Should we reward luck?
Over the past 20 years it has become usual procedure to pay executives with stock options. In his book “The Success Equation” Michael Mauboussin showed that whereas only 1 percent of a CEO’s pay was tied to the stock price in 1985, 60 percent of their pay was tied to it ten years later.
In many ways it makes perfectly sense to make stock options the primary means for paying executives, because it guarantees that they stay in the same boat as the investors.
However, the problem with using stock options as rewards is that they reflect an enormous amount of randomness. A change in the price of stock options combines a set of expectations for the company’s financial performance in the future and lots of variables that are outside of the company’s control, including interest rates, the rate of general economic growth, regulations, the appetite for risk of investors, and so forth.
In other words: changes in stock prices are the result of some skill but also a great deal of luck. And that’s the problem. Most company’s reward systems are not able to distinguish between skill and luck. This is not to say the skill doesn’t matter, but in an environment that has lots of luck it might be more important to reward good process than outcomes.
The question that any investor, owner or executive must ask themselves is: How can we build a reward system that untangles skill and luck?