Examining the World through the Lense of Analytics
In Part 4, we learned how mutual fund and hedge fund investors can be driven towards a strategy with a risk profile similar to the Martingale strategy: one with a high probability of a positive return and with a low but significant possibility of a total loss. This is sometimes referred to as "picking up nickels in front of a steamroller". They are driven to pursue it because a) they have a high probability chance of having success in the short term, enriching themselves personally and b) they are not risking their own money.
Unfortunately, this effect is generalisable to the directors of any large corporation. Modern companies are typically comprised of 4 sets of “stakeholders”, or people who have an interest in the success of the firm: owners, directors, employees, and customers. In most organizations, only owners and directors have decision- making influence.
Owners are the investors who hold stock in the company, or the people whose money is ultimately at risk. In theory, they will be actively interested in the day-to-day management of the firm. In practice, however, they are often quite removed from the company. They may be investors in a diversified index fund, owning a microscopic piece of hundreds of firms. They may be pensionholders who have handed control to a professional money manager. In the vast majority of cases, they do not own enough stock to have a strong influence and do not devote the attention needed to monitor the performance of the company.
The directors of the firm, on the other hand, are the executives who are making management decisions from day-to-day. They are your CEOs, COOs, CFOs, and other CxOs who determine the strategy and tactics that a firm will pursue in the marketplace.
Similar to the fund manager we discussed in part 4, corporate directors are judged on a very short timeframe. Investors watch quarterly earnings statements like hawks, looking for any drop in efficiency or profits. Company directors can be quickly disposed of if there are unacceptable results.
Incentives are similar as well. The typical CxO has a significant upside for his compensation: if company results are good, he will earn millions. On the other hand, he often has significant upside even if company results are poor. If a CxO is fired, he is typically entitled to a firing bonus, or "golden parachute".
This is theoretically designed to attract top talent. An underperforming firm will seek a new CEO with a track record of success to right the ship. However, a CxO at a successful firm will be loathe to leave it for a floundering one. So, the only way an unsuccessful company can attract talent is by offering perks, and there are few perks better than a multi-million dollar payout regardless of success.
Of course, these agreements are not in the best interest of the company's owners. As we've seen, however, the true shareholders are often removed from such decisions. Instead, they are made by professional money managers who are, again, interested only in short term results.
So, even though it works against their interests, shareholders routinely bring in directors under terms that will enrich them for failure and pay off much more for success. Consider then the incentives of a director. They seek success, certainly, but they are not terribly concerned about failure.
A Martingale strategy is a great fit for a company director. Odds are, the gamble will pay off, the firm will beat the average, and the director will collect extravagant returns. Of course, the strategy brings with it a risk of disaster. However, the director will take his exit fee on such an outcome, leaving the losses to the shareholders.
A company director pursuing a more conservative strategy – one likely to grow at a slower rate, but much less likely to suffer a catastrophic loss – will look like a low performer in a typical quarter. Similar to the fund managers, executives are measured against each other. If the other companies in the industry put up stronger returns, the executive will come under pressure from his shareholders, a significant number of whom are fund managers who are themselves under pressure from their shareholders.
So the director has a strong incentive to pursue a risky strategy. All he has to lose is his reputation, and he can often pin failure upon externalities. While you often hear executives lament the effect of a recession on their results, you rarely hear one say "we had a good quarter due to a currency appreciation that turned out to be lucky for us".
Psychologists call this phenomenon the Fundamental Attribution Error. It states that people will often claim credit for a positive outcome while they will blame external factors for any failure. If another car skids off the road, you are likely to attribute it to poor driving. If your car skids, however, suddenly the road conditions come into focus. Maybe it was a lack of visibility, a pothole, or an errant deer sprinting in front of the vehicle.
It is a natural human instinct to attribute personal success to individual decisions and failure to external factors. Company directors are typically charismatic individuals who have risen to their positions over time. They will have a track record of success along with some failures. Critically, they will have a narrative to explain the failures: the product was ahead of its time, meddling government regulation got in the way, the economic collapse crushed it, etc. CxOs are precisely the people who can convincingly explain failures while harvesting credit for successes, even if they were simply the result of being at the right place at the right time.
Putting it all together, decisions with a payout similar to the Martingale Strategy will often be attractive to a company director. The benefits of a successful gamble outweigh the consequences of a negative outcome. Directors at other, competing companies are likely to be pursuing Martingale strategies: cutting corners on safety measures, relying on single-source suppliers for critical parts, making subprime loans, failing to secure websites, eliminating R&D investment, sparking a price war. All of these are likely to look positive in the short term by reducing expenses or increasing short term revenues, but increase the risk of a catastrophic loss.
If we, as a society, wish to avoid future bail-outs and company failures that threaten systemic collapse, we need to start by examining the incentive structures of the decision-makers at the top of our firms. They will make choices in the interest of shareholders only if they are compensated to do so.