"Long term results"

Gordon Brown says he wants to “end the short term bonus culture, building rewards on long term results.”
However, even long-term results are no proof at all of genuine skill in financial markets. Take three examples.
1) Under-pricing tail risk. Imagine you have an asset that pays tolerably well in good times, with the small chance of being wiped out. This could be a portfolio of risky bank loans, or bonds with default risk, or insurance, or writing put options.
Let’s imagine this asset pays 5% in good times but has a one-in-20 chance of losing you 95%.
This asset is under-priced, as it has an expected value of zero: (0.95 x 5) + (0.05 x -95) = 0. No risk-averse person would hold it. But there’s a 60% chance of it paying off over 10 years, and a 46% chance of it paying off over 15.
Moderate luck would give our financier “long-term results” - even though he’s an idiot.
2) The bad asset allocator. Imagine a choice of two assets - a safe one paying 3% a year, and a risky one with expected returns of zero but standard deviation of 25% a year. Again, only a fool would choose the risky asset, unless he’s risk-tolerant. But there’s a 33% chance of it out-performing over 10 years.
3) The bad stock-picker. Say a fund manager has negative skill - over the long-term he’s expected to under-perform his benchmark by 2 percentage points a year. But his fund has a tracking error of 10% a year.
Over 10 years, he has a 28.1% chance of actually beating the benchmark.
These three examples show that, over a period as long as 10 years, there’s a good chance of an idiot getting “long-term results.” This is because in financial markets the noise-signal ratio is high. If we are to judge financiers by “long-term results”, the long-term has to be very long indeed - maybe infeasibly long.
Now, anyone with a vague acquaintance with financial markets knows this problem. So, why does Mr Brown seem to suppose that long-term results would be good evidence of ability?
One possible answer is that he thinks we live in a deterministic world in which leaders, experts and managers can reliably deliver results.
But no-one’s that stupid, are they?

Comments

[kinglear]

unfortunately, he is,,,

[David Heigham]

Chris raises an interesting question. Gordon Brown is an intelligent bloke, but the negative correlation between individuals' intelligence and their stupidity appears weak. My guess is that Mr. Brown is our stupidest Prime Minister since Antony Eden; though one might make acase for the stupidest since Ted Heath.

[marksany]

Oh to get the Cabinet to play the Red Bead game!

[OneEyedMan]

The asset described in part 1 is worse than described.
Most people agree that over the long term, an asset's return should be be thought of as the geometric mean return, not the arithmetic mean return.
The asset may have an arithmetic mean return of 0 but has a geometric mean return of about -10% per year.

[Riz Din]

60%, 33% 28.1%. Looks like we have some figures we could use to adjust performance rewards over said the long horizon, so why not just tweak the idea and call it a long-term, probability-adjusted reward system.

[premie verzekering]

Yes, in view of current financial picture I agree to the fact that the long-term results are with no proof at all of genuine skill in financial markets.

[ajay]

The question is not: "would paying bonuses based on long-term results be absolutely sure to stop idiots getting bonuses?"
The question is: "would paying bonuses based on long-term results be better than paying them based on short-term results?"

Your argument is equivalent to saying: "What a fool Gordon Brown is for advising people to wear seat belts. What good is a seat belt going to do if your car falls off a cliff? Or if a qat-crazed Somali gunman shoots up your car with a DShK? He seems to think that we live in a perfect world where a seat belt will protect you from all harm. But no-one's that stupid, are they? Stupid, stupid Gordon Brown. What a stupid head."

[Bob B]

Absolutely, ajay.

As JMK said, "It's better to be roughly right than precisely wrong."

Also, the next issue is whether GB and AD are set on a better course of fiscal policy than the egregious twit who described a fiscal stimulus to soften the recession as "fiscal insanity."

In the news today:

"LONDON (Reuters) - World leaders need to pump more money into the economy in a coordinated effort to boost demand and pull the world out of recession, the White House's chief economic adviser said on Monday.

"In an interview with the Financial Times, National Economic Council Director Larry Summers said kickstarting growth should take precedence over ironing out global imbalances."
http://www.reuters.com/article/politicsNews/idUSTRE52805720090309

[Luis Enrique]

I think an interesting thing about this, is that a "solution" might well lie in the sort of things economists are traditionally suspicious of - a change in the "culture" of the organization, or such like.

I know our host is optimistic that changes in the structure of an organization might be powerful enough to provide the right incentives for sensible long-term behaviour, but I'm less sure. What I am talking about is behaviour that the agents do not have an incentive for, in the narrow economic sense, whatever the organisational structure. Perhaps we need a culture where the sorts of things identified in this post are identified as bad things and have a negative stigma attached to them, you cannot gain status in the organisation by doing them, and people avoid them because they don't want to be thought badly of.

Mind you, having said that, I'm suspicious of the above. Just hoping people will learn to behave better is not a very robust response, and how this change in culture is supposed to come about I don't know. Still, it might happen just through some processes of cultural learning. I expect there's a whole lot of "learning by doing" having gone on recently.

[Bob B]

Talking about the bonus culture, I was shocked, shocked, to learn from the news that redundant bankers and other financial services types are now heading towards our schools to teach during the recession until the next career opportunity with million-pound bonus perks materialises.

Experience from history shows that neighbourhood and corporate cultures are very resilient to change. How about bonuses for teachers in failing schools to get 11 years-olds reading and 16 year-olds through their GCSEs at A*-C grades, including maths and English?

"Up to 12 million working UK adults have the literacy skills expected of a primary school child, the Public Accounts Committee says. . . The report says there are up 12 million people holding down jobs with literacy skills and up to 16 million with numeracy skills at the level expected of children leaving primary school."
http://news.bbc.co.uk/1/hi/education/4642396.stm

[Aaron S.]

Very interesting article and thank you for sharing!

Sincerely,

Aaron