 federal civil service offers, in those who have remained in it past 
 middle life, an excellent illustration of the possibility of an economic 
 career which is touched with the minimum amount of uncertainty 
 concerning tenure, compensation, and conditions of work; opportuni¬ 
 ties for such riskless endeavor the socialist state might easily multiply. 
 
SOCIAL ASPECTS OF RISK-BEARING 
 
 391 
 
 Outside the market for individual services, the chief difference 
 between the risks of present-day industry and those which we would 
 anticipate under a socialistic organization would arise from the elimina¬ 
 tion of the risks which arise from the tendency under competition for 
 individuals alternately to accumulate and reduce stocks in anticipation 
 of price changes. This tendency, which, as was shown in chapter v, 
 is the major cause of the cyclical tendency of business, seems to be 
 inescapable so long as individuals make their business decisions each 
 in ignorance of what the others are deciding on the basis of the same 
 evidence. Any system of centralized control of production, whether 
 arising from governmental monopoly or from private monopoly, could 
 in large part escape this weakness of the competitive system, and save 
 a considerable portion of the waste which attends the alternation of 
 excessive activity and stagnation in the industrial process. 1 
 
 1 In view of the extent to which current theory ascribes the cyclical tendency 
 in business to the “pecuniary” organization of society, it may be well to examine 
 the probable effects of socialization more carefully. By the term “pecuniary 
 organization” there is designated, rather inaccurately, the system of directing 
 production in such a way as to produce the maximum profit for business men; 
 in other words, the attempt to produce those things for which the social demand, 
 as expressed in offers of payment, is the greatest, relative to the costs incurred. 
 A socialistic organization would face the necessity of making a similar adjustment 
 of supply to demand, but not necessarily to demand as expressed in offers of purchas¬ 
 ing power (though if purchasing power were equalized the chief objection to the 
 method would disappear). 
 
 Whether production be adjusted to demand as expressed by offer of purchasing 
 power, or by the ballot, or by the results of statistical investigations by experts, 
 or by any other method, the critical point in determining whether the cyclical 
 tendency would be eliminated, seems to be the question of centralization of control. 
 A private monopoly controlled by the pecuniary calculus would be freed from the 
 tendency, if its business were not interdependent with that of mother businesses 
 which are subject to the tendency; on the other hand, in fields where adjustment 
 requires time a group of independent producers all controlled by a philanthropic 
 desire to direct production into the channels of greatest social efficiency would be 
 subject to the cyclical tendency if they made their decisions independently and on 
 the basis of their knowledge of the same general situation. 
 
 QUESTIONS 
 
 1. The ultimate effect of improvements in business methods is usually to 
 lower prices to consumers, yet society depends on the self-interest of 
 business men, through profits, to secure the adoption of improvements. 
 Is this rational? 
 
 2. Profit is sometimes stated to be a compensation for the “irksomeness” of 
 riskbearing. Discuss. 
 
392 
 
 RISK AND RISK-BEARING 
 
 3. Can you cite cases where profit is collected without either monopoly 
 conditions or significant risk, (a) temporarily? ( b) permanently? 
 
 4. Formulate a general statement of the conditions under which profit is 
 socially useful. 
 
 5. It is frequently assumed that the placing of control in the hands of those 
 who carry risk tends to prevent recklessness in the conduct of business. 
 Does the history of governmental business enterprises confirm this ? 
 
 6. Under a socialistic organization, who would take the risks incident to the 
 introduction of new methods? 
 
APPENDIX 
 
 REFERENCES FOR FURTHER READING 
 
 CHAPTERS I TO IV, INCLUSIVE 
 
 Fisher, Irving. Nature of Capital and Income , chap, xvi; Appendix I. 
 New York: Macmillan Co., 1906. 
 
 Haynes, John. “Risk as an Economic Factor,” Quarterly Journal of Eco¬ 
 nomics, IX (1895), 409-49. 
 
 Knight, F H. Risk, Uncertainly, and Profit. Hart Schaffner & Marx 
 Prize Essays. Boston: Houghton Mifllin Co. (Riverside Press), 
 1921. 
 
 Ross, E. A. “Uncertainty as a Factor in Production,” Annals of the 
 American Academy of Political and Social Science , VIII fi8q6), 304-31. 
 
 Willett, A. H. “Economic Theory of Risk and Insurance,” Columbia Uni¬ 
 versity Studies in History, Economics and Public Law, Vol. XIV. New 
 York: Columbia University, 1902. 
 
 chapter v 
 
 Clark, J. M. “Business Acceleration and the Law of Demand,” Journal 
 of Political Economy, XXV (March, 1917), 217-35. 
 
 Hansen, A. H. “Cycles of Prosperity and Depression in the United States, 
 Great Britain and Germany,” University of Wisconsin Studies in tht 
 Social Sciences and History, No. 5. Madison: University of Wisconsin 
 1921. 
 
 Lavington, F. The Trade Cycle. London: P. S. King Si Son, 1922. 
 
 Mitchell, W. C. Business Cycles. Berkeley: University of California 
 Press, 1913. 
 
 Selden, G. C. “Trade Cycles and the Effort to Anticipate,” Quarterly 
 Journal of Economics, XVI (1902), 293-310. 
 
 CHAPTER VI 
 
 Babson, Roger W. Business Barometers, 15th ed. Wellesley Hills: Babson 
 Statistical Organization, 1921. 
 
 Gaines, M. W. The Art of Investment, chap. vii. New York: Ronald 
 Press, 1922. 
 
 Hansen. University of Wisconsin Studies, No. 5. 
 
 Jones, E. D. Investment, chaps, xv-xvii, inclusive. New York: Alexander 
 Hamilton Institute, 1917. 
 
 Jordan, D. F. Business Forecasting. New York: Prentice-Hall, 1921. 
 
 Mitchell. Business Cycles. 
 
 Review of Economic Statistics, passim. 
 
 393 
 
394 
 
 RISK AND RISK-BEARING 
 
 Vance, Ray. Business and Investment Forecasting. New York: Brookmire 
 Economic Service, 1922. 
 
 CHAPTER VII 
 
 Chamberlain, Lawrence. Principles of Bond Investment, chap. ii. New York: 
 Henry Holt & Co., 1911. 
 
 Lavington, F. The English Capital Market , chaps, xiii-xv, inclusive. 
 London: Methuen & Co., 1921. 
 
 CHAPTER VHl 
 
 I 
 
 Atwood, A. W. The Exchanges and Speculation. New York: Alexander 
 Hamilton Institute, 1919. 
 
 Emery, H. C. “Speculation on the Stock and Produce Exchanges of the 
 United States,” Studies in History, Economics and Public Law , Vol. 
 VII. New York: Columbia University, 1896. 
 
 Huebner, S. S. The Stock Market. New York: D. Appleton & Co., 1922 
 Meeker, J. E. The Work of the Stock Exchange. New York: Ronald 
 Press, 1922. 
 
 Pratt, S. S. The Work of Wall Street , rev. ed. New York: D. Appleton 
 & Co., 1921. 
 
 II 
 
 Chamberlain, Lawrence. Principles of Bond Investment , chap. xl. 
 
 Dewing, A. S. The Financial Policy of Corporations, Vol. II, chaps, vii-ix, 
 inclusive. New York: Ronald Press, 1920. 
 
 Moulton, H. G. The Financial Organization of Society. Chicago: Uni¬ 
 versity of Chicago Press, 1921. 
 
 CHAPTER IX 
 
 Browne, Scribner. Practical Points on Stock Trading. New York: 
 
 The Magazine of Wall Street, igi8. 
 
 Gaines, M. W. The Art of Investment, chap. x. 
 
 Gibson, Thomas. The Pitfalls of Speculation. New York: Moody Maga¬ 
 zine & Book Co., 1916. 
 
 -. “The Facts about Speculation,” serially in Financial World, 1923 
 
 Selden, G. C. Investing for Profit. New York: The Magazine of Wall 
 Street, 1913. 
 
 chapter x 
 
 Chamberlain, Lawrence. Principles of Bond Investment. 
 
 Clay, Paul. Sound Investing. New York: Moody's Magazine & Book 
 Co., 1915. 
 
 Gaines, M. W. The Art of Investment. 
 
 Jones, E. D. Investment. 
 
 Jordan, D. F. Investments, rev. ed. New York: Prentice-Hall, 1921. 
 Lagerquist, W. E. Investment Analysis. New York: Macmillan Co., 1922. 
 
APPENDIX 
 
 395 
 
 CHAPTERS XI, XII 
 
 “American Produce Exchange Markets,” Annals of the American Academy 
 of Political and Social Science , Vol. XXXVIII (September, 1911). 
 Clark, F. E. Principles of Marketing , chap. xvii. New York: Macmillan 
 Co., 1922. 
 
 v 
 
 Emery, H. C. Studies in History, Economics and Public Law, Vol. VII. 
 Hibbard, B. H. ' The Marketing of Agricultural Products, chaps, x-xiii, 
 inclusive. New York: D. Appleton & Co., 1921. 
 
 Weld, L. D. H. The Marketing of Farm Products, chaps, xv, xvi. New York: 
 Macmillan Co., 1916. 
 
 CHAPTERS xill-xvn, INCLUSIVE 
 
 Annals of the American Academy of Political and Social Science , Vol. LXX 
 (entire) (March, 1917, Part I “Life Insurance”; Part II, “Fire Insur¬ 
 ance”; Part III, “Accident and Compensation Irsurance.” 
 
 Blanchard, R. H. Liability and Compensation Insurance. New York: 
 D. Appleton & Co., 1917. 
 
 Fackler, E. B. Notes on Life Insurance. New York: Spectator Co., 
 1907. 
 
 Gephart, W. F. Principles of Insurance, Vol. I, “Life”; Vol. II, “Fire.” 
 New York: Macmillan Co., 1917. 
 
 Hamilton, W. H. Current Economic Problems, chap, xi, rev. ed. Chicago: 
 University of Chicago Press, 1919. 
 
 Hudnut, J. M. Studies in Practical Life Insurance. New York: New York 
 Life Insurance Co., 1911. 
 
 Huebner, S. S. Life Insurance. New York: D. Appleton & Co., 1915. 
 
 -. Property Insurance , rev. ed. New York: D. Appleton & Co., 
 
 1922 
 
 Riegel, Robert, and Loman, H. J. Insurance Principles and Practices. 
 New York: Prentice-Hall, 1921. 
 
 Willard, Charles E. The A B C of Life Insurance. New York: Spectator 
 Co., 1917. 
 
 Woodbury, R. M. Social Insurance, an Economic Analysis. New York: 
 Henry Holt & Co., 1917. 
 
 Zartman, L. W., and Price, A. A. Yale Readings in Insurance, rev. ed. 
 Vol. I, “Personal Insurance”; Vol. II, “Property Insurance.” New 
 Haven: Yale University Press, 1920. 
 
 chapter xvin 
 
 Emery, H. C. “Speculation,” in Everyday Ethics. New Haven: Yale 
 University Press, 1910. 
 
 Knight, F. H. Risk, Uncertainty, and Profit, chaps, xi, xii. 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 . 
 
 
 
 
 * 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
I 
 
 INDEX 
 
 Abandonment, notice of, 321-22 
 Abstracter, bonded, 332 
 Accident, industrial, 345-57 
 Admiralty bonds, 330-31 
 
 Agricultural production, as a barometer 
 of business, 92-95 
 
 Analysis of securities, industrial, 190- 
 200; public utility, 200-202; rail¬ 
 road, 200-202 
 
 Annuities, life, 259-62; 276-80 
 Assumption of risk, in industrial ac¬ 
 cidents, 348 
 
 Automatic premium loan, 264 
 Automobile insurance, 322-23 
 Averaging down, 160 
 
 Babson Compositplot, 103-6 
 Bank acceptance, 327-28 
 Banking barometers, 96-101 
 Barometers of business, 86-101 
 Barometric data, sources of, 114-15 
 Basis contract, in future trading, 206 
 Blanket policy, in fire insurance, 298, 
 300 
 
 Bond house, see Investment bank 
 Bonds, investment, 187-88; written by 
 surety companies, 330-32 
 
 Bond tables, error in, 182-83 
 Bradstreet’s index of prices, 87 
 Brookmire barometers, 106-8 
 Brokers, stock exchange, relations with 
 customers, 131; classes of, 137-47 
 
 Bucket shop, 135 
 
 Builders’ risk policy, in marine in¬ 
 surance, 322 
 
 Bureau of Labor Statistics’ indices, 87 
 Business cycle, phases of, 63-71; causes 
 of, 71-83 
 
 Business failures, as a business bar¬ 
 ometer, 90-91; statistics of, 117 
 
 Business forecasting, chap, on, 84-115 
 Business managers, qualifications of, 
 43-45 
 
 Business problems, analysis of, 48-53 
 
 Calendar trading, 164, 218 
 Call loan rate, 161-62 
 Capitalist lender, risks assumed by, 
 33-34 
 
 Chicago Board of Trade, 208-14 
 Clearing methods, used by stock ex¬ 
 changes, 131; by boards of trade, 
 211-12 
 
 Coinsurance, in fire underwriting, 299- 
 301; in credit insurance, 324 
 
 Collision insurance (automobile), 323 
 
 Combination, reduction of risk by, 19- 
 21 
 
 Commission houses, 137-38 
 Commission rates, on stock sales, 137-38 
 Compensation, reduction of risk by, 26 
 Composite barometers, 101-14 
 Conflagration hazard, 290-91 
 Consolidated Stock Exchange, 148 
 Construction and the fire hazard, 290 
 
 Constructive total loss, in marine in¬ 
 surance, 321 
 
 Continuous instalment, in life in¬ 
 surance, 259-62 
 
 Contract bonds, 331 
 Contracting out, 60-61 
 Contributory negligence, in industrial 
 accidents, 348 
 Control and risk, 364-66 
 Convertible term policy, 243 
 Co-operative method of reducing risk, 
 18 
 
 Cornering, 131 
 
 Corporate suretyship, 328-31 
 Credit insurance, 324-26 
 Criminal bail bonds, 330 
 Crisis, 68-71 
 Crop insurance, 323-24 
 Curb market, 130, 147-48 
 Customs and internal revenue bonds, 
 33i 
 
 Dean Schedule, in fire insurance, 316, 
 318 
 
 397 
 
39? 
 
 RISK AND RISK-BEARING 
 
 Deferred annuity, 279 
 
 Depository bonds, 331 
 
 Depreciation and fire loss, 289 
 
 Depression, business, 63-64 
 
 Direct settlement, in future trading, 
 210-n 
 
 Disability clause, in life insurance 
 policies, 243, 280-81 
 
 Disbursement of life insurance funds, 
 258-69 
 
 Distribution clause, in fire insurance 
 policies, 298 
 
 Diversification, 202-5 
 
 Employers’ liability legislation, 348-49 
 Endowment life policy, 243 
 
 Ethics of gambling, 369-72; of in¬ 
 surance, 373-74; of speculation, 
 
 374-85 
 
 Excess profits tax, 356-57 
 Excess floater, in fire insurance, 298 
 Expense, in life insurance, 258-59 
 Exposure, and the fire hazard, 290-cp 
 Extended insurance, 263-64 
 
 Factory mutuals, 305 
 Fair return, 357-60 
 Farmers’ mutuals, 303-4 
 
 Fellow-servant doctrine, in industrial 
 accident, 348 
 
 Fidelity bonds, 330 
 Fiduciary bonds, 330 
 
 Fire insurance, chap, on, 288-319; 
 automobile, 323 
 
 Fleet insurance, 322 
 
 Floating policies, in fire insurance, 298; 
 in marine insurance, 322 
 
 Fraternal insurance, 272-76 
 Friday, David, 366-68 
 Foreign government bonds, 188-89 
 Futures contract, 205 
 Futures markets, 207 
 
 Gambling enterprises, 125-26; ethics 
 of, 369-74 
 
 General policy, in fire insurance, 298 
 
 Government bonds, United States, 187; 
 foreign, 188-89 
 
 Gross premium, in life insurance, 251 
 Group insurance, 269-71 
 Guaranty and suretyship, chap, on, 
 327-35 
 
 Harvard General Index of Business 
 Conditions , 108-14 
 
 Hazard, fire, 288-91 
 
 Hedging, 60; chap, on, 223-56; 375-78 
 
 Idle car figures, a barometer of business, 
 88 
 
 Improvement (a phase of the business 
 cycle), 65-66 
 
 Indemnity, doctrine of, in fire insurance, 
 292, 293 
 
 Indices of general business conditions, 
 see Barometers of business 
 
 Indorsement, as guaranty, 327-28 
 
 Industrial corporations, reports, 88-90; 
 securities, 190-91; analysis of finan¬ 
 cial position, 194-200 
 
 Industrial insurance, 271-72 
 Insurable risks, 320 
 
 Insurance, field of, 57-59; speculative, 
 59-60; against unemployment, 342- 
 y 44; against business losses, 366-68. 
 ^ See also Life, Credit, Fire, Crop, 
 Title, and Miscellaneous Insurance. 
 
 Interest rates, a business barometer, 
 98-101; adjustment to risk, 121; and 
 life insurance, 250-57 
 
 Inter-insurance ^ see Reciprocal insur¬ 
 ance 
 
 Internal revenue bonds, 331 
 
 Investment, distinguished from specula¬ 
 tion, 124-26. See also Securities. 
 
 Investment banking, 152-55; ethics of, 
 188 
 
 Judgment, business, 7-8; 45-55 
 Judicial bonds, 330 
 
 Labor, risks of 33-34; chap, on, 336-54 
 
 Land speculation, 220-22; 384-85 
 
 Large numbers, law of, 19, 29-30 
 
 Level premium, 243-44 
 
 Liability, in industrial accidents, 347-48 
 
 Liability insurance, automobile, 323 
 
 License bonds, 331 
 
 Life annuities, 243, 259-62, 276-79 
 
 Life insurance, chap, on, 237-87 
 
 Limited orders, 146, 157 
 
 Limited payment life insurance policies, 
 
 243 
 
 Liquidation, a phase of the business 
 cycle, 68; of debts, as an investment. 
 117-18 
 
INDEX 
 
 399 
 
 Lloyd’s, insurance, 59-60, 305-6 
 Loading, in life insurance, 251, 257-58 
 Loans, policy, 264-69 
 Lost security bonds, 331 
 
 Manipulation, 173-74 
 Margins, 138, 209, 212 
 Marine insurance, 320-22 
 Market analysis, 12-15 
 Market orders, 146, 157 
 Market risks, 3-7 
 
 Marketability (of securities), 185-86 
 
 Miscellaneous property insurance, chap, 
 on,320-26 
 
 Monopoly, as a source of profit, 42-43 
 Monopoly profits, interference with, 
 357-59 
 
 Monthly income policy, 279-80 
 Moral hazard, 291-92, 322, 323 
 Mortality charge, in life insurance, 251 
 Mortality tables, 248-50 
 Mortgage clause, in fire insurance, 298- 
 99 
 
 Municipal bonds, 187-88 
 
 Mutual insurance, life, 246-47; fire, 
 303-5; tornado, 322 
 
 Named policy, 322 
 
 Natural premium, 244 
 
 Net premium, 251 
 
 New York Cotton Exchange, 214 
 
 New York Stock Exchange, 129-40 
 
 Occupancy and the fire hazard, 290 
 Occupation boads, 331 
 Odd-lot dealer, 144-47 
 Open policy, 322 
 
 Optional settlements, in life insurance, 
 259-64 
 
 Overinsurance, 291-92 
 Over-the-counter market, 150-51 
 Owner-manager, risks assumed by, 33- 
 34 
 
 Paid-up insurance, 263-64 
 
 Participating policy, 244 
 
 Permit bonds, 331 
 
 Personal loans, risk in, 121-22 
 
 Pig iron, a barometer of business, 91-92 
 
 Pit scalping, 218 
 
 Policy, life insurance, 241-45; fire, 
 295-98; marine, 320-22; title, 333-34 
 
 Policy loans, 264-69 
 Premiums, see Rates 
 
 Profit, 34-43; insurance of, 301-2; 
 social aspects of, 385-91 
 
 Profiteering, 362-63 
 
 Prices, as barometers of business, 86-87; 
 as affected by speculation, 378-79 
 
 Probabilities, calculation of, 27-31; 
 classes of, 45-46 
 
 Produce exchanges, organization and 
 purposes, 205 
 
 Property damage (automobile) insur¬ 
 ance, 323 
 
 Prosperity, 67-68 
 
 Protection and the fire hazard, 290 
 Public official bonds, 330 
 
 Public utilities, analysis of securities, 
 201-2 
 
 Pyramiding, 158-59 
 
 Railways, reports of, as a business 
 barometer, 87-88; securities, anal¬ 
 ysis of, 200-202 
 
 Rates, in life insurance, 248-58; fire, 
 313-19; marine, 322; automobile, 
 323; compensation, 353-54 
 
 Real estate titles, insurance of, 331-35 
 Reciprocal insurance, 306-13 
 
 Recovery, a phase of the business cycle, 
 65-66 
 
 Rediscount rate, effect on expansion of 
 business, 99-100 
 
 Renewable term policies, 243 
 Rent insurance, 301-2 
 Reproduction cost and fair return, 
 357-59 
 
 Research, reduction of risk by, 11-15; 
 limitations of, in the social sciences, 
 17-19 
 
 Reserves, reduction of risk by, 21-26; 
 in life insurance, 251 
 
 Reversionary annuity, 279 
 
 Riders, in fire insurance contracts, 298 
 
 Ring settlement, 211 
 
 Risk, defined, 1; sources of, 2-5; 
 methods of reducing, 11-36; as¬ 
 sumption of, 33-34; a source of 
 profit, 40-41; and control, 43, 365- 
 67; transfer to specialists, 56; adjust¬ 
 ment of interest rate to, 121; factor 
 in investment policy, 181 
 
400 
 
 RISK AND RISK-BEARING 
 
 Risk-bearing, specialization in, 56, 119- 
 21, 364; and the social order, 385-91 
 
 Scalping, 158 
 
 Schedule rating, in fire insurance, 315; 
 in compensation insurance, 354 
 
 Securities, market for, 128; distribu¬ 
 tion of, 151-56; analysis of, 186-93; 
 speculation in, 381-84 
 
 Short sale of stocks, 138-40; ethics of, 
 
 380- 81 
 
 Single premium insurance, 243 
 Socialist state, risk in, 390-91 
 Space risk, 387-88 
 
 Specialist, on stock exchange, 143-44 
 
 Specialization, in risk-bearing, 33-34, 
 56, 119-21, 364; of capital, a source 
 of risk, 388 
 
 Specific policy, in fire insurance, 298 
 
 Speculation, chaps, on, 157-80, 205-22; 
 inland, 220-22, 384-85; in securities, 
 
 381- 84 
 
 Spot market, 226-27 
 Spreading, in futures, 219 
 Stock clearing corporation, 131 
 
 Stock companies, in life insurance, 246- 
 47; in fire, 302-3 
 
 Stock Exchange, New York, 129-40 
 Stock prices, a barometer of business, 
 95-96 
 
 Stop-loss order, 146, 158-60 
 Surplus, in life insurance, 251 
 Surrender values, in life insurance, 262- 
 64 
 
 Tailing on, 218 
 Tape, ticker, 133 
 Tax exemption, 183, 187 
 
 Technical position, 161-63 
 
 Term insurance, 243 
 
 Theft insurance (automobile), 323 
 
 Three-quarter value clause, in fire in¬ 
 surance, 301 
 
 Ticker, 132-33 
 
 Time and motion study, 15-17 
 
 Time policies, 322 
 
 Time risk, 122-24; 387-88 
 
 Title insurance, 332-34 
 
 Tornado insurance, 322 
 
 Torrens System, 334-35 
 
 Transfer, in futures markets, 211-12 
 
 Transfer of risk, methods, 32-33; ex¬ 
 amples, 56-61 
 
 Two-dollar brokers, 142-43 
 
 Underwriting of security issues, 328 
 
 Unemployment, of productive factors, 
 24-26; of labor, 337-45; insurance, 
 342-44 
 
 Universal Mercantile Schedule, 315-17 
 Use and occupancy insurance, 301-2 
 
 Valued policy, in fire insurance, 293; in 
 marine insurance, 321 
 
 Voyage policies, 322 
 
 Wages, and the risk of accident, 346-47 
 
 Warehouse bonds, 331 
 
 War risk insurance, 281-86 
 
 Wash sales, 131, 174 
 
 Weather forecasting, 2 
 
 Weather map reading, 218 
 
 Whole life policy, 243 
 
 Wire houses, 142 
 
 Workmen’s compensation, 349-54 
 
 PRINTED IN THE D.S.A. 
 
Materials for the Study of Business 
 
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