Some financial decisions should be no-brainers. Yet it's when the brain gets in the way that things turn most interesting

By Matt Golosinski

How to minimize risk while maximizing reward is the heart of finance. In their efforts to break new ground on this subject, Kellogg School finance professors employ a variety of tools and theories to conceptualize risk, all of which prove extremely beneficial for those looking to make smart decisions about capital reallocation, for instance.

These frameworks and methodologies include such industry bulwarks as the capital asset pricing model, real options, agency theory, portfolio theory and more. Each of these ways of thinking about risk and reward yields its own special discoveries, but at root each approach requires researchers to take a close look at what motivates people to invest or disinvest in practice.

	© Nathan Mandell In their research, Professors Andrea Eisfeldt and Andriano Rampini seek a better understanding of asset reallocation and explore the role managerial incentives play.

The "in practice" qualifier is an important one, since from a Finance I perspective, certain investment decisions ought to be straightforward, based on fundamental assumptions and driven by the numbers. Theoretically, some transactions should be merely the outcome of using the capital asset pricing model (CAPM, a way of thinking about diversifiable and nondiversifiable risk) to calculate net present value (NPV, the difference between the cost of undertaking a project and the expected returns from that project). In this scenario, the hardest part may simply be waiting for the earnings statement to reflect the financial architect's wise, if conventional, choices.

While some decisions are this obvious, many others are far more complex, their risks subtle and their outcomes shrouded in the whims of a volatile market that the finance models try to keep up with. It is this fact that makes finance so engrossing, or nerve-wracking, depending upon one's perspective and portfolio.

One idiosyncratic challenge facing economists, finance scholars, investment bankers and CFOs is that, unlike many other academic disciplines, finance works in a more "real-time" relationship with the marketplace.

"Whether you are doing macroeconomics, labor economics or finance, you're sort of stuck with the historical record," says Robert Korajczyk, senior associate dean: curriculum and teaching, and an asset pricing expert.

"You don't have the luxury that experimental sciences have. There are some people doing experiments in finance, but there are issues about whether those experiments with small groups generalize to a market where you have people competing with one another," adds Korajczyk, who is also the Harry G. Guthmann Distinguished Professor of Finance.

Behaviors apparent in a smallenvironment may not be sustainable in a larger environment, he points out.

Yet despite this experimental limitation, Kellogg School finance professors continue to produce compelling research. Their typical destination? Into the unknown. After all, it's uncertainty that breeds risk: the things we don't know can create situations in which asymmetric information establishes a dynamic where fortunes are won or lost.

Why bad managers need a bigger paycheck
Large severance payments to managers leaving firms are certainly controversial, but if Andrea Eisfeldt and Adriano Rampini are correct in their theories about asset reallocation, those big bonuses are no mistake.

The Kellogg School finance professors have been focusing their attention on the role managerial incentives play in capital budgeting, in particular, the way managers' preferences influence investment decisions during both economic booms and downturns.

At the heart of their recent work is understanding how to get capital resources —such things as machines, manufacturing plants, and other physical inputs —into the hands of those firms that can make the most productive use of them. Too often, they say, underperforming companies are reluctant to sell their resources. As a result, firms that are performing well may not be able to acquire additional resources, even though there are potentially large gains from trade.

To makes matters worse, this curious dynamic plays itself out in a way that makes recessionary troughs deeper while acting as a drag on the potential of boom times to deliver even greater returns, say Rampini and Eisfeldt.

"We're trying to understand aggregate output over the business cycle," says Eisfeldt. "You have recessions where aggregate output is low, and booms where aggregate output is high. Part of what determines aggregate output is how resources are allocated between people who can use them really well, and people who can't use them well."

She and Rampini have investigated the factors that they believe drive this dynamic. Their findings point to managerial incentives and draw upon the insights of agency theory, a way of thinking about incentives in corporate teams. Agency theory considers the relationships between shareholders (or principals) and managers (their agents). The theory's central assumption is that not everyone has the same goals or motivations, even if they're on the same team—something the Kellogg School researchers have validated and developed in their own theories.

"It's puzzling. We see a lot of reallocation of capital during booms, versus recessions. We see lots of mergers and acquisitions, and sales of capital and equipment. We see the flow of capital from low-productivity firms to high-productivity firms in good times, when the benefits in terms of productivity differences across firms are smaller, and not so much in bad times, when the potential productivity gains are largest," says Eisfeldt.

"Our question is: What is it that keeps capital from moving to the highest productivity firms, in particular in bad times?"

Part of the answer is that managers of less-productive firms are unwilling or very slow to divulge negative information about the performance of the assets under their control.

Managers of low-productivity firms (or divisions within firms) will know details about their under-performance long before that information becomes public and can be acted on by stakeholders. By the time this information makes the rounds, considerable damage has already been done: opportunities to reallocate with maximum effectiveness will have been lost, and costs associated with the poor productivity will have already taken a toll on the firm.

This dynamic, played out over many firms, also influences the aggregate market, contend Eisfeldt and Rampini. This fact makes the implications of their research important for investigating new capital reallocation strategies that minimize the fallout from under-producing firms by encouraging this capital to flow to the firms that can best utilize it.

The challenge is to provide incentives for the low-productivity manager to sell assets to the high-productivity manager, Rampini says. It's difficult to get managers to reveal bad news early. "You've got to give them something to motivate them to reveal this information. If you don't do anything, they won't tell you, because the outcome is only bad for them."

The incentive typically involves cash. But here is where things get tricky. Pay managers too much, and the incentive value disappears, since managers may figure that they will be compensated handsomely regardless of performance. Pay them too little, and they are likely to conceal that all-important productivity information essential to capital reallocation.

Most people will be able to explain why you would pay managers more when they do well and pay them less when they do poorly, says Eisfeldt.

"That's the standard way of thinking," she says. "Our idea is going to have you paying managers when they do poorly. That's hard to explain to some people. But if you don't pay managers when they're doing poorly, they might know they're doing poorly and not reveal it," resulting in even more serious problems for the firm.

Next page: "The lenders know it, the investors know it, the entrepreneurs know it. Why don't people then diversify the risk?"
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