Money Management and the Agency Problem

"Best defense, no be there."
--Myagi (Karate Kid)

The previous post describes an 'agency problem' (Alchian & Demsetz, 1972; Fama, 1980; Jensen & Meckling, 1976). Lacking either skill, motivation, or time, an investor (the principal) retains a professional money manager (the agent) to invest capital. Because it is difficult for the investor to understand precisely how the money manager is behaving, the possibility exists that the money manager may not be acting with the investor's best interests in mind.

Even if the money manager prefers to act in the client's interest, institutional pressures may drive alternative behavior. Institutional pressures arise to some degree in any social setting. Categorically, these pressures are of normative (widely held prescriptive rules that govern behavior), mimetic (copying what appears to be effective behavior), and coercive (do this lest you will be punished) nature.

The career risk that Grantham discusses is largely shaped by these institutional pressures. The 'iron cage' famously elaborated by DiMaggio and Powell (1983) suggests the difficulty that even well meaning money managing agents will encounter when trying to effectively serve their investing principals.

The best solutions to this agency problem are likely found outside of the institutional field of professional money management. Investors who 'do it themselves,' for example, are less prone to the herding that Grantham discusses. For example, individuals can make concentrated bets that fly in the face of standard portfolio theory. They can also radically alter asset allocations in short order to express a macro view of the world--a macro picture that may be subject to frequent revision in today's turbulent context.

Both of these actions are frowned upon in the professional investment community.

Most individuals will of course argue that they possess neither the time nor the skill to make investment decisions themselves. Thus, they need to retain a specialized professional.

Those that value superior investment returns, and understand the difficulty of achieving them in the institutional field of professional money management, may decide that self-management of their economic future is worth the effort.

References

Alchian, A.A. & Demsetz, H. 1972. Production, information costs, and economic organization. American Economic Review, 62: 777-795)

DiMaggio, P. & Powell, W. 1983. The iron cage revisited: Institutional isomorphism and collective rationality in institutional fields. American Sociological Review, 48: 147-160.

Fama, E.F. 1980. Agency problems and the theory of the firm. Journal of Political Economy, 88: 288-307.

Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.