Sometimes, what seems like the obvious best choice can end up having perverse effects, whether the selection happens on the farm or on Wall Street.
The problem comes when bad criteria are used for selection. Let’s start with a farm example. Each year, sheep producers must select ewe lambs to replace sheep that have died or been culled from the breeding flock. The key is to select the best replacements. One method is to pick out the biggest ewe lambs.
The problem is that at the age one must choose, the biggest lambs often are those that were single births and daughters of ewes that average fewer twins in the long run. At the same age, twins may be thriving, but their average size will be smaller than the singles. If you choose replacements on the basis of size, you select for lower twinning rates.
And twinning is key to increasing sheep profitability, at least on farm flocks. To select for twinning, you have to identify ewes that bear twins frequently and save their offspring. Or, at least, you should keep replacements that were twins themselves. But this is harder than just picking out the biggest ewe lambs.
The same was true before hybrid corn, when farmers saved their own seed. Save the biggest, most beautiful ears and you select against corn that had two ears per stalk, which ultimately is more important to yield.
What does this have to do with Wall Street? The answer is that big financial firms’ system of paying large bonuses to fund managers or traders that made the highest short-term profits selected against prudent risk management.
Suppose there are two fund managers, Joe and Frank. Joe puts together a portfolio that earns 9 percent returns. Frank’s makes 20 percent, and he gets a fat bonus. The next year, Joe’s earns 8 percent and Frank’s, 18 percent. Another bonus for Frank, and Joe is warned about his poor performance. Succeeding years have similar results.
By the fifth year, Joe has been fired, and Frank is made an officer in the company. Then in the sixth year, Frank’s portfolio blows up, not only losing all its cumulative earnings but 90 percent of the investors’ original principal besides. Frank already is leaving for another company eager to boost its profits by hiring top producers from wherever it can poach them.
It is now painfully obvious that over the past 20 years, Wall Street firms drastically misjudged the risks they took on. They did not do this despite the brilliant, highly paid traders with MBAs or even PhDs in finance and mathematics. They did it because of their supposedly brilliant, highly paid traders.
Their whole incentive system, where bonuses comprised a large portion of total pay and most bonuses depended on one-year profits, functioned to promote traders who systematically underestimated risk.
Like identifying lambs with genetic traits for multiple births, constructing incentives for fund managers to successfully balance risk against long-term reward isn’t easy. Over the decades when investment banks were partnerships, senior partners groomed younger traders with just such skills. When most became publicly traded corporations, that discipline ebbed away.
If Wall Street sticks with its current system of bonuses that largely ignore long-term considerations, we will have more financial crises down the road.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.