Why your boss is overpaid

My friend has a huge problem with her boss.

She claims that she works like a dog while he sits all day and purrs like a fat contented cat behind his rosewood altar, drinks herbal tea and swivels aimlessly in his leather chair. His daily ritual is to rearrange the post-its on his computer and send mails to the lesser-paid mortals asking for updates or demanding that they justify their existence. And when the cat is in a particularly foul mood, whoever comes into his line of fire gets skewered. 

She has figured out his apathy: His mind is either on permanent vacation, or worse still, has already retired but the company just refuses to let his body follow suit, for a reason she cannot fathom.

Her biggest grouse is that while she and her colleagues work their backs off to add to the bottom line, he is at the receiving end of a bloated salary and inflated bonus.

Before I continue, let me set the record straight. This post is NOT about my bosses, who, incidentally, all read this blog hence my urgency to clear the air. All my bosses (that's right, I have more than one) sit at work stations identical to the rest, no plush leather seats or polished wooden desks - be it mahogany or teak or rosewood. None of them use post-its or, to my knowledge, drink herbal tea.

Back to my friend. While I do (silently) admit to the possibility of exaggeration on her part, the point is hard to miss. Are our bosses really overpaid?

Years ago, economist Tim Harford tackled this issue in his book The Logic of Life and presented a downsized version in Forbes titled Why Your Boss is Overpaid. According to him, there is a logic to bosses making obscene sums of money while the downtrodden cubicle slaves toil. The ugly truth is that your boss is probably overpaid because of you. He isn't being paid for the work he does but, rather, to inspire you. So you work your socks off in your underpaid job in the hope that one day you will become an overpaid fat cat yourself.

Economists (bless that breed of individuals!) have a name for this: Tournament Theory.

According to Tournament Theory, workers are frequently ranked relative to each other and promoted not for being good at their jobs but being better than their rivals. For instance, Andy Murray was paid $1.9 million for winning the US Open. He was not paid to work hard. He was not paid to play objectively brilliant tennis. He was paid to beat his opponent - Novak Djokovic. And not in his backyard or anywhere else, specifically at Flushing Meadows. Harford goes into great detail about “tournament theory” and “promotion tournaments” in the office space, which I don't have the patience to delve into.  

This very month when the Occupy Wall Street movement completed a year, The Economist tackled the issue of overpaid bosses. With Steven Kaplan’s help, The Economist challenges three propositions:

• CEO pay just keeps on going up
• CEO pay is not tied to performance
• The Boards are not doing their job of holding fat cats’ paws to the fire

Kaplan questions the notion that CEO pay always goes up and argues that CEOs are paid for improving the performance of their company’s stock and provides data to back his claim. But according to a much earlier article in The New Yorker, overpaid CEOs are not just expensive, they are even destructive. And, you guessed right, they have data to back their claim too. 

The New Yorker ends with the conclusion that in the long run companies that do not balance pay with performance will suffer on the stock market. The Economist concludes by saying that CEO pay packets are determined by demand and supply. 

So basically, scarce good talent is heavily in demand but the supply is drastically limited. Hence the steep premium. Companies pay what it takes to woo the best bosses and show them the door if they falter. Whether the boss delivers due to his business acumen or intelligence or because he possesses the ability to attract great talent and drive them like slaves is another issue altogether and meaningless to some extent, at least to the Board. The results are what they look at.  

Back to my friend. She has rubbished all of the above. But the thought of sitting behind that rosewood desk in soft leather has got her pulse racing. 

How to win by not losing

Amidst all the huffing and puffing over the nude photos of the young royals, the Brits have a new hero: Andy Murray.

They mourned when Roger Federer’s brilliance drove him to tears at Wimbledon. As Simon Kuper of Financial Times commented of Britons obsessing over their decline: “Once Wimbledon was where posh British dilettantes effortlessly dismissed upstart Johnny Foreigners. Postwar, it became a home of British defeat.” 

Then came the emphatic victory which got them the Olympic Gold, with none other than Federer at the receiving end. But the clincher was a Brit winning a Grand Slam after 76 years. Murray finally regained some of Britain’s lost glory (which the queen should certainly be grateful for).

Of course, Murray almost jeopardized his moment of victorious glee at the US Open when he could be seen saying “I don’t have it, I don’t have it”. 
The “it” being a watch.

No, it was not a million dollar watch. 

Neither was there any sentimental mush associated with it. 

It was the 7-figure sponsorship deal with Rado that caused him to get into a tizzy. He needed to prominently display it if he did not want to tick off his sponsor and keep the bucks flowing. Fortunately, his girlfriend came to the rescue. Check out his Rado D-Star Automatic Chronograph which can be seen in these photos from The Telegraph. 

After basking in his well-deserved applause, even his normally silent coach could not contain his delight. Tennis legend Ivan Lendl, shared an  interesting insight in The Guardian. 

“A loss is a loss; and a loss is not a loss. You learn from certain losses and become depressed from other ones. When you have losses, when you put it all out there and go hard, you can be proud of yourself. And you can learn from it, and that is really important.”

Lendl's reference to losses reminded me of a book written ages ago by Dr Simon Ramo - Extraordinary Tennis for the Ordinary Tennis Player. According to him, there are two ways to play the game of tennis.

The winner's game played by pros/experts: Those who qualify are actually a remarkably small club though there are plenty of delusionary folk who are of the opinion that they fit right in here.

The loser's game played by mediocre/ordinary players: This is more the norm than the exception and most tennis-playing mortals would feel right at home here.

If you are an ordinary player, then Ramo (who graciously admits he is one) suggests that it is ridiculous to try to play with the same strategy of a professional. Come to terms with the fact that the brilliant shots, consistent-powerful-punishing backhands, long and exciting rallies, and mind-blowing crosscourt service returns are miraculous, extremely few and very far between. 

Ordinary tennis is almost entirely different. The ordinary player seldom beats his opponent, he is too busy beating himself. The ball is fairly often hit into the net or out of bounds and double faults at service are not uncommon. The victor in this game of tennis eventually gets a higher score because his opponent is losing more points. 

A summation: Professionals win points. Amateurs lose points. 

In expert tennis, the ultimate outcome is determined by the actions of the winner. The winner is able to force an error by his opponent or drive the ball just out of reach. These players seldom make mistakes. 

The mediocre player is not good enough to overcome the many inherent adversities of the game. His efforts to win more points will only increase his error rate. The strategy for winning in a loser's game is to lose less by not making too many mistakes. Avoid trying too hard. By keeping the ball in play, give the opponent as many opportunities as possible to make mistakes and blunder his way to defeat. 

In brief, by losing less become the victor.

Charles Ellis takes this very principle one step further and applies it to investing in his book 
Winning The Loser's Game and in an article published in The Financial Analysts Journal titled The Loser's Game. 

In order to outperform a diversified market-weighted portfolio, an asset manager must capitalize on the mistakes of other professionals. Ellis states that one may have a lucky outcome once in a while, but the only way an investor can beat the market is to exploit other investor’s mistakes. He suggests simplifying the professional investment management process by doing a few things unusually well, making fewer and better investment decisions and bringing down turnover. 
Concentrating on your defences is another. In a Winner's Game, 90% of all research effort is geared towards buy decisions. In a Loser's Game, the focus should be on sell decisions. Because its too hard to outperform the other fellow in buying. Also, almost all of the really big trouble that you're going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you might come out the winner in the Loser's Game.

For regular investors like you and me who are determined to try and win the Loser's Game, he offers some help:  

1) Save & Invest. Don't speculate. 

2) Invest with a long-term goal in mind and stick to it. Don't churn too much. Review your investments annually. Don't procrastinate.  

3) Most tax shelters make poor investments so don't invest in something primarily to save tax. There are exceptions, so plan carefully. 

4) Don't invest in new or interesting investments. They are too often designed to be sold to investors, not to be owned by investors. 

5) Don't invest in bonds just because you have heard that bonds are conservative or safe. Their prices also fluctuate and are a poor defense against inflation. 

6) Don't trust your emotions. When you feel euphoric, you are probably in for a bruising. When you feel down, remember that it is darkest just before dawn and take no action. Activity in investing is almost always in surplus. 

So in the investing game, don't worry too much about generating alpha. Just focus on not shooting yourself in the foot. Chances are that you will emerge one lucky loser. 

Game theory, dating & investments

My friend ran into an interesting dilemma on her last date.

Let’s call my friend X and her date Y.

X and Y met up for coffee. X felt hungry but Y was not. After a while, she was famished so she ordered something to munch on. When the bill came, Y gave no indication of paying. So X reached into her wallet to produce her credit card. The cafeteria told her that they did not accept cards. She barely had sufficient cash. As a result, Y had to hand out the dough.

Here is her take on the incident.

The first time they went out, Y paid.

The second time, when X offered to pay, Y obligingly passed the bill to her.

This time he was not too eager to settle it, probably on the presumption that she was the one who was famished and placed the order so it was her responsibility.

Besides feeling a bit embarrassed at not having money, she was perplexed: “Has he now assumed that I will be the bankrolling most of our dates”?

I am not taking sides here but I don’t blame him. A significant part of his young adult life has been lived in the shadow of a recession. Secondly, he does not know if the girl is stringing him along so is obviously playing it safe by not being fiscally macho. Unless you are a hippie of some sort, money is a big deal and nothing screams “loser” louder than the realization (in the “post-getting dumped” scenario) that all the reckless spending in the early days of the relationship amounted to nothing but a busted ego and a lighter wallet.  

Neither do I belittle my friend’s concern since the same logic holds true for her too.

If you have ever dated, you would have certainly encountered such situations which have all the potential to ruin a relationship. Don’t scoff! Researchers like David Buss (author of The Evolution of Desire), believe that the human brain and cognition evolved as a consequence of problems posed by complex social relationships. Which probably means that the human brain has reached its current size mostly to figure out such social dynamics (did you know that we have bigger brains than most animals?). Maybe we could learn a lesson or two from elephants and whales since their brains are bigger than ours.

So how should the next date play out? Should he pay the bill? Should she reach out for the bill? Should they alternate paying for it? Should they split it everytime? Should she bring up her concern?

Let’s see what game theory has to say. Game theory can be applied to anything: international diplomacy, war, love, dating, evolution or business strategy. A report in the New York Times claims that it can even be applied to whether or not you should wait for the bus.

According to this theory, a game is any situation in which one player makes a decision that affects the other (let’s restrict it to two players). So, even though X and Y are just dating and not playing games, by the definition of this theory they unconsciously are. The game begins with one player making a choice (a move) resulting in a situation the other reacts to (resulting in another move). So their social interactions over time are just a combination and culmination of many games (goodness, economists are really so unromantic!).

The essence of the theory is that the action of each of the rational adversaries would depend on what the other side was likely to do. But real life scenarios are much more complicated than a mathematical model. It also involves understanding your opponent in the game. If you think he is rational but he is not, then your moves could backfire.

In game theory, you cannot master the game because it is not technicalities at play here.  

You cannot ask: What is the best way to date?

Instead, go with: Is there a better way to date in this situation?

In my friend’s case, the best way to tackle the situation would not be to play the game with the idea of beating the opponent but to just do well for herself. Since they both enjoy each other’s company, the best outcome would be one that comes out of a cooperative stance.

In that case, she can immediately suggest at the next date that they go dutch.

Or, she could just wait for him to pick up the tab.

Or, she could go along with the flow. If he does not pick up the bill and she finds herself footing the bill most of the time, she can either suggest at that time they go dutch or tell him that she finds it unfair. His move will then determine the direction the relationship will take.

A cooperative strategy (as against a non-cooperative one in game theory) would help them both reach a reasonable solution.

Paula Szuchman, author of a book on relationships and game theory, says that if game theory teaches us anything, it’s that relationships are not about having it all. It is about achieving the best possible result under the circumstances. Well said Paula!

If such relationships are based on the cooperative strategy, some will benefit from the non-cooperative one. Professor Kenneth Binmore, who researches game theory, was widely known for his role in designing the UK 3G Spectrum Auction, which was rumored to be based on game theory. Auctions are a sort of game with rules of the game, allocation rules and bidder strategies. The aim is to sell an object to bidders whose valuations are unknown to sellers and other bidders. The auction outcome is then determined via a non-cooperative game played by bidders under rules determined by their beliefs about the good’s valuation and/or signals from other bidders.

In the case of investments, game theory principles can be enlightening. When you decide to buy a stock, many players come into the picture immediately. If banks hike up their interest rates, the company that you invested in may find itself steeped in too much debt. If a competitor enters the market and the company loses market share, profits will be hit. This will result in analysts downgrading the stock resulting in the price falling.

You cannot play the market and expect a “guaranteed” win because there are too many players in this game. And not all players have the same level of information or the ability to interpret it accurately.

Of course, a stock trader could make an assumption that given a particular amount of volatility or level of the Sensex (or any other index), one strategy would be preferred over the other. But then you have situations like the Kobe earthquake of 1995, the Asian financial crisis of 1997, the Russian bond default of 1998, the 9/11 terrorist attack in New York in 2001, the credit crisis of 2008, the ongoing Euro drama and the entire game can be overturned by such external factors. So it's not just the uncertainty due to actions of the other players, there is also uncertainty due to randomness.

But one way or the other, game theory touches all of our lives. :)

Disclaimer: I am NOT an expert on game theory and my knowledge on the subject is woefully stunted. If I have erred, I am dreadfully sorry... :(

Food for thought, fodder for investment

I am no rabid chocoholic. 
But I am inexplicitly drawn to the price of cocoa (which, in case you were unaware, is an ingredient that goes into the making of chocolate). 

I guess Armajaro's antics are what got me hooked. 

This firm has a reputation for its audacious gamble on the humble cocoa bean. The last “heist” (if it can be called that) was in July 2010 when the firm reportedly purchased around 240,100 tonnes of cocoa beans, worth more than $1 billion, sending the spot price of cocoa skyrocketing to a 32-year high. Co-founder Anthony Ward probably bought it on the presumption that the next cocoa bean harvest would be a poor one, driving up the price of the commodity and catapulting him to chocolate heaven. 

In most transactions, traders exchange contracts to buy and sell the commodity at various prices but do not take physical possession. This time, actual delivery took place and the mountain of beans was most likely stored in warehouses across England and The Netherlands. 

To drive home the magnitude of the trade, the media had intriguing parallels to ignite someone’s imagination. That investment could have materialized into more than 5 billion small chocolate bars. Or, try this: It was sufficient to fill 5 Titanics (credit for that goes to the then-chairman of the Financial Services Club, Chris Skinner, in an interaction with BBC).

Armajaro did not confirm nor deny the reports, but the street knew it. In 2002, Ward pulled the same stunt when he purchased 204,000 tonnes of cocoa at a time when supply was limited because of poor harvests and political instability in West Africa. The Daily Mail reported that he made more than £40 million in just two months after the price of the commodity rose steeply from £1,400 to £1,600/tonne. Traders at that time nicknamed him Chocfinger after the Bond villain Goldfinger.  

Such speculation (and stockpiling) in the notoriously fickle and famously unpredictable commodity markets stifles supply and forces the price even higher.
So why am I reminiscing about him now? 

Because prices of commodities are going through the roof. Bloomberg has reported that money managers recently raised bets on higher prices for cocoa which has hit a 9-month high at the start of the month on the back of poor weather conditions. Incidentally, the last I heard of Chocfinger was when I read that the price of cocoa dropped by 26% resulting in a huge loss on his position. Not the first time he would have lost. Ward had dabbled in another cocoa bet in 1996 which backfired when the firm had to unwind the trade after a slump in cocoa bean prices.

Speculation is a dangerous game. Mark Twain would know. He was an avid speculator who went bankrupt before the age of 60. His words of wisdom stemmed from painful experience: "There are two times in a man's life when he should not speculate: when he can't afford it and when he can". Touché!

But I doubt Twain speculated in agricultural commodities which has taken on a moral dimension. According to the United Nations Food & Agriculture Organisation (FAO), excessive food price volatility and the speed at which price swings have been occurring over the past few years has resulted in a "human impact" driving home the point that food commodities cannot be used as pure financial instruments. In the past few years, there have actually been food riots across the globe caused by rising prices. 

A report by the Institute for Agriculture & Trade Policy states that food and energy prices have become linked and unstable over the last decade largely due to speculative investments. 
The Independent has stated that investments in food commodities by banks and hedge funds has risen from $65 billion to $126 billion over the past five years. This has pushed prices to 30-year highs causing sharp price fluctuations that have little to do with actual supply of food. The likes of Goldman Sachs, Morgan Stanley and Barclays Capital dominate the food commodities market. 
Commerzbank has restricted investments in agricultural products after accusations that speculation has pushed up food prices and fuelled unrest in some poor countries. 

While there are ethical implications to commodity speculation, I am not saying I subscribe to the unvarnished view that speculation is the sole cause of price volatility. I believe it does exacerbate swings in prices already vulnerable to climate shocks, lack of investment in agriculture, rise in global food demand, decrease in per capita arable land and the loss of agricultural land to grow biofuels. And it is because of such factors, I doggedly believe that an investment in agricultural stocks would be a shrewd diversification in an investor's portfolio over the long term. Don't speculate. But profit from volatility and invest in an opportunity. 

Perceptions, Presidents & Investments

When I think of perceptions, my mind goes back to former French President Nicolas Sarkozy.
At the start of his term, he was France’s most popular leader since World War II hero General Charles de Gaulle. Five years down the road, he was the most unpopular incumbent French president since the war. 

He appeared refreshing at the start, but intolerable towards the end.
Once people began to perceive him differently, it overrode everything else.
When they finally voted him out of office, it was almost a personal referendum on him.

Daily Mail nastily referred to him as a man who wants to be Steve McQueen. 

Guardian  commented that he was “shamelessly admiring of money and those who have it…”
The flamboyant Sarkozy had expensive tastes in accessories (who can forget the Rolex and Patek Philippe wristwatches and Ray-Ban sunglasses?) and made a glaring faux pas when he celebrated his election victory at Fouquet’s, a fancy restaurant on Paris’s Avenue des Champs Elysees, with a dozen of his rich buddies, and then sailed away on a yacht belonging to one of them.

He later said that he regretted both those moves and blamed it on his “disorientation” because of his troubled second marriage. A laughable explanation which was scoffed at by the public because he ended up getting married rapidly– just three months after divorcing existing wife and two months after meeting the new one – to an ex-supermodel whose past conquests reportedly include Eric Clapton and Mick Jagger.

Guardian also said that he was “pushy, vulgar, uncultured, impetuous, in-your-face-rude….” 

Poor Sarkozy, he asked for it. He was caught on video an at agricultural fair saying "Sod off..." to a man who refused to shake his hand; audaciously sent text messages to his wife during an audience with the Pope; imprudently paraded his first public date with Carla Bruni at Disneyland weeks after his high-profile divorce and brazenly turned up at the presidential palace in jogging shorts and shoes on his first day in office.

As perceptions changed, it turned out to be politically suicidal. Sarkozy would have learnt that much of what happens to us in life hinges on how we are perceived by others. 

But perceptions don't just affect how we are viewed and treated. Perceptions also drive our decisions - most of them.
At this point, my thoughts go to the US presidential campaign.
Paul Ryan’s selection as Mitt Romney’s running mate has got tongues wagging and keyboards punching away opinions on what this means for the campaign.

While Examiner has said that Romney is playing to perceptions, Daily Caller refers to Ryan as doing a “wonderful job wrapping himself in the mantle of a fiscal conservative, but there simply isn’t any evidence to back up the perception.”

Here’s their take on bipartisan.

Democrats want Ryan perceived: as a fiscal conservative so they can condemn him as a draconian slasher who wants to gut essential government programs and drag them back into the 19^th century.

Republicans want Ryan perceived: as a crusader against the bloated federal budget and the perfect “bridge” pick to help Romney attract those fickle budget hawks and libertarians to his cause.

What Ryan really wants: To drastically increase the size and scope of the federal government. Since the truth is not useful to either major party, it’s discarded.

Ryan is perceived as bold and decisive, and intelligent and articulate, just what is needed to give a new dynamic to Romney’s campaign that was running out of steam. 

Examiner is probably spot on when it states that in politics perception is reality. 

What about investments?
Don't perceptions influence our decisions? Does perception become our reality?

Seeking Alpha tackled this well. 

Company A: a money-losing socially networking company in an exciting growth market
Company B: a profitable and mature enterprise in the unattractive traditional media space 

Company A enjoys an excessively elevated valuation in relation to Company B, despite the fact that Company B is profitable and has a long history of stable operations and reasonably stable outlook.

Company A’s valuation is driven by a perception of strong growth going forward and will be favoured by growth investors; Company B is perceived to be in a mature industry and thus not worthy of a valuation close to Company A but will be eyed by value investors. 

The article goes on to explain how perception will eventually influence a few of the basic fundamentals of the company. But I need not go into that here.

My point is that perceptions matter when deciding where to put your money. Have you not gravitated towards a larger fund simply because you perceived that if many put their money there it is probably good? After all everyone cannot be a sucker. Take heed, the Goliaths are not always superior to the Davids.  
Bigger does not necessarily mean better. 

A parallel can be drawn in sport. Livestrong argues that fist size or hand size does not make much of a difference in martial arts or boxing. It is the force behind the punch and the technique that is used in delivery. Make sure your fund manager has more hits than misses and is not simply riding a heavyweight.  
Size does not always matter (in investing). :)