Incentive Misalignment in the Money Management Business

As we have written before, the art of successful investing requires both discipline and an even temperament.  The more emotional an investor becomes, the more likely he is to buy high and to sell low – following the herd to failure.  An average result can easily be obtained by simply purchasing a low-cost index fund, and this can be a good strategy for a large swath of people.  To excel, however, requires that an investor remain both calm and rational.  A manager must be willing to look and act differently in order to obtain superior returns.  Benjamin Graham notably described this mentality in The Intelligent Investor: “You are neither right nor wrong because the crowd disagrees with you.  You are right because your data and reasoning are right.^[1]”

In the money management business, the profit-maximizing strategy for an investment advisory firm is often to mimic the returns of a benchmark and to market like crazy.   Given peoples’ strong proclivity towards recency bias, one of the quickest ways to lose these assets once acquired is to substantially underperform a peer group or benchmark for part of a market cycle.  The benchmark index is by definition fully invested, so inherent in this incentive structure is also the pressure to be fully invested, particularly in a market that has recently risen.  This pressure is greatest at precisely the wrong time.  Expensive securities offer low expected returns and a high risk of permanent capital loss, but a manager’s perception of career risk – even if merely subconscious – can cloud his assessment of value and weaken his discipline.

Note that these incentives to justify high valuations and to hug a benchmark do not align with those of the underlying investors, who are instead hiring the manager to deliver long-term outperformance.  It is impossible to create incentives that perfectly align managers with their clients’ interests, but we have tried to build a framework at Cook & Bynum that promotes rational investing and diminishes the pernicious effects of such misaligned incentives.  As part of this framework, we have sought partners who know that our strategy may lead us to look foolish for extended periods of time but recognize that our efforts should be solely dedicated to the goal of compounding their capital for the long run.  In contrast to most firms, the particular collection of partners we have attracted empower us to seek the correct facts and analysis irrespective of the pressures of the moment.  We appreciate that you did not hire us to merely reflect the ‘wisdom’ of the crowd.