Onto the next rule:

“We pay disclosed compensation.  We pay undisclosed compensation.  We don’t pay both disclosed compensation and undisclosed compensation.”

I didn’t originate this rule, and I am not sure who did.  I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s.  There is a broader rule behind it that I will get to in a moment, but first I want to explain this.

There are many efforts in business, particularly in sales, where some want to hide what they are truly making, so that they can make an above average income off of the unsuspecting.  At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate.  We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan.  His recommendation would play a large role in whether we made the sale or not.

Naturally, he wanted a commission.  That’s where the rule came in, and from what I remember at the time, many companies similar to us did not play by the rule.  When the sale was made, the client would see a breakdown of what he was going to be charged.  If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making.  If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.

Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services.  We would bundle or unbundle, depending on what the gatekeeper and client wanted.  If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.

What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.

We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also.  Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.

Here’s the broader rule:

“Don’t be a Pig.”

Some of us had a saying in the Pension Division, “We’re the good guys.  We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.”  Given that what we did had almost no capital requirements, that was pretty good.

Most scandals over pricing involve some type of hiding.  Consider the pricing of pharmaceuticals.  Given the opaqueness is difficult to tell who is making what.  Here is another article on the same topic from the past week.

In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent.  In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden.  Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.

I’ll give you an example from my own industry.  My fees may not be the lowest, but they are totally transparent.  The only money I make comes from a simple assets under management fee.  I don’t take soft dollars.  I make money off of asset management that is aligned with what I myself own.  (50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)

Why should I muck that up to make a pittance more?  It’s a nice model; one that is easy to defend to the regulators, and explain to clients.

We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done.  That said, how would the brokers have lived under total transparency?  How would life insurance salesmen live?  They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.

Even as a bond trader, I learned not to overpress my edge.  I did not want to do “one amazing trade,” leaving the other side wounded.  I wanted a stream of “pretty good” trades.  An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!

You only get one reputation.  As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:

I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.

This is a smell test much like the Golden Rule.  As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)

That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away.  But I digress.

Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet.  In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.

Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing.  For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle.  Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.


Ben Graham, who else?

Well, I didn’t think I would do any more “Rules” posts, but here one is:

In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.

This is a more general variant of Ben Graham’s dictum:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better.  Ben Graham lived in a time where capital was mostly physical, and he invested that way.  He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant.  In one sense, Graham kept the peas and carrots of life on separate sides of the plate.  There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).

Voting and weighing are discrete actions.  Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate.  Most of us act like we are party hacks. 😉 )

What drives asset prices?  New information?  Often, but new information is only part of it. It stems from changes in expectations.  Expectations change when:

  • Earnings get announced (or pre-announced)
  • Economic data gets released.
  • Important people like the President, Cabinet members, Fed governors, etc., give speeches.
  • Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
  • A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc.  (I’ve even budged the market occasionally on some illiquid stocks…)
  • Asset prices move and some people mimic to intensify the move because they feel they are missing out.
  • Holdings reports get released.
  • New scientific discoveries are announced
  • Mergers or acquisitions or new issues are announced.
  • The solvency of a firm is questioned, or a firm of questionable solvency has an event.
  • And more… nowadays even a “tweet” can move the market

In the short run, it doesn’t matter whether the news is true.  What matters is that people believe it enough to act on it.  Their expectation change.  Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels.  (Street 1, Retail 0)

But if the news seems to have permanent validity, the price will adjust to a higher or lower level.  It will then take new data to move the price of the asset, and the dance of information and prices goes on and on.  Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons.  They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.

Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.”  Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before.  (How many times has radio died?)

“Stocks rallied because the Fed cut interest rates.”

“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”

“Stocks rallied just because this market wants to go up.”

“Stocks rallied and I can’t tell you why even though you are interviewing me live.”

Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.

We like our answers big and definite.  Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points.  The tremendous growth that everyone expected to last forever is a farce.  The world did not end; every firm did not go bankrupt.

So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.”  Even more, who can do that precisely at the turning points?

No one.

There are few if any people who can both look at the short-term information and the long-term information and use them both well.  Value investors are almost always early.  If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right.  Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness.  Vice-versa, for bullish Pollyannas.

Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time.  Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit.  The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.

As with most things I write about, the basic ideas are easy, but they work out in hard ways.  We may not live long enough to see what was true or false in our market judgments.  There comes a time for everyone to hang up their spurs if they don’t die in the saddle.  Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave.  Keynes, the great value investor that he was, said, “In the long run we are all dead.”  The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.

As it was, Ben Graham left the game, but never left the theory of value investing.  Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day.  That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.

After all, in the end, the truth measures us.

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense.  Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives.  We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him.  But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter?  You bet it does.  When will it matter next?  Uh, we can’t answer that.  When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash.  Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term.  The short-term gets the news day-by-day.  The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.”  It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities?  I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules.  Far from it, why did I write this series?!  What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market.  There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful.  They reduce risk and enhance return.  I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works.  This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything.  You should expect disappointment, and even embarrassment with some degree of frequency.  That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times.  But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that.  In general, he made errors, but he rarely compounded them.  His successes he compounded, and then some.

The rule I stated above is meant to be a paradox.  In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk.  Do I always succeed?  No.  Do I make significant mistakes?  Yes.  Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me.  Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right?  We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so.  At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value.  Or at least, value for a time, because the modus operandi of the Fed became inflating a financial/housing bubble.  That would not work in the long run, but it would work for a time.  After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run.  I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets.  I have learned from such men, and that is what I aim for in my investing.  That means I lag when things are crazy, and that is fine with me.  I don’t play for the last nickel — that nickel may cost many bucks.  Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run.  In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series.  I think there is a lot of wisdom here, but markets play havoc  with wisdom in the short run, even if it wins in the long run.  If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003.  Thus, this is the end of the series.

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets.  When things get tough, scaredy-cats buy put options.  That pushes up option implied volatilities.  The same doesn’t happen when prices are rising, because that happens slower.  Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally.  Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up.  As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged.  Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise.  People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility).  Use this knowledge to guide your portfolio positioning.  At present, it is more reliable then many other measures of the market.

Next time, I end this series.  Till then.

Productivity increases are only so when they result in an increase of desired consumer goods purchasable at prior prices.

As I commented in my last piece, I’m scraping the bottom of the barrel as I come to the end of this series.  I’ll keep this short.  The concept of hedonics has some value as it tries to adjust price indexes for quality improvements.  Where it goes wrong is equating technical improvement with usefulness.  With products where technology is improving rapidly, often hedonic improvements cannot be measured, because the prior product is no longer being sold.  If it were being sold, it would provide significant information about how much people value product improvements.  As it is, sometimes economists try to estimate improvement in value off of technical improvements.

A computer that is twice as fast, with twice the RAM and twice the storage, is not twice as valuable.  To the degree that hedonics takes shortcuts  to estimate value, it overestimates how much value is added by technological improvement.

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?  KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel.  As with most aspects of life, the best things get done first.  After that diminishing marginal returns kick in.

Here’s the issue.  It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders.  As such, equity implied volatility helps inform us as to how likely default will be.  But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years.  In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable.  Remember, the equity has the option to default, but they also control the company until they do default.  Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made.  Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal.  If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it.  The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing.  The world is more complex than the math will admit.  So be careful applying math to markets.  Think through what the assumptions and models mean, because they may not reflect how people actually work.


The more that markets are united through derivatives, the more systemic risk is created.

Derivatives exist to subvert regulations, at least the regulations that don’t involve derivatives.  Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so.  And the same for laying off risk.

But here’s the difficulty.  You can create all the derivatives you want, but total risk never goes away, it is only shifted.  There are many idiosyncratic risks for which there is no natural counterparty, i.e., one that faces the opposite risk.  What does it take to get someone to speculate on a risk?  Well, you have to offer them good terms, such that on average, they have the expectation of a profit.  The speculator may try to delta-hedge, and/or cross-hedge his risks, or he may not.  But the speculator is usually in a weaker financial position than the hedger.  Let me give an example:

In the insurance world, with a few exceptions, large direct writers have higher ratings than reinsurers.  And for what few reinsurers of reinsurers there are (“retrocessionaires”) they usually have lower ratings than the reinsurers.  There is a tendency for the economic world to arrange itself like a Collateralized Debt Obligation.

Think about it.  In a CDO, the junior tranches insure those that are more senior against loss.  In exchange, they are offered a higher yield.  That’s what goes on with those that speculate with derivatives.  The one being insured typically gives up some economics to the speculator.

Now if this goes on in a small way, there is no trouble.  But if large numbers of parties lay off their risks in this way, a large amount of  risk is in the hands of speculators which don’t have the best balance sheets.  It’s not as bad as people holding stocks in 1929 on 10% margin, but you get the idea.

Anytime risk is concentrated in the hands of those less well capitalized, there is heightened systemic risk.  Think of AIG writing gonzo amounts of subprime AAA RMBS CDS for a pittance.  Everyone on Wall Street took advantage of them, except for one thing — because everyone was insured by AIG, no one was truly insured by AIG.  If the Fed hadn’t stepped in, who knows who could have been insolvent — and that’s what should have happened, with the regulators letting holding companies fail, but protecting regulated subsidiaries, so that ordinary people would not be harmed.

When risks are in the hands of those with weak abilities to bear risk, not only are the weak affected but the strong also.  The strong, thinking their risks are covered, lever up more because they aren’t worried about the risks.  When the weak fail, and the strong find that risk is shifting back to them, they find that they themselves are hard-pressed, because they don’t have so much equity to cushion the losses.

There is no free lunch with risk.  The most we can do is try to analyze who is bearing the risk.  If it is in strong hands, we don’t have to worry.  If it is in weak hands, perhaps it is time to reduce risk, and not synthetically, but by genuine sales of assets.

If we want to solve this problem we should require insurable interest, and only let hedgers initiate transactions.  But who will take on the lobbyists?

Leverage and risk eventually transfer to the least regulated

I’m coming near the end of this series.  It will either end at LX or LXI.  To refresh, I started a file in 1999 of insights before I started writing at RealMoney or Aleph Blog.  I ended it in 2003, near the time I started writing for RealMoney.  I threw a few of the insights away, but not many — there may have been near 70 when I was done.  These ideas stemmed for all of the new ideas I ran into as I transitioned from being an investment actuary to being a portfolio manager.  Onto tonight’s idea!

After the recent crisis, tonight’s insight may seem rather banal, but I saw it as an actuary many times as onshore insurers would shed reserves using reinsurance treaties to Bermuda companies and other domiciles with weak reserving, capital or tax rules.  It was reinforced to me when I blew it badly regarding Scottish Re.  It was only in the midst of their crisis, that I finally saw a full diagram of their corporate structure.  It was a hodgepodge of all of the weak insurance domiciles, with many lines going this way and that.

A picture is worth a thousand words, and as I have often said, complexity within financial companies is rarely rewarded.  That diagram focused my research, and changed my view of what was going on.  After having bought into the decline, we sold into an incredible one day rally when some positive news was released, while my view had shifted that cash could not make it to the holding company, and the common would go out at zero.

What a mess, and the best thing I can say was that selling into the rally was the right thing to do, as the common did go out at zero.

But in the recent crisis:

  • How many weakly capitalized investment banks died or were acquired?
  • How many REITs, particularly mortgage REITs died or were acquired?
  • How much of the mortgage insurance industry died?
  • How much of the financial guaranty industry died?
  • How many significant GSEs died?
  • And with all of these, how many barely survived?

These all had weak financial models, taking on too much credit risk, with weak, backward-looking models for risk.  It is no surprise that the bad credit risks found the fools that assumed that housing prices could only go up, and incurred considerable leverage to make their bets.

All of these were weakly regulated.  There was more than a bit of the “this is free money” attitude to many of these businesses — it was an era that rewarded yield hogs for a time.

Thus, when you see financial firms with weak balance sheets taking on significant credit risks, be wary, it is often a sign that the credit cycle is about to turn.

Financial intermediation reduces volatility.  In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.  They do even better if they save and invest, but really, they don’t know what to do.  Market returns are like magic to them.  They don’t know why they occur, positively or negatively.  Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.  That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.  People need vehicles in which to park excess cash that are more predictable than direct investing.  Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.  Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.  But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.  After losses, they seek guarantees.  That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.  When easy money is being made by amateurs, the temptation comes to imitate.

  • If my stupid brother-in-law can make money flipping houses, so can I.
  • If my stupid cousins can make money buying dot-com stocks, so can I.
  • If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.  Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.  Don’t follow the crowd.  Develop the mindset of  a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.  Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.  The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.  Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.


When do employee and corporate incentives line up?  Ideally, incentive schemes should reward people with a fraction of the additional profitability that resulted from the additional work that they did.  Difficulties: measurement impossible in many cases, people could receive a bonus when the firm is not profitable, neglects synergies (both positive and negative).

Though I wrote that in 2002, I formulated the idea in the late 1980s.  The concept of how bonus/incentive systems should work intrigued me.  Part of it also stemmed from Warren Buffett’s observation that he would never hand out stock options, because employees can’t control P/E expansion or shrinkage, but employees have some impact on profits, if fairly measured.  So Buffett would offer profit incentives, rewarding employees with a share of the profits over a given threshold.

The first time I mentioned the idea publicly was at the Fellowship Admission Course for the Society of Actuaries in 1991.  The first case study was on a misuse of employee incentives, and I commented something close to “rule” that I mentioned above.  After I said that, a female consulting actuary based in Australia said that it was one of the stupidest comments she had ever heard.  But beyond that, she didn’t explain.  The discussion moved on.  I didn’t make too much of what she said, because she offered no reasons for her opinion.

In 1994, my best boss came to me, and said, “Well, you drew the short straw.  You get to try to redesign our compensation system for our representatives.”  He described to me the current system, and what the overall goals were.  I assented, and he left.  Shortly after that, the division’s Radar O’Reilly, “Roy” came to me and said, “You got the compensation project?”

I told him that I had been given the project, and he told me not to put too much time into it early, or it would suck up gobs of time, and besides, no compensation scheme over the past five years had lasted longer than a year.  I thanked Roy, he was a loyal friend, and never told less than the truth.

But then I had to think.  Surely there had to be a way that would work here, and maybe putting in some development time in on the front end could pay off, maybe?

I had been playing around with reduced discrepancy point sets with my free time.  Like Assurant, my boss gave me eight free hours per week to come up with new ideas, and temporarily, I created the best method of creating structured randomness — how best to have “r” points represent an n-dimensional unit hypercube.  The practical upshot was that I could create scenario analyses that were far more accurate than any others around.  (Note: better methods emerged within 10 years, and I never published my work, because my insights were intuitive rather than provable… but it enabled me to do some amazing things for the next ten years.)

I set up my profit model, and chose my criterion: Try to pay commissions equal to 1.25% of the Present Value of the Gross Value Added.  My model had four components.  I can’t remember all of them now, but the last one was the most significant, an item called the “revenue bonus.”  Over a certain threshold offices (with multiple representatives) would receive extra compensation for exceeding targets.

It leveled out the amount paid versus the Present Value of the Gross Value Added.  Success, except that my best boss ever had one of our two fights over it — he thought it was a horrible idea — we could be paying out too much money in a bad year, or too little in a good year.  I argued  that it was better than what we currently had, and that we could tweak it in future years.  We will learn from the errors of the method.  He told me that it was fine for me to present it to the chief marketing officer and the CEO of the division, but he would not be behind me.

Much as I respected him, I had done my work, so I presented it two days later to the CMO and CEO.  They went gaga for the idea, and in the meeting my boss said “I see it now.”  Later, he came to me and apologized, and as is usual with me, I accepted it, saying it was no big thing.

So what happened?  Not only did the compensation scheme work for a year, it stayed in place for four years without modification, while sales and profitability grew dramatically, and the division grew to be the star of the company.

That said, after the CEO retired, the CMO became the new CEO, and I got transferred to a different division to clean up operations and financials there.  After four years, the representatives complained that the scheme was too tough, and they needed some low hanging fruit to motivate them.  And so my scheme was abandoned, and sales did not improve, but they were worse.

Profit-based incentives work if they are structured right.  You want representative to write good business, and should incent them to do so.  Offering them a percentage of the expected improvement of the value of the company is a smart thing.