The Agency Dilemma in Finance

Principal/Agent dilemma is one of the major issues in the business world, having direct repercussions in the financial area.

Principal is someone who hires another person or entity (the agent) to represent him / her in a specified way.

For example, shareholders vote for the Board of Directors, which then hires CEO and other executives. If you own stocks in a company, you’re the principal whose interests the agents are supposed to represent.

Although, the agents are supposed to put your interests first, often this is not the case. Company’s management may be concerned with their own benefits (bonuses, stock options, corporate jets) rather than maximizing shareholders’ wealth.

At times, corporations, to satisfy investors, will play with accounting numbers (so-called  “window dressing”). Often, these are short-term solutions designed to achieve rewards for the principals.

Not often, but it happens, executives will steal from the companies they manage and fake the numbers (also known as “cooking the books”). There are many examples of shareholder wealth destruction such as WorldCom, Enron, Tyco, and so on.

Another example of principal/agent conflict is when it comes to financial advising/planning. Advisors get paid by their clients (principals), otherwise they wouldn’t make a living. However, it becomes a problem when an advisor will offer a product that pays the highest commission to the advisor, rather than taking his client’s interests above his own.

The dilemma is that we entrust money to others, while they don’t always care about our interests.

Becoming an educated investor is certainly a way to protect yourself from being exploited. 

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Agents need to be competent and loyal to their principals