Long-term investing & the equity premium

Juts a quickie, but there's a theory out there advanced by the likes of Richard Thaler that the equity premium (the amount equities outperform say bonds) may be due to myopic loss aversion - a mixture of investors seeking to avoid losses and frequently reviewing portfolios. If this is the case, does it follow that if investors like pension funds can be persuaded to develop genuinely long-term investment strategies then the equity premium would reduce?

Goodwin's pension

There are a few issues tied up in the hoohah over Fred Goodwin's pension. Much as I think the size of many company directors' pensions are completely unjustified, I'm wary of the demand to unpick contractual arrangements, because it may be thin end of the wedge. In short my worry is that if we set a precedent it may get applied further down the food chain when someone is said to have 'failed'.

However, in this case the principal issue as far as I can see is that (if the reports are accurate) he has got an unreduced pension at 50, when the scheme's normal retirement age is apparently 60. If that's the case then this was a serious failure by the company's remuneration committee, and I'm gobsmacked that they suggested it or let it go through. It's also almost certainly not contractual and as such not forced on them. So why on earth should he get any sort of sweetener? This is surely further evidence of just how badly boards have become infested with self-serving attitudes in respect of remuneration. I'm actually less surprised that Goodwin has said he won't voluntarily give up any of his pension.

More broadly, whilst £650k a year is a serious wedge, it probably wouldn't put Goodwin in the top 5 in terms of the highest annual pensions for directors of FTSE100 companies. There's another problem here - the continuing differential treatment of pensions for staff and directors in the same companies. In some companies directors get a better accrual rate in DB schemes, or a better contribution rate in DC schemes, or massive payments in lieu of a pension (50% plus of salary for a couple of directors at HSBC for example). There is absolutely nothing to stop remuneration committees changing these arrangements so that future accruals/contributions are made on the same basis as for other staff. And there should be a maximum limited on payments in lieu.

Unfortunately to date institutional investors have (surprise!) shown very little interest in this differential treatment. Let's hope that, now they are under pressure to up their game, institutions crack down on this unjustifiable double standard.

More on Animal Spirits

Chris Dillow has a boss review of it here. I'll try and post up my own (rather less informed) review of it shortly.

Chuggers and motivation

There's an interesting paper in this book which looks at the effects of incentives and punishments on behaviour. The paper is called 'Incentives, punishment, behavior' if you're interested.

In one experiment Israeli schoolkids were given the job of trying to elicit charity donations from members of the public by going door-to-door (apparently 'donation days' are a regular thing in Israel). They were split into three groups, and within in each group divided up into pairs. The first group were given a motivational talk beforehand, and told that results of of the collection would be published so that the amount collected by each pair would be public knowledge. The second group were given the same information, but also told that they would be given a reward of 1% of value of the donations elicited (to be paid separately rather than taken out of the donations). The third group were also given the same information but also told they would receive a reward of 10% of the value of the donations.

So the results - the first group (no incentive) collected the most, the second (small incentive) collected substantially less, the third group (significant incentive) collected more but still some way behind the first group. It does seem to suggest that small incentives may crowd out intrinsic motivation.

One caveat - if we were to try to apply this to the Charity Muggers - is that I have read another bit of research (can't find it immediately) that suggests that intrinsic motivation does drop off if it's a mundane task. Which suggests that actually offering a decent incentive for longer-term campaigns is sensible in terms of keeping chuggers motivated. This doesn't take into account the impact that they have on the subjects of requests for donations stopped on busy streets and whether this affects their desire to make donations... :-)

Framing nationalisation

Via S&M I came across this. Interesting to see how framing has become part of policy (it always has been, of course, but Lakoff seems to have given it more emphasis).

Animal spirits

Here's a very simple argument from Akerlof and Shiller for why behavioural factors need to be taken into account in macroeconomics:

In their attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structure and scientific disciple by focusing on how the economy would behave if people had only economic motives and iof they were also fully rational. Picture a square divided into four boxes, denoting motives that are economic or noneconomic and responses that are rational or irrational. The current model fill only the upper left-hand box; it answers the question: How does the economy behave if people have only economic motives, and if they respond to them rationally? But that leads immediately to three more questions, corresponding to the three blank boxes: How does the economy behave with noneconomic motives and rational responses? With economic motives and irrational responses? With noneconomic motives and irrational responses?

We believe that that the answers to the most important questions regarding how the macroeconomy behaves and what we ought to do when it misbehaves lie largely (though not exclusively) within those three blank boxes.

I'll post some bits and pieces from the book, which is pretty good if not quite as great as I was expecting, in the next few days.

And here's the passage from Keynes' General Theory that they take the title of their book from, which is rather good too:

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on the exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but mathematical expectation, enterprise will fade and die; - though fears of loss may have a basis no more reasonable than hopes of profit had before.

Apologies for typos as usual...

A lack of clear thinking on bonuses

Via Owen I came across this article by Jamie Whyte, author of Bad Thoughts: a Guide to Clear Thinking. It's the second time he has written about financial incentives in the banking sector, and the second time I think he has failed to demonstrate clear thinking himself. His point this time can be summed up in these two paras:

Bank managers do not have short-term incentives. Most already receive a large proportion of their variable pay in bank shares or in cash bonuses that depend on the share price. Share prices provide a long-term view of a company’s performance, being determined by its expected profits from now until eternity.

Bank managers took excessive risks not because they had short-term incentives but because, in the years before 2007, the credit and stock markets failed to “price in” those risks. If not for this failure, banks’ cost of capital would have begun to rise, and their share prices to fall, much earlier. Bank managers seeking to maximise their bonuses would have reduced the risk-taking that caused the current crisis.

Given that he's a self-appointed clear thinker I'm surprised he failed to spot a few qualifications we need to make. First up, what do we mean by 'short-term'? If it's not defined then we are in trouble. For a pension fund investing in bank shares, short-term might be measured in terms of a few years. Given that bonuses and even long-term incentive plans often have a performance measurement period that is less than many fund management mandates awarded by pension funds, I think it is fair to describe the incentives provided as short-term, for those types of investors.

Second, we need to consider the scale of the incentives available. Not all bankers want to get to the top of the tree or spend their whole career in the industry. The scale of rewards on offer do sometimes enable individuals to think in terms of their retirement. And if they can make enough quickly enough to think about bailing out, again I think it's fair to talk about the incentives being short-term.

Third, the fact that some rewards are liniked to share prices doesn't necessarily prove anything. One could make the argument that actually rather than making the incentives long-term, it actually provides a further short-term incentive - to keep the share price up. This may involve... err... taking excessive risk, if the market isn't keeping too close an eye on how the bank is making money.

Finally he says the real story is that markets failed to price in risk. Probably this was a contributory factor, but how does that disprove that short-term incentives spurred on some of the reckless decision-making? Why does there have to be a single cause? Weak market pressure AND short-term incentives could have been drivers. And we could add that perhaps 'the markets' didn't price in risk because some of the participants also have short-term incentives, and therefore also wanted/needed to keep the party going as long as possible.

Far from clear-thinking, this article seems to be designed to let remuneration policy off the hook. I might have some sympathy with that, because I'm really undecided on what impact incentives have on behaviour, but that's an entirely different proposition. To me the argument in this article just doesn't hang together.