Beware of Incentives that Can Haunt You

What was at the rootof the market debacleand the horriblecorporate scandalsof the late 1990s?Of course, there was more than onecause. But if you press experts to namejust one, most will probably say that itwas not requiring corporations toexpense the cost of executive stockoptions. This provided corporate boardsthe excuse to award options to theirexecutives by the truckloads, which inturn motivated the executives at manycorporations to pump up their stockprices in the short term in any way theycould, including resorting to fraud.

Options provide the holder the rightto buy a stock at a particular price,called the exercise price, within a certainperiod, called the option life. Whatmakes them so attractive is that theexercise price is generally set at the marketvalue when the options are issued,and the life is often 10 years. So if acompany's stock is selling at $30 todayand an executive is granted 1 millionoptions, then for every dollar the stockprice goes up during the option's life,the executive will earn $1 million.

Now suppose the stock price goes upat the modest rate of 6% per year overthe 10 years. By most measures this willbe considered poor performance. Yet,the stock price would be about $54 atthe end of 10 years, and the executivewould earn $24 million. Furthermore,an executive can generally cash in theiroption at anytime after a short waitingperiod of 2 to 3 years. Therefore, theexecutive will have every incentive topump up the stock price in any way theycan and as early as they can, and thentake the money and run.

The Perverse Incentive

If executive options are such a onewaystreet, how did we all come toaccept them as a great incentive compensationtool? Well, the argument was, andstill is, that options align the interest ofthe executives with those of the shareholders,because executives holding a lotof options would try their best toincrease the stock price, which will benefitthe shareholders as well.

The problem is that options hardlyalign their interests, because if the stockprice goes down, the executive sufferslittle, whereas if it goes up, the executivebenefits handsomely. Any shareholderwould love to get that deal, especiallywhen it comes free.

But the worst part of the story—which played the key role in the stockmarket bubble and corporate scandals—is that corporations were allowedto pretend that options are cost-free (ie,their value does not come out of thepockets of the shareholders). This wasthe key argument against expensingoptions. So the arcane accounting issueof whether stock options should beexpensed plus the perverse incentivesnot-expensing provided, caused muchpain and suffering to so many people.

Closer to Home

A major business magazine recentlyreported in glowing terms the test aninvestor with a $6-million portfolio setup to find their ideal investment manager.The portfolio was divided amongfour finalists and they were told thatevery 6 months the manager with theworst performance in the last periodwould be fired and the money would beredistributed among the remaining managers.This way the "ideal" managerwould be found in just 18 months.

Think about it. All this would do isencourage each manager to take wildrisks, because that is the best strategy tomaximize their chance of winning thisgame in the short term. The moneymanager who survives after the 18-month period will almost certainly do soby chance, and the portfolio will probablycollapse shortly after that.

Although this plan may sound ridiculous,we play variations of this game allthe time in investing—think of the feestructure of hedge funds, as well as otheraspects of our life. How humans willrespond to any incentive is very difficultto predict. So it is important to thinklong and hard before setting up anyincentive system because all too oftenthey produce perverse results.

Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at chandansen@aol.com.