Why finance heads shouldn't be judged by the market

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck.

By , Guest blogger

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    The Nasdaq Composite stock market index is seen inside their studios at Times Square in New York in this file photo. Marron argues that linking financial managers' pay so closely with market performance is unwise because of the amount of luck involved in market fluctuations.
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Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:

American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.

Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important ”misallocation of financial, real, and human capital.”

Recommended: Stock market quiz: Can you predict the market based on the trader's face?

Well worth a read.

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