“The day I tried to win / I wallowed in the blood and mud with all the other pigs / And I learned that I was a liar” – Chris Cornell, “The Day I Tried to Live”
We live in an era dominated by the "principal-agent problem," an economic concept that explains what happens when you hire someone to manage your money, but their motivations diverge entirely from yours.
When a money manager is compensated heavily for short-term gains but bears none of the downside risk for permanent losses, you have a recipe for disaster. This is what Dean LeBaron called "agency risk". The agents managing the money may not care much about the long-term health of the portfolio; they are instead deathly afraid of missing out on a bonus or looking conventionally wrong.
Wall Street loves a "heads-I-win, tails-you-lose" fee structure. In the run-up to the 2008 financial crisis, we saw this everywhere. Loan originators had nothing riding on the loans’ long-term performance because they were selling them onward. Investment bankers packaged and resold toxic CDOs before they went bad. They tried to "win" without putting their own true survival on the line. When managers lack "skin in the game," they are willing to wallow in the mud of risky subprime debt, lying to their clients—and themselves—about the underlying dangers.
As Jack Bogle pointed out, the mutual fund and investment industry’s primary goal became "amassing assets under management," and the focus fundamentally shifted "from stewardship to salesmanship". True stewards aim to protect their clients from loss and generate a reasonable return with risk in check. Salesmen just want the fees.
The Financial Takeaway: Do not entrust your capital to anyone who does not suffer alongside you when they are wrong. Look for stewards, not salesmen. As the old saying goes, "Nobody spends somebody else’s money as carefully as he spends his own". If your manager is getting rich while you are taking all the downside risk, you are in the wrong partnership.
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