What is Agency Theory?
Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executive, as agents.
Agency Theory is a management and economic theory that explains the various relationships and areas of self-interest in companies. Put another way, agency theory describes the relationship between principals and agents as well as the delegation of control.
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Roger G. Schroeder, M. Johnny Rungtusanatham and Susan Meyer Golstein, in their 2011 article, “Operations Management in the Supply Chain: Decisions and Cases” stated that Agency theory also explains how best to organize relationships in which one party, called the “principal,” determines the work and in which another party, known as the “agent,” performs or makes decisions on behalf of the principal.
In proprietorships, partnerships, and cooperative societies, owners are actively involved in management. But in companies, particularly large public limited companies, owners typically are not active managers. Instead, they entrust this responsibility to professional managers who may have little or no equity stake in the firm.
There are several reasons for the separation of ownership and management in such companies:
- Most enterprises require large sums of capital to achieve economies of scale. Hence it becomes necessary to pool capital from thousands or even hundreds of thousands of owners. It is impractical for many owners to participate actively in management.
- Professional managers may be more qualified to run the business because of their technical expertise, experience, and personality traits.
- Separation of ownership and management permits unrestricted change in owners through share transfers without affecting the operations of the firm. It ensures that the ‘know-how’ of the firm is not impaired, despite changes in ownership.
- Given economic uncertainties, investors would like to hold a diversified portfolio of securities. Such diversification is achievable only when ownership and management are separated.
While there are compelling reasons for separation of ownership and management, a separated structure leads to a possible conflict of interest between managers (agents) and shareholders (principals). Though managers are the agents of shareholders, they are likely to act in ways that may not maximise the welfare of shareholders.
In practice, managers enjoy substantial autonomy and hence have a natural inclination to pursue their own goals. To prevent from getting dislodged from their position, managers may try to achieve a certain acceptable level of performance as far as shareholder welfare is concerned.
However, beyond that their personal goals like presiding over a big empire, pursuing their pet projects, diminishing their personal risks, and enjoying generous compensation and lavish perquisites tend to acquire priority over shareholder welfare.
Agency theory assumes that the interests of a principal and an agent are not always in alignment. The lack of perfect alignment between the interests of managers and shareholders results in agency costs which may be defined as the difference between the value of an actual firm and value of a hypothetical firm in which management and shareholder interests are perfectly aligned.
To mitigate the agency problem, effective monitoring has to be done and appropriate incentives have to be offered. Monitoring may be done by bonding managers, by auditing financial statements, by limiting managerial discretion in certain areas, by reviewing the actions and performance of managers periodically, and so on.
Incentives may be offered in the form of cash bonuses and perquisites that are linked to certain performance targets, stock options that grant managers the right to purchase equity shares at a certain price, thereby giving them a stake in ownership, performance shares given when certain goals are achieved, and so on.
The design of optimal compensation contract depends on several factors such as the extent to which the actions of managers are observable, the degree of informational asymmetry between managers and shareholders, the differences in the time horizons of managers and shareholders, the differences in the risk tolerance of managers and shareholders, and the adequacy of performance metrics.
Good corporate governance, including optimal compensation contract design, is important for maximising the value of the firm and optimising the allocation of capital in the economy.
Special Considerations in Agency Theory
Agency theory addresses disputes that arise primarily in two key areas: A difference in goals or a difference in risk aversion.
For example, company executives may decide to expand a business into new markets. This will sacrifice the short-term profitability of the company in the expectation of growth and higher earnings in the future. However, shareholders may place a priority on short-term capital growth and oppose the company decision.
Another central issue often addressed by agency theory involves incompatible levels of risk tolerance between a principal and an agent. For example, shareholders in a bank may object that management has set the bar too low on loan approvals, thus taking on too great a risk of defaults.
Agency Costs
Agency costs refer to the conflicts between shareholders and their company’s managers. Suppose a shareholder, a principal, wants the manager, the agent, to make decisions that will increase the share value. Managers, instead, would prefer to expand the business and increase their salaries, which may not necessarily increase share value. In a publicly held company, agency costs occur when a company’s management, or agent, place their own personal financial interests above those of the shareholder or principal.
Agency costs can be either:
- Those incurred if the agent uses the company’s resources for his own benefit.
- The cost of techniques that principals use to prevent the agent from prioritizing his interests over shareholders’ interests.
To prevent the agent from acting to benefit himself, shareholders, or principals, may offer financial incentives to keep shareholders’ interest as the top priority. “This typically means paying bonuses to management if and when share price increases or by making the management’s salary partial shares in the company”. Such incentives are an example of agency costs. If the incentive plan works, these agency costs will be lower than the cost of allowing the management to act in their own interests.
Agency costs are important because although they are difficult for an account to track, they are just as difficult to avoid. This is because principals and agents can have very different motivations.
Agency Conflicts
Implied in the fact that agents and principals have very different motivations, is the fact that conflicts can easily arise because of those differing goals. These causes of agency problems can arise because of differences between the goals or desires between the principal and the agent. Put another way, agency problems arise because of the inherent conflict of interests between agents and principals.
“Agency theory assumes both the principal and the agent are motivated by self-interest. This assumption of self-interest dooms agency theory to inevitable inherent conflicts. Thus, if both parties are motivated by self-interest, agents are likely to pursue self-interested objectives that deviate and even conflict with the goals of the principal”.
Agency problems, also known as “principal-agent problems or asymmetric information-driven conflicts of interest,” are inherent in corporate structures. This conflict arises when separate parties in a business relationship, such as a corporation’s managers and shareholders, or principals and agents, have disparate interests.
Principals hire agents to represent principals’ interests. Agents, working as employees, are assumed and obligated to serve the principal’s best interests. Problems occur when the agent begins serving different interests, such as the agent’s own interests. Thus, conflict occurs between the interests of principals and agents when each party has different motivations, or incentives exist that place the two parties at odds with each other.
Resolving Agency Conflicts
Companies use several methods to avoid agency conflicts, including monitoring, contractual incentives, soliciting the aid of third parties or relying on other price systems.
- Creating incentives for employees: If agents are acting in their own interests, changing incentives to redirect these interests may be beneficial for principals.
“For example, establishing incentives for achieving sales quotas may result in more sales people reaching daily sales goals. If the only incentive available to sales people is hourly pay, employees may have an incentive discouraging sales”.
Companies would do well to create incentives that encourage hard work on projects that benefit the company. This will motivate more employees to act in the business’s best interest. By aligning agent and principal goals, agency theory attempts to bridge the divide between employees and employers created by the principal-agent problem. - Using standard principal-agent models: Financial theorists, corporate analysts and economists create principal-agent models to spot and minimize costs.
For example, most agency experts try to design contracts that can align the incentives of both parties – the agent(s) and principal(s) – in a more efficient manner. Unfortunately, such contracts result in unintended consequences. Using a much-used cliche, the principal-agent model seeks to help companies and investors create a win-win situation. - Using agency theory, itself: Agency theorists use written contracts and monitoring, to avoid agency problems.
For example, Apple Inc. in 2013 began requiring senior executive employees and board of directors members to own stock in the company. This move was intended to align executive interests with those of shareholders as management was no longer benefited from actions that harm shareholders because members of management were themselves, investors. As in the principal-agent models, Apple sought to create a win-win situation for principals and agents. - Using the market for corporate control: The most frequent example of market discipline for corporate managers is the hostile takeover, in which bad managers damage shareholders’ interests by failing to realize a corporation’s potential value. The solution is to provide an incentive for better management to take over and improve operations. Even better: Giving new management a stake in the company, through equity shares for example, would help align the interest of management, the agents, and the investors, the principals.
Influence of Psychology
Psychological influences, which have been brushed aside by the rational model of finance, seem to matter. Hence, in recent decades many researchers have looked at how human psychology shapes financial decision-making and financial markets. The efforts of these researchers have led to the emergence of behavioural finance, a relatively new field.
According to behavioural finance, investor’s behaviour in market depends on psychological principles of decision making, which explains why people buy and sell investments. It focuses on how investors interpret information and act on information to implement their financial investment decisions. In short psychological process and biases influences investors decision making and influence the market outcomes.
The votaries of the rational model have, however, criticised behavioural finance as it lacks a unified theory. But, such criticism, cannot detract from the need to recognise the importance and relevance of psychology in understanding the behaviour of investors, finance practitioners, managers, and financial markets. This need was recognised decades ago by John Maynard Keynes, regarded by many as the most influential economist of twentieth century. Here is a passage from his seminal work The General Theory of Employment, Interest, and Money, published in 1936.
“If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the markets, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise.
As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.”
While the theory that currently dominates finance teaching provides a useful framework for thinking about finance problems, it has its limitations. So, it should be taught less inflexibly and more pragmatically.
As Robert Shiller put it, “For me, alternative views that must be incorporated into our teaching include those promoted by the other social sciences: psychology, sociology, political science, and anthropology. For me, maintaining a proper perspective on alternative views means also incorporating historical analysis. For me, too, we must also keep in view that fundamental importance of institutions, our established organisation practices, and laws- and remind our students that these must be taken into account before judging any economic model.”
Psychological Tendencies Affecting Financial Decision-Making and Financial Markets
Behavioural finance is informed by three strands of psychology. First is cognitive or behavioural psychology, where the focus is upon how our minds undertake the requisite calculations required to maximize wealth. The second is emotional responses to the intensity of trading, where the focus is on decision-making. The third is social psychology, which recognises the need to find acceptance and even encouragement of our acts.
Cognitive biases describe the innate tendencies of the human mind to think, judge, and behave in irrational ways that often violate sensible logic, sound reason or good judgment. The average human – and the average investor – is largely unaware of these inherent psychological inefficiencies, despite the frequency with which they arise in our daily lives and the regularity with which we fall victim to them.
Following are the most common psychological tendencies, chosen for both their prevalence in human nature and their relevance to investing in the financial markets:
Anchoring
Also referred to as focalism, anchoring is the tendency to be over-influenced by the earliest information presented to us when making decisions, thereby allowing oneself to be driven to a decision or conclusion that is biased towards that initial piece of information. This earliest piece of information is known as the “anchor,” the standard off of which all other alternatives are judged. Thus, subsequent decisions are made not on their own, but rather by adjusting away from the anchor.
For example, in price negotiations over a used car, the first price offered by the salesman sets the anchor point from which all subsequent offers are based. By offering an initial price of, say, $30,000, a used-car salesman anchors the customer to that price, implementing a bias towards the $30,000 level in the subconscious of the other party. Even if the $30,000 offer is significantly above the true value of the car, all offers below that level appear more reasonable and the customer is likely to end up paying a higher price than he or she originally intended.
Loss Aversion and the Endowment Effect
First demonstrated by prominent psychologists Amos Tversky and Daniel Kahneman, the concept of loss aversion refers to the human tendency to strongly prefer decisions that allow us to avoid losses over those that allow us to acquire gains. Many studies on loss aversion commonly suggest that the human perception of loss is twice as powerful as that of gain. This forms the basis of what is known as Prospect Theory, a behavioural economics concept that describes the way in which people choose between probabilistic alternatives that involve risk. At its core, Prospect Theory shows that a loss is perceived as more significant than an equivalent gain.
The endowment effect describes the human tendency to place greater value on a good that we own than that which we place on an identical good that we do not own.
It is easy to see how these tendencies can influence an investor. Loss aversion has a distinct impact on our risk tolerance both before and after executing a trade. Combined with other cognitive biases, our tendency to steer away from loss can lead to denial as losses build in a poor position, for example, causing us to ignore weakening positions in an attempt to diminish their emotional impact.
Similarly, if the endowment effect leads us to ascribe greater value to a security simply because we feel a sense of ownership over it, then that emotional attachment can lead to clouded judgment when the time comes to sell.
Framing Effect
The framing effect describes our tendency to react to, judge, or interpret the exact same information in distinctly different ways depending on how it is presented to us, or “framed” (most commonly, whether the information is framed as a loss or as a gain). People tend to avoid risk when information is presented in a positive frame but seek risk when information is presented in a negative frame.
It is no secret that investors in the financial markets are under a constant barrage of information from all different sides – bullish, bearish, and everything in between. The exact same information can be framed by multiple sources in many different ways, biasing your interpretation of it. As you filter the stream of news and financial data that comes your way, consider the manner in which those numbers, statistics or reports are framed and think about the impact that their presentation has on the opinions they lead you to form.
Confirmation Bias
Confirmation bias is the tendency to overweight, favour, seek out, exaggerate or more readily recall information or alternatives in a way that confirms our preconceived beliefs, hypotheses or desires, while simultaneously undervaluing, ignoring or otherwise giving disproportionately less consideration to information or alternatives that do not confirm our preconceived beliefs, hypotheses or desires. This inherent flaw in our cognitive reasoning leads to misconstrued interpretations of information, errors in judgment, and poor decision making.
The effects of confirmation bias have been shown to be much stronger for emotionally-charged issues or beliefs that are deeply entrenched. In addition to overvaluing information that confirms our preexisting beliefs, confirmation bias also includes our tendency to interpret ambiguous evidence as supporting existing positions, even if no true relationship exists.
In short, this concept says that individuals are biased towards information that confirms their existing beliefs and biased against information that disproves their existing beliefs, leading to overconfidence in our opinions and our decisions even in the face of strong contrary evidence.
As an investor in the financial markets, it can be difficult to maintain a separation between informed estimates or expectations and emotional judgments based on hopes or desires. By causing us to overweight information that confirms such hopes or desires, confirmation bias can affect our abilities to make sound assessments and form well-reasoned opinions about, for example, a stock’s upside potential.
Awareness of our natural biases towards confirming information and, perhaps more importantly, our biases against disproving information is the first step in combating the unwanted effects of confirmation bias.
Hindsight Bias
Hindsight bias describes our inclination, after an event has occurred, to see the event as having been predictable, even if there had been little to no objective basis for predicting it. This is the psychological tendency that causes us, after witnessing or experiencing the outcome of even an entirely unforeseeable event, to exclaim “I knew it all along!”
Sunk Cost Fallacy
The sunk cost fallacy rests on the economic concept of a sunk cost: a cost that has already been incurred and cannot be recovered. While theoretical economics says that only future (prospective) costs are relevant to an investment decision and that rational economic actors therefore should not let sunk costs influence their decisions, the findings of psychological and Behavioural finance research show that sunk costs do in fact affect real-world human decision making.
Because of our tendencies towards Loss Aversion and other cognitive biases, we fall victim to the sunk cost fallacy, which describes our irrational belief that sunk costs should be considered a legitimate factor in our forward decision making when, in fact, their consideration often leads us towards inefficient outcomes.
In an investment setting, the consequences of the sunk cost fallacy can be more severe. As the share price of a security falls, investors often begin to employ the logic that “I’ve already lost $XXX, it’s too late to sell now.”
As prices keep falling further and losses grow, the investor’s commitment to the sunk cost continues to escalate. “Now I’ve lost $XXXXX, there’s no way I can sell now. It has to come back eventually. I’ll just hold on to it.” Improper or irrational considerations of sunk costs can lead to poor decisions that continue to spiral out of control, simply because of an incorrect perception of an expense that is irrecoverable.
Gambler’s Fallacy
The gambler’s fallacy, also known as the Monte Carlo Fallacy, is the mistaken tendency to believe that, if something happens more frequently than “normal” during a period of time, it must happen less frequently in the future, or that, if something happens less frequently than “normal” during a period of time, it must happen more frequently in the future.
This tendency presumably arises out of an ingrained human desire for nature to be constantly balanced or averaged. In situations where the event being observed or measured is truly random (such as the flip of a coin), this belief, although appealing to the human mind, is false.
The gambler’s fallacy is, rather obviously, most strongly associated with gambling, where such errors in judgment and decision making are common. It can, however, arise in many practical situations, including investing. Winning and losing trades are in many ways similar to the flip of a coin and thus subject to the same psychological biases.
If an investor has a series of losing trades, for example, he or she can begin to erroneously believe that, since the statistics feel unbalanced, his or her probability of making a profitable trade increases. In reality, the probability of his or her next trade being profitable is unaffected by previous losses.
Hot-Hand Fallacy
The hot-hand fallacy is the mistaken belief that an individual who has experienced success with a random event has a greater chance of continuing that success in subsequent attempts. This cognitive bias is most frequently applied to gambling (where individuals in games such as blackjack believe that the luck they have randomly stumbled upon is actually a “hot hand” and will continue indefinitely) and sports such as basketball (where “hot” shooters see a spike in confidence after making multiple shots in a row, fueling a belief that the trend will continue throughout the rest of the game).
While previous success at a skill-based athletic task, such as making a shot in basketball, can change the psychological behavior and future success rate of a player, researchers continue to find little evidence for a true “hot hand” in practice.
Similar to what was discussed with the gambler’s fallacy, individuals often have trouble processing or believing statistically- acceptable deviations from the average, causing them to assume that forces other than normal statistics must be at play. As an investor, a series of winning trades can induce risky overconfidence one’s “hot hand” of the moment, leading to errors in judgment and poor decision making.
Money Illusion
In economics and behavioural finance, the money illusion describes the tendency to think of currency in nominal terms rather than in real terms. In other words, humans commonly consider money in terms of its numerical or face value (nominal value) instead of considering it in terms of its real purchasing power (real value). Because modern currencies have no intrinsic value, the real purchasing power of money is the only true (and rational) metric by which it should be judged.
Still, humans often struggle to do so because, derived from all the complex underlying value systems in both domestic and international economies, the real value of money is constantly changing. In the financial markets, many average investors commonly ignore the real value of their currency when valuing their investments or interpreting their appreciation, leading to incorrect perceptions of value and past performance.
