Why finance heads shouldn't be judged by the market
The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck.
The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck.
Harvard Business School professor Mihir Desai believes American companies and investment firms have erred鈥揾orribly鈥揵y linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:
Mihir has nothing against well-functioning financial markets. He emphasizes that they 鈥減lay a vital role in economic growth by ensuring the most efficient allocations of capital,鈥� and he believes that capable managers and investors should be 鈥渞ichly rewarded鈥� when their talents are truly evident.
The problem is that聽incentive compensation based on financial performance does a lousy job of聽distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck聽gets rewarded with聽undeserved windfalls (that are by no means offset by negative windfalls聽for the unlucky).聽And聽that, he argues,聽results in an important聽鈥漨isallocation of financial, real, and human capital.鈥�
Well worth a read.