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Incentives matter. But how much do they influence asset prices?
Nowadays, most investors delegate money management to professional asset managers, whose compensation has little downside risk and high upside potential due to variable compensation. At Robeco, we believe that such option-like incentives is one of the reasons the low-volatility effect is growing stronger. Experimental economics offers some deeper insights into this.
In a controlled trading environment, professor Kleinlercher and his co-authors* let 480 students trade a low-risk asset and a high-risk asset. When all market participants had bonus incentives, the risky asset ended up being overvalued by a hefty 70%. Meanwhile, when some investors had a linear incentive structure and a penalty incentive structure, the risky asset ended up with a significantly lower 30% overvaluation. In this case, investors with option-like incentives lost money while those with linear payoffs were able to grow their wealth and generate good total returns.
These results show how option-like incentives can strongly distort the price of low and high-risk assets. That’s good news for prudent investors: they may benefit from other bonus maximizing investors who rationally overpay for risk.
*‘The impact of different incentive schemes on asset prices’, Daniel Kleinlercher, Jürgen Huber and Michael Kirchler, European Economic Review, Volume 68, May 2014, Pages 137–150.