Valuation-Informed Indexing #343
by Rob Bennett
Say that your boss declared that starting today everyone in your company will set his or her own salary. And say that the company’s accountant recorded the salary changes made at the end of each year and plotted them on a graph. What would the graph look like at the end of a number of years?
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My guess is that for the first few years of the new system the salaries paid would not be too much different than they would have been had the old system remained in place.
All employees would be temped to increase their salaries by 100 percent or 200 percent or 300 percent. But few if any would be so bold in the early days of the new salary-setting procedures. They would wonder if the new policy was for real. Could it be some kind of set-up, a trick to identify the employees so lacking in concern for the larger enterprise that they would pay themselves excessively? Perhaps the better way to proceed would be to grant one’s self the same raise that one expected to receive under the old pay system or at least something close to it.
Of course this would not be true of every single employee. There are always a few bold ones in any group. While most employees would grant themselves five percent or ten percent raises to cover the effects of inflation and some skills enhancement, a small number would push the envelope by voting themselves 20 percent raises or 30 percent raises.
Over time word would get out if these outliers suffered no negative consequences for their boldness. If in the first year only 10 percent of the employees granted themselves raises that would have been considered excessive under the old system, perhaps that number would increase to 20 percent in Year Five and perhaps to 40 percent in Year Ten and perhaps to 80 percent in Year Twenty.
Most employees would worry that, if they got too greedy, they might lose their jobs and thereby ruin their good deal altogether. But that feeling would fade with time if ongoing experiences revealed the worries as unfounded. If the company were taking on debt to cover the excessive salaries, that doubt would accumulate slowly in the early years of the new system but then would begin to grow in bigger and more dramatic leaps as time passed.
The company’s accountants would probably from the first day feel alarmed that the debt that would have to be taken on to cover the excessive salaries would in time bankrupt the company. They would make their concerns known to whoever would listen. But most employees would probably not be too impressed by the logic of their case. Most of us like the idea of determining our own fates. A company in which we can set our own pay is a company in which our efforts never go unappreciated in a financial sense. Some might agree in the early years that the idea of permitting employees to set their own pay is a bit out there. But as years passed and nothing happened, the audience for continued voicing of these common-sense concerns would grow ever smaller. If it’s not broke, don’t fix it. If employees like setting their own pay and the company is doing fine, why make problems?
Eventually, though, the amount of debt being taken on really would get scary. At that point the accountants wouldn’t be able to hold back from expressing their alarm in apocalyptic terms. At that point, a few employees would start to wonder whether the new way really could be sustained. If debt got too high, the company would have to start letting workers go. The logical thing to do would be to put the names of employees who had been the most greedy in setting their own pay at the top of the termination list.
A few employees would set small raises for themselves for the next year. Others would find out that they had done so. These others would reason that the ones limiting their own pay were smart to do so; they were protecting the job. So the others would then limit their pay as well. This new way of gaming the system would increase in popularity much as the older way — granting yourself the most excessive pay raise imaginable — had gained in popularity in an earlier era. Insane pay increases had for a time been the thing. Now tiny pay raises or even pay cuts were in fashion.
Each new pay cut would cause the employees who had not yet joined the pay cut bandwagon to become more anxious re what their fate would be if they jumped on the latest trend too late. Just as excessive pay increases had at one time begot ever more excessive pay increases, now excessive pay cuts would beget ever more excessive pay cuts. If things got sufficiently out of hand, a situation might even develop in which employees voluntarily elected to pay themselves less than their bosses would have elected to pay them under the old system for setting the amount of pay increases; most employees would prefer to be paid less than to lose a job.
The chart of annual pay grades put in place under this system would resemble the chart of stock return gains that we have seen over the 145 years of stock return history available to us today. There is no “Bureau of Stock Returns” that determines how much stock prices should go up each year as the result of economic developments. We investors decide for ourselves how much of a “raise” we have earned each year for investing in U.S. businesses.
We usually vote ourselves raises. We have an inclination to vote ourselves excessive raises. When we get away with it for a time, we notice and respond by voting ourselves even more excessive raises. Then a few of us get spooked that the good times cannot last forever and pull back. Then more pull back. Then prices crash.
The pattern of pay increases described above is the pattern we see when we plot stock returns over long periods of time. There is nothing at all random about the return pattern that applies in the historical record. This same general pattern plays out over and over again. It is the pattern of an emotion-driven system. It is the pattern that would apply in a company which permitted its employees to set their own salary adjustments and it is the pattern that applies in a world in which those giving investing advice feel compelled by their desire for popularity to pretend that all stock gains, even the most insanely excessive ones, are real and in which millions of investors come to believe that they have the power to vote themselves raises as a result.
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