Tis the season to waste money. Joel Waldfogel at Yale University has notoriously estimated that people value the gifts they get at between 10 and 33 per cent less then they cost the giver. This suggests in the UK alone we will waste around £1bn this festive season. As Milton Friedman said: “You don’t pay anything like as much attention to the gifts you buy for other people as to the things you buy for yourself.”
Now, this finding isn’t universally accepted. But it alerts us to a problem that afflicts investors all year round – that people often fail to act in others’ interests even when they should do so. Economists call this agency failure.
We saw one example of this earlier this year when the the Financial Conduct Authority (FCA) fined Janus Henderson for charging its clients high fees for what were in fact closet tracker funds. It’s easy to see the motive for running closet trackers. Investors often stick with funds unless they egregiously underperform. A manager who runs a closet tracker avoids this danger and so keeps his fees. In doing so, he acts in his own interests rather than those of his clients.
We mustn’t, though, be too harsh on such managers. It’s actually very easy for a large fund to become a closet tracker simply because brute maths means that if you are holding a lot of large stocks your portfolio won’t deviate very much from the index.
Closet trackers, however, aren’t the only agency failure in fund management. A fund desperate to attract new money has the opposite incentive – to load up on risk in the hope of beating the market and attracting attention and funds. As Bamberg University’s Bjorn-Christopher Witte has shown, this means that investors can end up trusting their money to fund managers who are lucky rather than skilled. Again, fund managers don’t act in their clients’ interests.
The same can happen with financial advisers. Although the Retail Distribution Review is curtailing some of the more egregious agency failures – such as pushing clients into high-charging funds on which advisers get commission – advice is still imperfect. The FCA’s Debbie Gupta has said that half the advice given on whether people should sell their final salary pensions is unsuitable. “The potential for consumer harm is far too high,” she has said.
And then, of course, there are agency failures in companies. Economists have warned of these for almost as long as there has been a separation of ownership and management. In 1776 Adam Smith wrote that “negligence and profusion... must always prevail” in the management of joint stock companies because “managers rather of other people's money than of their own” will not watch over the company “with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”.
This leads managers to build up large cash piles so they can spend money without prior approval from shareholders. It leads to chief executive officers (CEOs) being paid fortunes even when companies do badly. And it can lead to inefficient investments as managers pursue projects that gratify their own egos rather than maximise shareholder value. In his fascinating book, Bullshit Jobs, the London Stock Exchange’s David Graeber estimates that more than a third of workers believe their jobs to be pointless. This is consistent with agency failure – bosses building empires of underlings rather than producing useful products.
Luckily, though, the market is solving this problem, albeit gradually and imperfectly. There are now fewer growth stocks listed on the UK market, in part because dispersed outside shareholding is a bad way of controlling such companies. Instead, growth companies – insofar as there are any at all – are more likely to be privately owned. Which is why investors wanting growth should consider private equity funds.
The inefficiency of some gift-giving, however, tells us something else about agency failures – that conventional economics is not entirely right about them. It pretends that such failures are due to selfishness, to hirelings pursuing their own interests rather than those of the people paying their wages. But this is only part of the story. Professor Waldfogel’s work shows that even when we want to do what’s best for somebody else we can fail because of ignorance and overconfidence.
This is true in other contexts. For example, Hargreaves Lansdown is being widely criticised for recommending Woodford’s equity income fund. But it did not do this because it had an especial financial interest in doing so. More likely, it was overconfident about its ability to identify good funds. That was an honest error.
So too are many of the worst examples of CEOs letting down shareholders. Bad takeovers – RBS’s of ABN Amro’s being the worst – or overly ambitious expansion plans are motivated more by overconfidence than by greed.
Perhaps, then, failures to act in others’ interests are inevitable and ineradicable because they arise not just from bad incentives (something that can be fixed) but from that most important feature of human nature – the fact that we often don’t know what we are doing.