Working Undercover for the Man

January 30, 2011

Work is an endlessly rich subject for reflection.  I devote my time, energy, creative output, emotional bandwidth — essentially, a huge chunk of my physical and cognitive space — towards the advancement of some enterprise, and in return I receive currency that I can trade for essentials that it would be less efficient or impossible to produce myself and, if I’m fortunate, non-essential items and experiences that I can enjoy. I tend to think I’d be at best a pretty mediocre subsistence-farmer, but instead I can spend my days manipulating abstractions, persuading and being persuaded by people, engaging in organizational blocking-and-tackling, and generally participating in the ‘knowledge economy’ and then go out and buy all kinds of food that someone else has produced.  How amazing is it to live in a world where this is possible?

As an investment professional, my work is both impersonal and highly personal.  It’s impersonal both in the sense that good decision-making often demands a degree of objectivity, and in the sense that certain norms exist that (theoretically) distinguish the conduct of agents acting on the behalf of institutions from that of the agents themselves.  As Sonny put it in The Godfather, “even shooting your father was business, not personal.”

At the same time, my work is highly personal because the analysis I perform and decisions I make may bear directly on the success or failure of a project or an investment.  It is difficult not to internalize failure under those circumstances.  Even if I were perfectly good at maintaining emotional distance from the output of my work, the ‘personal’ would find other ways to intrude.  In many lines of work, it’s difficult to avoid developing some kind of relationship with coworkers — perhaps some of them become friends, mentors, allies, rivals, saboteurs, or countless other variations.  At times I would prefer to work in an environment where no such relationships existed and where everyone functioned on the basis of a cordial objectivity; but I’m also grateful for the friendships I’ve made with colleagues, and at times those relationships are my only proximate motivation for clocking in.

In short, I feel broadly and deeply conflicted about working in general, and my work in particular.

I’ve been in the process of transitioning to a new job for the past several months.  Superficially, this shouldn’t be particularly stressful.  I’m taking on a role that’s extremely similar the one that I’ve had recently, and will even be working for the same manager with whom I’ve worked for the past two years and whom I trust and admire.  And yet, as the transition date approaches, I’ve found it increasingly difficult to sleep when it’s bedtime, to stay awake during the day, to take care of minor errands, to stay in touch with people I care about; basically, to act like a normal human being.  Could a relatively modest change in my work environment potentially introduce stress on a subconscious level, even if I don’t experience any real concern on a purely rational basis?

Perhaps.  Psychologists have examined the links between life changes, stress, and illness for decades, and in so doing have attempted to quantify the stressfulness of various life events.  Predictably, experiences of death, marriage/divorce, and physical trauma rank highly.  But several work-related events, such as being fired or experiencing a change in work conditions, apparently rank alongside pregnancy or the death of a close friend on a well-known scale of stress. This suggests that I ought not be too surprised that I’m having some trouble functioning at the level I’d like.

But… isn’t this somewhat disturbing?  That it’s considered normal that I could be experiencing a comparable level of stress right now (even if not consciously) as if I had lost a close friend?  Perhaps I am misinterpreting the logic of this scale, but I’m happy for the dose of perspective it has given me as I prepare to sleep poorly again tonight.

Bonus? You Just Met Us! (Part 3)

January 25, 2011

Certain professional roles allow individuals to directly and measurably contribute to the success of a commercial enterprise and, in so doing, to generate profits (and losses) on a vastly greater scale than is possible in the roles in which the majority of people work.  As a consequence, these individuals are often in a position to attract outsized (and at times, outlandish) compensation for their effort.  It can be tempting to attribute this earning power to unusual individual skill, education, work ethic, or the like, but these attributes are rarely sufficient and may not even be necessary (certainly not on Wall Street, at least).

On some level, it’s just a matter of being in the right seat at the right time.  An investment banker’s career is heavily influenced by the robustness of the sectors in which she specializes.  An institutional salesman or relationship manager may print money in buoyant markets, but may find himself out of business if a few key clients defect.  A trader who generates profits is progressively given more capital and more opportunity (in dollar terms) to generate future profits, and to capture a share of that increasing pie for himself.  Wall Street is not alone in this regard: how important is the “big break” in a performer’s career, or the opportunity to appear in front of the right talent scouts (and avoid injury) in an athlete’s?  It is extremely competitive to even have a chance at ending up in that right seat at that right time, and it is not guaranteed by any amount of skill or hard work.  I believe this dynamic contributes to the difficulty “Wall Street” and “Main Street” have in understanding each other when it comes to compensation (with continued apologies for the oversimplification and caricature).  Main Street looks at how much those people in those chairs make, and thinks it’s indecent.  Wall Street looks at how bitter the struggle is to even get in those chairs, and thinks it’s justified.

One might think that investors and paymasters would attempt to diagnose to what extent skill, luck, momentum, and ‘beta’ (i.e., general market direction), among other possible factors, contribute to the success of a line of business or to the returns on an investment.  In reality, they do make an attempt, but this is a pretty hard exercise, and it’s a more pleasant and convenient practice for all parties to attribute as much as possible to ‘skill’ – this makes employers look sophisticated and makes their investors happy to believe their capital is in the best hands.  Nassim Taleb is one of several scholars who have explored this topic in illuminating detail (Fooled By Randomness is more on point than The Black Swan for my discussion here).

Is it ‘fair’ that equally skilled, knowledgeable, and hard-working traders can have vastly discrepant career trajectories just as a result of small differences in their initial conditions (e.g., how much opportunity were they initially given to take risk, and how did those trades go over the time-horizon of their manager’s patience)?  On an intuitive level, probably not; but nobody really cares.  Within the Wall Street bubble, there’s the gambler’s mentality that imagines beating the odds and hitting it big, so there are few tears shed for those who weren’t so fortunate.  Outside of Wall Street, people don’t even understand why these people should be making so much money in the first place, so the search for gradations of fairness seems pretty silly.

That all being said, attempting to control for randomness in promotion and compensation seems like a generally good practice for any professional organization, but it doesn’t really tell us how to balance this with the organization’s need to “attract and retain top talent” (howsoever defined).  In my view, the conceptual problem has nothing to do with attracting and retaining top talent, but everything to do with the problem of running an organization where everyone wants to believe that he or she is top talent.  In organizations (not to mention entire industries) with such an orientation, pay expectations will always be anchored to the very top of the spectrum – and as long as the cost of meeting those expectations can be passed through to clients and investors, it will be possible to do so.  What does this mean, in practical terms, for ‘reforming’ Wall Street compensation?  I’ll return to this question some other time.

Tuesday: Haikus and Mysteries IV

January 25, 2011

State of the Union:
We’ve got ninety-nine problems
But a witch ain’t one

(with apologies to Jay-Z)

Today’s mystery: What’s the most painful foot-related joke one can make about the Jets game, within the 140 characters provided by Twitter? I’m proud of my humble contribution, but I would love to see this surpassed.

Bonus? You Just Met Us! (Part 2)

January 20, 2011

Wal-Mart, AT&T, and Goldman Sachs are giants in their respective industries and routinely rank among the world’s most profitable companies.  In the last four quarters for which information is available as of the date of this post, Wal-Mart earned net income of $15.1B, AT&T earned $12.8B, and Goldman Sachs earned $10.3B.  Each of these numbers is staggering, but consider another few morsels of data.  Wal-Mart reports having 2,100,000 full-time employees.  AT&T, 267,720; Goldman Sachs, 38,900.  If you’re looking for a quick answer as to why employees of Goldman Sachs so well-paid, whereas Wal-Mart is often accused of squeezing its ‘associates’ at every turn – divide the figures above.  On a per-employee basis, Wal-Mart earns roughly $7,200; AT&T, $48,000; and Goldman Sachs, over $260,000.  And these profits are calculated even after taking into account the cost of compensating employees!  The reality is that the average employee of Goldman Sachs generates more profits for shareholders than does an employee of Wal-Mart by a factor of 35.  Forgetting about questions of justice and merit for a moment: should it be so surprising that the pay of an average employee of Goldman Sachs is many multiples greater than that of an employee of Wal-Mart?

My former colleagues at McKinsey argue that profit per employee is a meaningful measure of corporate performance; in particular, of how effectively firms in knowledge-intensive sectors leverage their intellectual capital.  (Didn’t that sound so consultant-esque? Full disclosure: I contributed to the research cited in the link.)  My choice of companies for the purpose of this comparison is meant to make a similar point.

  • Wal-Mart’s business model is highly labor and capital-intensive; it’s a logistical masterpiece that sells many goods, on impossibly thin margins, at prices competitors can’t match.  The competitive advantages of Wal-Mart include its size, lean-ness, and omnipresence.  Only a small percentage of employees are truly critical to this equation.
  • AT&T generates its income through a combination of labor- and capital-intensive, traditional telecom business lines; and higher-margin business lines (such as wireless), which include some deliciously rich opportunities to generate almost free money from roaming charges and ringtone downloads.  Certain populations of employees are largely fungible in terms of the overall business plan of AT&T, e.g., those in customer service; others, perhaps highly skilled engineers who come up with the grand designs for the next wave of wireless infrastructure, can directly influence huge successes or failures of the enterprise.
  • Goldman Sachs… well, most people probably have no idea how Goldman Sachs makes money, beyond the suspicion that it must be nefarious.  Truthfully, many of Goldman Sachs’ employees are not as critical to the enterprise as they might like to believe, but theirs is also a lean organization in which the costs of unwanted staff turnover can be significant.  Almost any business function, from big-ticket deal-making to trade reconciliation, carries meaningful economic consequences for success or failure.  It is up to the firm’s employees to create ways to profit from the firm’s financial capital and other intangible assets (e.g., intellectual capital and privileged relationships).

To take the argument to an extreme: why do certain hedge fund founders earn billions of dollars?  Because hedge fund management companies are contractually entitled to a percentage of the dollar profits that investors realize; and hedge fund founders typically own the lion’s share of the economic interests in the management company.  This is a thoroughly ridiculous arrangement that the market seems to tolerate; I will come back to this another time.  But, indulging for a moment: it is not unreasonable to assume that a hedge fund management company may run $5B with a staff of, say, 100.  In a year where their investments are up 20%, they will generate $1B in gross profits, of which investors might receive $800M and the company receives $200M.  In other words, the average employee ‘earns’ the company two million dollars, roughly a factor of 8 greater than our Goldman Sachs superstars, and over 275x the employees of Wal-Mart.  And people wonder why Goldman Sachs gets jealous about hedge fund compensation!

Defenders of Wall Street pay practices often make tone-deaf arguments about how hard their professionals work, and how the pay is necessary to “retain top talent.”  Many people toil in unglamorous roles and if ‘working hard’ were a meaningful criterion for determining pay, there would be many more millionaires coming out of slaughterhouses and classrooms.

A more intellectually honest argument (which I am going to make in a tone-deaf way, just to be clear) is that Wall Street is one of the few sectors of the economy in which a significant proportion of workers are not individually irrelevant to the success of the enterprise.  Wal-Mart may have some extraordinarily competent and diligent minimum-wage staffers in its stores, but the consequences of their exceptional performance is virtually invisible in the results of the enterprise.  However, the departure of just one senior investment banker and her small team could cost Goldman Sachs millions of dollars in annual revenue.  When the performance of a specific individual is so closely tied to the economic results of the enterprise (particularly if it is tied in a measurable way) it is obvious that such an individual will be positioned to capture a significant share of the value they create for shareholders.

This observation holds across other sectors with professionals who are generally paid well, and where some individuals receive shockingly high compensation: law, technology, medicine, media, sports, etc.  It is tempting to draw the wrong conclusion that these salaries are a justified consequence of individuals’ effort and educational attainment (e.g., in law or medicine) or of individuals’ innate talents (e.g., among celebrities and star athletes).  Those may matter, but they are nothing without a context in which they belong to someone who has measurable individual influence over the success of a commercial enterprise.  Many talented athletes will never play professionally.  Many exceptionally smart and highly-educated people will not have (or seek) the opportunity to become a partner at a white-shoe law firm.

A much better question to ask with respect to compensation, particularly on Wall Street, is: why are certain roles (and the people who fill them) so critical to the success of the enterprise?  The head of a major trading desk is in a unique position among human worker bees: he or she can make or lose millions (in some cases, billions!) of dollars.  Billions of other humans will never have that chance – but of course, at least three billion people out there would be better than average at it.  To put a less facetious point on it: why is there rarely an attempt to normalize for the conditions that enable certain individuals (by virtue of their institutional roles as well as their innate abilities) to exert significant individual influence over the results of the enterprise?  I will explore this question next time.

Some house-keeping notes on the above:

  • Any company data cited above were pulled from Yahoo! Finance on 1/20/2011 and pertain to the most recently available SEC filings as of the date of this post
  • One can quibble over how to appropriately measure profitability; I choose GAAP net income here because it’s consistent, but I would argue that the choice is immaterial to my argument
  • AT&T reported an $8.3B increase to its Q3 2010 net income as the result of a one-time tax settlement with the IRS, which I subtract from the reported GAAP net income to arrive at the figure I report above; again, I claim this is immaterial to my argument

Bonus? You Just Met Us! (Part 1)

January 19, 2011

Financial institutions and investment firms (to which I will sloppily refer as ‘Wall Street’ here) have been busy tallying the numbers for 2010 in preparation for the annual ritual of bonus payments.  Predictably, there will be some jaw-dropping headline numbers about the size of firms’ payouts and the amounts received by certain individuals; and there will be some uproar from politicians, talking heads, and ordinary people about how such compensation is unjustifiable and probably evil.  Over the next several days, I intend to share some thoughts about the compensation model of Wall Street that I hope will frame the issue in relatively non-judgmental terms, as the pragmatic and moral conclusions one draws from this spectacle will be incorrect absent an objective diagnosis of its root causes.  My general view is that Wall Street’s compensation model exists because clients and investors are willing to pay for it, rightly or wrongly, and that whatever reform one might hope for is a fool’s errand in the absence of meaningful pressure from those stakeholders.  And, more broadly, this model reflects the reality that individuals can generate profits on an enormous global scale, and that our society will (and should) struggle to balance a number of competing values — meritocracy, compassion, liberty, community — in figuring out how to adjust to this reality.

But, first, a small attempt to reframe the narrative of the Wall Street bonus, although one might instead euphemize it as profit-sharing, variable compensation, or simple blood money.   The conventional term ‘bonus’ does not really help Wall Street from a PR point of view, because it connotes something over and above the fair and expected compensation for an employee.  In reality, expectations for bonuses, which may constitute half or more of an employee’s total compensation, are explicitly part of employee’s career decisions.

A better reference for Wall Street bonuses, although at a different scale, would be tips for restaurant servers.  A server would likely not be induced to work just on the basis of his stated wage – it is expected that tips will contribute as well.  His take in tips depends on some factors he can control directly (e.g., his level of service and skill at cross-sales at his tables), some he can influence indirectly (e.g., by exhibiting hospitality and creating a good atmosphere for other servers’ tables), and others totally beyond his control (e.g., whether the economy makes people more or less likely to dine out).  On Wall Street, an individual’s bonus is a function of her personal contribution to the firm’s profitability, her group’s or business unit’s contribution, the firm’s overall results, and other variables such as her political savvy or competitors’ practices.  There may be some mechanisms for pooling tips across tables to mitigate the randomness that comes with table assignments, as banks have multiple business units with different profits and losses.  And I think one can argue reasonably about whether it’s fair that a waiter at Per Se is entitled to the same customary percentage service charge as a diner waiter who “works just as hard” filling orders at a fraction of the check size – just as one might debate the absolute compensation levels on Wall Street relative to, say, the manufacturing sector.

I draw this distinction because narrative matters to our intuitions about fairness.  Take the case of a senior investment banker whose annual compensation is, say, typically $200k of base salary and $800k of bonus.  (I’m making these numbers up.)  She does a phenomenal job and brings in some hugely profitable deals for the bank and its shareholders, but the bank had an awful year because a bunch of traders made bad bets on, hypothetically of couse, mortgage-related securities.  When bonus time comes, perhaps she is only awarded $300k.  From the public’s perspective, it is still outrageous that a struggling bank would pay out any sort of bonus, particularly an amount that is so far above the median income.  From her perspective, however, her wage was unexpectedly cut in half through no fault of her own – a situation not unlike that of displaced factory workers, for instance, but for which the public lacks sympathy because of a sense that she is still “paid enough” already.  Would it be fair for a contractor to finish remodeling your house, only to have you pay half his agreed-upon invoice and escort him outside?  I think the right answer is, “no, except under certain circumstances” and a more constructive debate is whether any of those circumstances obtain rather than whether the overall level of construction costs is too high.  (One such circumstance might be: you would have been forced into bankruptcy if you paid his whole bill, in which case a costly process would have ensued that potentially left everyone worse off – not that I’m trying to find analogies for the financial crisis at every turn…)

I don’t think it’s fair to imagine that Wall Street employees demand ‘lavish’ bonuses because they believe they deserve it for doing God’s work, but rather that they (like everyone) work under certain expectations for what their level of pay will be, and that it’s generally lousy to change the rules after people put in the work that they committed to.  But it is fair to examine critically the myths and realities that drive (total) compensation in the financial sector, which I will take up next time.

Some tidbits in the meantime: the Economist has a fairly reasonable take, and their third point is one of the better arguments in the debate — although I’d note that it doesn’t directly apply to investment firms, which make up a considerable portion of the ‘overpaid’ elite; and I don’t think it goes far enough in examining the way bank employees extract personal rents by virtue of their privileged positions in the economy. This latter point is touched on by RBS’ chairman in this thoughtful interview from the Beeb, although his point is a slightly different one (with which I, generally, agree) — that much of the talent mythology in financial services is, as our friends across the pond might put is, bollocks.

On Odds and End Zones

January 18, 2011

I am about to lose a subset of my audience by writing about football, so I will note up front that: (a) this post is actually mostly about probability, although this may be a worse admission if I’m trying to retain readers; and (b) an erudite friend offers a similar discussion in the context of nominees for Golden Globes, in case football isn’t enough of a spoonful of sugar to help the algebra go down.

As the New York Jets continue their improbable NFL play-off run, I find myself grateful that I don’t bet on sports.  This is not to say that I don’t enjoy gambling, in tightly-managed moderation; and I should point out for good public-sphere hygiene that my completely-legal conduit for such hypothetical wagers would be my parents, as proud residents of the greater Las Vegas area.  Rather, even though I consider myself a loyal fan, I’ve been deeply skeptical that the Jets were a playoff-caliber team, and I was fairly sure that bets against them in each of their last two contests were the closest thing to free money that I could imagine.  (There’s also a bit of a “macro hedge” at work in betting against one’s preferred team, as one has a reason to be happy with either outcome; fans loyal to a bad enough team may even find this a profitable strategy.)

I wouldn’t have said it was impossible that the Jets might win against the Patriots this past Sunday, but my intuition was that the probability couldn’t have been more than 20%, and was likely even closer to 10%.  I attempt to practice what I preach with respect to evaluating the process of risk-taking rather than the outcome, so in the days before the game I turned to the Las Vegas bookmakers to get a feel for what probability was reflected in the market.

Bets on American football come in two flavors: the money line bet, in which odds for the favorite and underdog are explicitly defined; and the point-spread bet, where a handicap is applied in favor of the underdog in an effort to make a “fair” contest out of unevenly matched teams.  A variety of proposition bets may also be offered, such as whether the final score of the game will be greater or less than a given number of points, although analytically these are subsets of the above.  The odds and spreads are generally set by professional bookmakers, in contrast to a sport like horse racing in the U.S. where a parimutuel wagering system sets the odds.

Although the size of the point spread is a crude measure of how much stronger the favorite is than the underdog (i.e., do you need to spot the underdog a field goal, or two touchdowns, to make it an even match?) it is much less precise than the money line as a method for deriving a market-implied probability that either team will win. 

As of January 10th, bookmakers quoted the Patriots (-425) as favorites against the Jets (+325).  These figures are interpreted as: if you bet 100 units on the Jets, you will earn a profit of 325 units if they win; but if you want a profit of 100 units from betting on the Patriots, you will need to risk 425 units.  The size of the wager doesn’t really matter here.  As a concrete example, a $10 bet on the Jets would have returned $42.50 for a win ($10 original investment + $32.50 profit).  A $10 bet on the Patriots would have returned $12.35 ($10 original investment + $2.35 profit).  Clearly, the Patriots were heavy favorites.

Using some basic algebra, one can convert money line odds into probabilities.  Odds of “X to 1” imply a probability of 1/(1+X):
              In 1/(1+X) of cases, your payoff is X
              In the remaining X/(1+X) of cases, your payoff is -1
              Therefore, your expected payoff is 0, making it a fair wager
The money line on the underdog is a bit easier to understand intuitively.  In my example the Jets were listed at odds of 3.25 to 1, which implied a 24% probability that they would win, and by extension a 76% probability that the Patriots would win.  (Ties are not be possible.)

Note, however, that you can only bet on this probability if you want to express the view that the Jets will win.  To bet on the Patriots, you must take the -425 line.  Odds of “1 to X” can be shown to imply a probability of X/(1+X) using the same analysis of expected payoff as above.  So, in this example, the money line implies an 81% probability that the Patriots will win and obviously a 19% probability that the Jets will win – different from the probabilities implied by a bet on the Jets.

If you believe the Jets will win, you will clearly prefer a bet that is priced at a 19% probability that they will win over one that is priced at a 24% probability, but that is not the bet you’re permitted to take; vice versa for the Patriots.  This disconnect is exactly where bookies should make their money.  An analogy in financial markets is the bid-ask spread: a dealer may offer to sell you an asset for $101, but may only bid you $99 if you try to sell that same asset to him.  Wider spreads generally indicate a greater risk to holding an inventory in the asset, for which a market-maker demands compensation.  I won’t discuss bid-ask spreads here other than to note that the money line on a sporting event implicitly makes a bid-ask spread out of the probability of either team winning.

I say bookies “should” make their money based on this spread because it’s certainly possible for bookmakers to lose money – for example, if the book is heavily skewed towards one team, the market clearly believes the bookmaker’s implied probabilities are incorrect, and he stands to make or lose significant money based on the outcome of the game.  This is not a particularly desirable position for a bookmaker.  I assume that bookmakers must have mechanisms to trade risk among themselves, perhaps at ‘wholesale’ spreads; but it is also possible that Las Vegas as a whole may be significantly exposed to one outcome over another.  This also happens in financial markets, but that is another story for another time!

1.  I’ve not looked at the academic literature on sports-betting, but I’d imagine there are troves of cognitive biases and market distortions that have been documented.  The paper linked here seems like a good starting point for going into a bit more detail, but I’m not knowledgeable enough about the field to say that with confidence.

2.  As of Jan 10th, the consensus line on the Jets winning the Super Bowl was approximately 15-1, which implied about a 6% chance that the Jets would go all the way.  Starting from a “mid-market” probability of, say, 21% that they would beat the Patriots, this could have implied that the Jets were 50/50 or better to win their division and the Super Bowl if they got past the Patriots.  These odds don’t necessarily reflect exactly these probabilities – it could have been, say, 75% to win the division, but only 40% to win the Super Bowl – but given that the teams for those contests weren’t known as of Jan 10th, and my general intuition that the Jets would be legitimate Super Bowl contenders in the state of the world where they beat the Patriots, these odds made sense to me (and I wish I had taken them!).

Tuesday: Haikus and Mysteries III

January 18, 2011

wintry mix with ice:
bad forecast for the weather,
good name for a drink!
                                                                              (for mfa)

Today’s mystery: why investigate celebrity Twitter feeds for market manipulation instead of praising them as a tax on idiots?