Politics and Investments don't mix

Politics is often about getting votes. Politicians campaign for the next election as soon as the last is over. Long-term objectives are not their strength.

Investing well is about thinking long-term and not chasing short-term results. Investment cycles are generally longer than election cycles.

One area where these short-term and long-term goals conflict most obviously is in the management of large university endowments. The goal of the investment manager at an endowment is to contribute some percentage of its assets (usually about 4.5 to 5%) to the university's operating budget. They also need to earn a little extra to keep up with inflation (about 3% more). So, their target is about 8%, and they need to be as consistent as possible to keep the school's budget from jumping up and down.

At the end of 2007, the S&P 500 Index had increased by 12.8%, on average, for 5 years. This return was above normal, and some universities earned more than this. Some politicians started calling for endowments of large universities to expand scholarship programs to more people who can't afford college (and who were constituents of said politicians). However, many investment managers realized it was too good to last, the markets would eventually fall, and were resisting paying out more. The politicians, in turn, made it a point in a public letter to tell their constituents how greedy these folks were. How could they possibly deny opportunities to bright young students when the markets had provided such surpluses?

In 2008, the S&P 500 dropped -38.5% in the midst of a recession that started in late 2007 and a credit crisis fueled by irresponsible behaviour by many parties, including politicians (I'll need several other posts to talk about that!).

So, the chatter about expanding scholarship programs subsided, and the blame game continued, but with different rules. How could these investment managers so foolishly lose all of this money? Even more, some of them are getting bonuses? Those criminals!!!

Well, the reason some investment managers were due to get bonuses is that they are paid for performance relative to an index, and usually over a multi-year period. For example, if the S&P is down -38%, and they were down "only" 35%, they saved their employer a lot of money. Bonuses were set up this way to encourage long-term thinking and discourage excessive risk-taking in up markets. After all, investment manager can't control which way the wind blows, only how they set their sails.

Now, the politicians are pounding their chests about taking these bonuses away (sometimes by voiding contracts). Why should anyone get a bonus for losing money? Don't they realize people are losing their jobs? Never mind that these bonuses would likely be paid out of the money saved by managing the money well. Also never mind that there are good reasons the bonuses were set up this way. Also never mind that large endowments are increasingly competing for talent with investment firms that pay much, much more.

In response to political pressure, some bonus arrangements are being re-written so that no bonus is paid in negative years, and higher bonuses paid in positive years.

So, the next time there is a tech bubble or housing bubble, or any short-term mania in the market, the government will be responsible for setting up a system that strongly encourages investment managers to take as much risk as possible in order to get the biggest bonus they can before the bubble inevitably bursts! Which means their employers are likely to lose even more money on the way down, and be in even bigger trouble.

Of course many investment managers will be responsible custodians of the money they manage, in spite of short-sighted incentive systems. But, there are also many who will do what they are paid to do. People respond to the incentives put before them, particularly if they report to a board that might fire them for trailing their peers in a bull market, or if honoring bonus contracts leads to public shaming with the press at full attention.

Also, there are politicians who understand investing and the need to think beyond the next election. But, whether investment performance is good or bad, there will be politicians who need to show their constituents how much they care about them and that they need their vote. They will focus on the short-term problem, and how to get credit for attempting to "fix" it. And then there are constituents who don't mind letting politicians have it both ways.