Why Banks Should Use Less Debt Financing

In the aftermath of the financial crisis, there have been numerous calls for banks to finance themselves less with debt and more with equity, to reduce the risk of another crisis. But this has been met with great resistance by bankers. They argue that equity is costlier than debt, and so forcing them to use more equity will make it more expensive for them to raise capital. If they can't raise as much capital, they won't be able to lend as much to small businesses and homeowners; if it's more expensive to raise capital, they'll need to take on riskier projects to generate a high enough return to meet their cost of capital. For example, Jamie Dimon of JP Morgan has said (paraphrased): "If they force us to hold more equity, we will have to take on riskier projects to hit our required return on equity".

The Modigliani-Miller theorem, taught in undergrad or MBA finance 101, tells us that (under certain conditions), firm value is independent of capital structure - equity is no more costly than debt. Indeed, Jamie Dimon's seemingly intuitive argument involves not one, not two, but three violations of basic finance theory:

1. It treats the required return on equity as a constant (as if it were pi or Avogadro's number). But, basic finance theory tells us that it depends on financial risk. If the firm is financed by more equity, it's less risky, and so shareholders demand a lower return on equity. Banks won't need to take on more risk, because the target will have fallen.
2. Basic finance theory tells us that the required return on equity also depends on business risk. If the firm "takes on riskier projects", shareholders will demand a higher return as a result. Thus, banks won't have an incentive to take on more risk, because this will cause the target to rise.
3. Equity is not something that you "hold". It doesn't sit idly on the balance sheet doing nothing - the bank can invest or lend the money raised by equity. Equity isn't an asset, it's a liability - it's how a bank finances itself. If a firm finances itself with equity rather than debt (changes its liability mix), it needn't change the projects it invests in (its asset mix).

The fallacies inherent in most bankers' arguments are exposed in Anat Admati and Martin Hellwig's influential book "The Bankers' New Clothes"; see this link for non-technical articles on this topic. However, some bankers may counter that the Modigliani-Miller theorem doesn't hold in the real world. There are valid reasons for why it's advantageous to finance with debt rather than equity - debt gives tax shields, and incentivizes management to work harder to avoid bankruptcy.

But a new paper by Roni Kisin and Asaf Manela of the Olin School of Business at Washington University in St. Louis exposes these arguments - using banks' own actions! They find that bankers' own behavior suggests that they don't view debt as useful - that the above advantages of debt are small in the real world. Their identification is clever. They exploit the fact that, prior to the crisis, banks had access to a loophole - asset-backed commercial paper conduits (a form of securitization) that allowed them to lower their equity capital requirements by 90%.

Using these conduits was costly - the interest rate on asset-backed commercial paper is higher than that on directly-issued commercial paper (which didn't benefit from the loophole). Thus, banks traded off the benefits (of reducing equity capital requirements) with the costs of using the conduit. If financing themselves with equity, rather than debt, truly was costly, banks would have used the conduits to a large degree - particularly since the availability of the loophole was well-known to all banks.

But they didn't. Roni and Asaf estimate that, based on the limited usage of these conduits, it's not costly for banks to finance themselves with equity. Even if banks were to increase their equity ratios from 6% to 16%, this would cost all U.S. banks in aggregate $3.7 billion. The average cost per bank is $143 million, or 4% of annual profits. Lending interest rates would rise by 0.03% and quantities would decrease by 1.5%. While the above numbers are not small, they are far lower than the numbers branded around by bankers, and arguably a small price to pay to substantially reduce the risk of another crisis.

One caveat is that the authors are clear that they quantify the cost of increasing equity capital requirements, rather than the cost of increasing equity capital. It may be that the cost of increasing equity capital requirements is low, not because the cost of raising equity is low, but because banks have other ways of complying with the requirements (e.g. other loopholes, or changing the riskiness of the assets they invest in). Nevertheless, the paper provides innovative evidence that increasing capital requirements is much lower than what many banks claim.

How Corporate Credit Ratings Induce Short-Termism

Credit rating agencies were under particular scrutiny in the recent financial crisis, as critics argue they gave too high ratings to securities that turned out to be toxic. One potential culprit is the "issuer-pays" model, where it is the company being rated that pays for credit ratings, which may encourage rating agencies to be overly-generous to win business.

But, a recent paper by my new LBS colleague Taylor Begley points to an important additional cost of corporate credit ratings - and one that arises even if ratings are perfectly accurate. Companies may engage in short-term behavior to achieve a particular credit rating. This problem arises because credit ratings are discrete categories (e.g. AAA, AA+, BB) rather than a continuous number (e.g. 93.2, 87.8). Thus, a company has a strong incentive to just get into the AAA- category than be at the top of the AA+ category.

In turn, a major driver of credit ratings is a company's financial ratios. For example, for firms with an excellent business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of AA; a ratio of 2.0-3.0 typically leads to a rating of A. For firms with a fair business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of BBB-; a ratio of 2.0-3.0 typically leads to a rating of BB+ (which is below investment-grade, i.e. has "junk" status). (Source: Standard & Poor's Business Risk / Financial Risk Matrix).

These discrete thresholds thus give companies incentives to be lie just below a threshold. They can achieve this by short-term behavior such as cutting research and development (R&D). This increases EBITDA, thus reducing the Debt/EBITDA ratio and potentially meeting the threshold. Importantly, the incentives to engage in short-termism depend on where the firm is compared to the next lowest threshold. A firm with a Debt/EBITDA ratio of 2.1 has strong incentives to engage in short-termism, because it has a high chance of being able to lower it to below 2.0, but a firm with a Debt/EBITDA ratio of 2.5 has much weaker incentives. Taylor indeed finds that firms close to a threshold are significantly more likely to cut not only R&D, but also selling, general, and administrative (SG&A) expenses, which contains expenditure in advertising, information technology, employee training, and other forms of organizational capital.

Other papers have previously found evidence of short-termism to meet other types of thresholds - for example, companies may cut R&D to ensure their earnings fall just above analyst earnings expectations. But a particularly novel finding of this paper is that Taylor is able to document negative long-run effects of such short-termism. Companies close to ratings thresholds subsequently suffer declines in the number of patents that they produce, and also the number of citations to their patents (a measure of the quality of innovation). They also experience declines in profitability and valuation ratios.

The cost of credit ratings that critics typically focus upon is that inaccurate ratings lead to redistributional consequences. If the ratings of a security are too high, the buyer pays too much for them. Thus, the seller wins and the buyer loses. While these redistributional concerns are clearly very important, they don't directly affect the overall size of the pie (sellers get a larger slice, buyers a smaller slice). In contrast, Taylor shows that credit ratings have efficiency (rather than just redistributional) consequences - they affect the overall size of the pie. If companies cut investment to meet ratings thresholds, they erode their future value, making everyone worse off in the long-run. This is a particular concern for the 21st century firm, whose value is especially driven by intangible assets (such as brand strength, innovative capabilities, and corporate culture) which requires several years to build and bear fruit.

The paper certainly does not argue that credit ratings should be scrapped; these costs must be weighed against their numerous benefits. Many financial targets (e.g. analyst earnings expectations) also have the potential to lead to short-termism. Rather, the paper highlights a potential cost to credit ratings that boards may be able to mitigate. One potential remedy that discussed in a previous post is to increase the vesting period of executives' stock and options, to tie them to the long-run performance of the firm. 

Reforming CEO Pay - The Dangers of Short-Term Incentives

(This post originally appeared on LinkedIn)

Executive pay is a high-profile topic about which almost everyone has an opinion. Many shareholders, workers, and politicians believe that the entire system is broken and requires a substantial overhaul. But, despite being well-intentioned, their suggested reforms may not be targeting the elements of pay that are most critical for shareholder value and society.

Level 1 Thinking: The Level of Pay

Much of the debate is on what I call a Level 1 issue - the level of pay. For example, in September 2013, the SEC mandated disclosure of the ratio of the CEO’s pay to the median employee’s pay. The European Commission is contemplating going further and requiring a binding vote on this ratio. Separately, proposals to increase taxes – most prominently made by Thomas Piketty – are a response to seemingly excessive pay levels.

While high taxes or ratio caps would indeed address income inequality (an important topic, but beyond the focus of this article), it's very unclear that they would do much to improve shareholder (or stakeholder) value. The levels of CEO pay, while very high compared to median employee pay – and thus a politically-charged issue – are actually very small compared to total firm value. For example, median CEO pay in a large US firm is $10 million – only 0.05% of a $20 billion firm. That’s not to say that it’s not important – a firm can't be blasé about $10 million – but that other dimensions may be more important.

Level 2 Thinking: The Sensitivity of Pay

Instead, what matters for firm value isn't the level of pay, but the incentives that it provides to CEOs: as Jensen and Murphy (1990) famously argued, “it’s not how much you pay, but how”. Level 2 thinking studies the sensitivity of pay to performance. Specifically, it looks at how much of a manager’s total pay is comprised of stock and options (which are sensitive to firm value) rather than cash salary (which is less so). As the thinking goes, greater stock and options align the CEO more with shareholders and thus provide superior incentives. Indeed, Jensen and Murphy bemoaned the low equity incentives at the time as evidence that CEOs were “paid like bureaucrats”.

However, while seemingly intuitive, the idea that better-incented CEOs perform better is unclear. Out of all the banks, Lehman Brothers had arguably the compensation scheme closest to what Level 2 thinkers argued is the ideal – very high employee stock ownership. Using a larger sample, Fahlenbrach and Stulz (2011) “find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better.” Indeed, the European Commission has recently capped banker bonuses at two times salary, seemingly reducing bankers’ incentives to perform well – but also reducing their punishment if things go badly.

Level 3 Thinking: The Structure of Pay

The concern with high equity incentives is that they encourage CEOs to pump up the short-term stock price at the expense of long-run value – for example, writing sub-prime loans and then cashing out their equity before the loans become delinquent. But, the root cause of this problem isn't the amount of stock and options that the CEO has, but their vesting horizon – whether they vest in the short-term or long-term, and thus whether they align the CEO with short-term or long-term shareholder value. Level 3 thinking thus focuses on the structure of pay.

There's anecdotal evidence that horizons mattered in the financial crisis. Angelo Mozilo, the former Countrywide CEO, made $129 million from stock sales in the twelve months prior to the start of the crisis; a Wall Street Journal article entitled “Before the Bust, These CEOs Took Money Off the Table” documented similar practices among other bank CEOs. But, we can't form policy based on a handful of anecdotes - it's important to undertake a systematic study.

In this paper, Vivian Fang (Minnesota), Katharina Lewellen (Dartmouth) and I study how a CEO behaves in years in which he has a significant amount of shares and options vesting. CEOs typically sell their equity upon vesting to diversify, and so vesting equity makes them particularly concerned about the short-term stock price.

We find that, in years in which the CEO has significant equity vesting, he cuts investment in many forms - R&D, advertising, and capital expenditure. Moreover, in these years, he's more likely to exactly meet or just beat analyst earnings’ forecasts – if the forecast is $1.27 per share, he reports earnings of $1.27 or $1.28. Indeed, the magnitude of the investment cuts is just enough to allow the CEO to meet the target. Thus, vesting equity induces the CEO to act myopically – to cut investment to meet short-term targets. These results are robust to controlling for the CEO’s other equity incentives, such as his unvested equity and voluntary holdings of already-vested equity.

In this paper, Luis Goncalves-Pinto (National University of Singapore), Yanbo Wang (INSEAD), Moqi Xu (LSE) and I show that, in months in which the CEO has vesting equity, he releases more news. This is an easy way to pump up the short-term stock price, as news attracts attention to the stock. This attention also increases trading volume, which allows the CEO to cash out his equity in a more liquid market. Indeed, we find that these news releases lead to significant increases in the stock price and trading volume in a 16-day window, but the effect dies down over 31 days, consistent with a temporary attention boost. The median CEO cashes out all of his vesting equity within 7 days, so within the window of inflation.

The increase in news releases only relates to discretionary news (such as conferences, client and product announcements, and special dividends), which are within the CEO’s control, and not non-discretionary news (such as scheduled earnings announcements). Moreover, the CEO reduces discretionary news releases in both the month before and the month after the vesting month, suggesting a strategic reallocation of news into the vesting month and away from adjacent months. In addition to releasing more news items in the vesting month, the CEO releases more positive news – media articles immediately following these news releases contain significantly more positive words than normal.

Why Do We Care?

Both consequences of vesting equity are important. Investment is critical to the long-run health of a company. Indeed, in the 21st century, most firms compete on product quality rather than cost efficiency, for which intangible assets – such as brand strength and innovative capabilities – are particularly important. Building such intangibles requires sustained investment, particularly in R&D and advertising. Moving to news, many stakeholders, such as employees, suppliers, customers, and investors, base their decision on whether to initiate, continue, or terminate their relationship with a firm on news, or on stock prices that are affected by news. In addition to these efficiency consequences, news also has distributional consequences by affecting the price at which shareholders trade. Indeed, Regulation FD aims to “level the playing field” between investors by prohibiting selective disclosure of information. Public news releases to all shareholders achieve this goal – but the CEO may delay news until months in which he has vesting equity.

What Can Be Done?

One solution is to lengthen vesting periods. While increasing vesting horizons from (say) 3 to 5 years may not be as politically alluring to voters as a rant about the level of pay, it will likely have a much greater effect on shareholder value and society. For example, such a change will now incentivize the CEO to engage in a long-term investment with a 4-year horizon.

Can clawbacks achieve the same thing, e.g. pay out a bonus upon good short-term performance and then claw it back if long-term performance lags? Despite being widely heralded and attracting much fanfare, the legality of clawbacks is very unclear: I know of no cases in which a clawback has been successfully implemented. The CEO may have spent the money, or transferred it to a spouse or a relative. Trying to claw back a bonus that you have prematurely paid (based on short-term performance) is like shutting the barn door after the horse has bolted. The best solution is not to pay out the bonus in the first place, but wait until 5 years.

Is the lengthening of a vesting horizon simply kicking the can down the road? All equity has to vest at some point, and doesn’t this mean that the CEO will now act myopically in 5 years’ time rather than 3 years’ time? I have some sympathy with this concern – indeed, one of the other implications of our papers is that boards of directors, and other stakeholders, should scrutinize CEOs in months (or years) in which they have significant equity vesting. Since most of the current focus is on Levels 1 and 2 of the CEO’s contract, most stakeholders don’t pay attention to vesting horizons. But, the main benefit will be on the CEO’s behavior today – such a lengthening will now encourage him to take that 4 year project.

In short, paying CEOs according to the long-term will ensure they have the long-term interests of the firm at heart.

Time Management Tips to Boost Your Productivity

(A shorter version of this article was originally published in CityAM. A talk on time management and personal leadership is here.)

At work, often the last thing you can do is work.  Emails flood in, colleagues make urgent requests, and fires need to be fought.  But, a few pointers can help us get the most out of each day.

Focus on the Important, not the Urgent

Traditional time management involves writing a “To Do” list and doing the Urgent tasks first.  It’s extremely addictive to tick Urgent things off your list – but you may end the day having done 9 Urgent tasks, but not the 10^th, most important one.  Stephen Covey, in his excellent book “The Seven Habits of Highly Effective People”, instead advocates tackling the Important tasks first.  Urgent tasks are those that you have to do, externally imposed by others, and often low-hanging fruit – so it’s tempting to start with them.  Important tasks are those that you want to do, internally generated by you, such as developing a new idea.  No-one’s nagging you to do them, and they take significant time.  So if we don’t prioritize them, they’ll get swept aside by the Urgent. 

Covey also emphasised that people act differently when keeping score: you’ll run faster if wearing a stopwatch.  The same is true for work.  Have a stopwatch on your desk, and start it when working on an Important task.  Stop it when you’re distracted to surf the internet, or respond to an Urgent email.  Set yourself a target of how much real work you aim to get done that day. It will change your behaviour.

Control Your Email

Urgent email burns a hole in your inbox and demands to be attended to.  How can you focus on the Important, but still meet your deadlines?  Create a sub-folder called “Today”, and another called “This Week”.  When urgent emails come in, file them in the appropriate subfolder.  When they’re out of sight, they’re out of mind, freeing you to do the Important tasks.  Then, in the late afternoon, after the Important duties have been accomplished and when your mind is less sharp, you can turn your attention to these folders.

What if the Important tasks involve writing email?  Select “Work Offline” so that you’re not distracted by incoming email when doing so.  Change your settings so that you don’t have the “new email” little envelope in the bottom right, which demands to be clicked on.  Remove the “new email” chime for the same reason.

Emails to mailing list (e.g. advertising special offers) are neither Urgent nor Important.  Such emails will have “Unsubscribe” at the bottom.  Create a new sub-folder called “Mailing Lists”, and use a filter rule (in Outlook, go to File – Manage Rules and Alerts) to automatically move messages with the word “Unsubscribe” into this sub-folder.  You can read them at the end of the day.

Outsource and Automate

Many emails you send will contain stock phrases, e.g. directions to your office.  In an Outlook email, go to Insert – Quick Parts, and save these phrases, so that you can paste them into an email at a flash. 

For incoming email that you can give a standard response to, but don’t trust an auto-responder, create a sub-folder that your secretary has access to.  File these emails into the sub-folder, and inform your secretary of the stock responses to such emails. 

For non-work-related admin, use a virtual assistant (e.g. AskSunday or GetFriday).  For example, a virtual assistant could download all talks from a website, or delete duplicate photos from your computer. 

Use Natural Stimuli

On the hour, every hour, do a short physical activity – a set of press-ups if you have your own office, a brief walk if not.  This accomplishes two goals.  First, the actual activity is energizing.  Second, you’ll try to complete the task in hand before the next enforced break.  I dislike doing press-ups, so if it’s 10:50am, I think “I only have 10 minutes before an unpleasant activity” and make the best use of them. 

As an alternative to coffee, Jamie Oliver recommends a fresh chilli.  One or two seeds will give you a pick-me up.  Sounds maverick? Maybe so, but a lot of punch can come from something very little.  That’s the art of time management.

The Effect of the 2014 World Cup on Stock Markets So Far

(Update 15 July)

The 2014 World Cup is now over. After Argentina's loss in the final, its market was up 0.2%, underperforming the world index which rose by 0.6%. Germany's index rose 1.2% - the biggest gainer among the major European indices.

Excluding the anomalous Brazil defeat (which is explained below), out of the 39 losses by a country with an active stock market, 26 (= two thirds) were followed by the national market underperforming the world market. A loss was followed by underperformance by 0.2% on average; a loss by the "big seven" soccer nations (England, France, Germany, Italy, Spain, Argentina, Brazil) was followed by underperformance by 0.4% on average.

Thanks to everyone who followed this post as the World Cup unfolded. A series of three interviews that I did on CNN on the effect of the 2014 World Cup on stock markets is here.

(Update 11 July)

So far this World Cup, most defeats have been met by national stock market declines. Indeed, Holland's market fell by 1.7% on Thursday after being eliminated by Argentina on Wednesday, while the world market fell only 0.7%. But, after Brazil's 7-1 humiliation by Germany on Tuesday, the stock market rose 1.8% on Thursday (the market was closed on Wednesday), while the world market fell 0.4% over Wednesday and Thursday. Surely this disproves the theory?!

Actually, the Brazil situation has an interesting twist. Here, the market rose because the defeat was so bad that investors think it significantly increases the chances that socialist President Dilma Rousseff will be ousted in October's elections and be replaced by Aecio Neves, the leader of the more pro-business PSDB party. The economy has been mired in stagflation under Rousseff's presidency. Her popularity may be particularly tied to the soccer team because she chose to spend billions on stadiums for the World Cup instead of keeping her pre-election promises to spend on schools, hospitals, and general infrastructure.

Is this just clutching at straws to make an excuse for a major contradictory data point? In fact, this hypothesis was predicted even before the start of the World Cup. UBS analysts argued that a Brazilian exit would boost the stock market by hindering Rousseff's re-election bid, and Brazil's Ibovespa stock index had risen 19% from a low on March 14 due to speculation that the economy's poor performance would lead to her being ousted. Overall, out of the 38 losses by a country with an active stock market, 25 have been followed by the national stock market doing worse than the world market.

Moreover, the stock market increase upon seemingly bad news is consistent with a more general phenomenon studied in one of my other papers, with Itay Goldstein (Wharton) and Wei Jiang (Columbia). Typically, we think that a high stock price suggests that the CEO is doing well. But in fact, a high stock price may suggest that the CEO is doing badly - so badly that investors think that the firm will be the target of a hostile takeover, and so bid up the price. Thus, there's an interesting two-way relationship between prices and real decisions. A low price may trigger a corrective action (e.g. hostile takeover of a CEO, replacement of a President) - but the expectation of the corrective action drives the price up.

Indeed, Commerzbank was a takeover target around the financial crisis due to its poor performance. It was believed to have adopted a rather unusual takeover defense - it spread rumors that it was a takeover target, to increase its stock price, preventing a takeover from ultimately occurring! Thus, stock prices may be self-defeating - prices prevent the very actions that they anticipate.

As Shakespeare's Hamlet said, "thinking makes it so". But in financial markets, "thinking may make it not so".

(Update 9 July)

At the time of writing, Germany is the only major European stock market that's up - all other European stock markets are down due to negative economic news. Luckily for Brazil, their stock market is closed for a public holiday to mark a constitutional revolt in 1932.

(Updated 8 July)

In an earlier post I summarized my paper (with Diego Garcia and Oyvind Norli) which shows that international football defeats lead to declines in the national stock market index. Controlling for other drivers of stock returns, a World Cup defeat leads to a next-day fall of 0.4%, and a defeat in the elimination stages leads to a next-day fall of 0.5%. We also found that the effect was stronger in England, France, Germany, Spain, Italy, Argentina, and Brazil. A brief, humorous, 5-minute talk about the paper is here. 

How has this theory played out in the 2014 World Cup so far? Typically you find that stock market effects get weaker after a paper is published, because investors are aware of the effect and trade against it. However, we have indeed seen stock market declines after defeats in this World Cup. Across all countries with a stock market index, a defeat has led to the index falling by 0.2% faster than the MSCI World index. Moreover, defeats by the "big seven" countries (notably England, Spain, and Italy) have led to declines of 0.5%. Out of the 36 defeats by countries with an active stock market, 24 have been followed by market declines faster than the MSCI World.

Let's look at some of the most negative stock market responses:

Spain 1-5 Netherlands. The Spanish market fell by 1% the next day, while the world market went up by 0.1%. This was a crushing and surprising defeat by the reigning world champions. 

England 0-1 Italy. The English market fell by 0.4%, while the world market was flat.

Japan 1-2 Ivory Coast. The Japanese market fell by 1%, while the world market was flat. Japan went into the tournament with high expectations since the general consensus was that they had an easy group.

Italy 0-1 Costa Rica. The Italian market fell by 1.5%, while the world market was flat. This was perhaps the biggest shock of the World Cup so far, and severely jeopardized Italy’s chances of qualifying.

Switzerland 2-5 France. The Swiss market fell by 0.7%, while the world market was flat. While this loss wasn't too unexpected, the magnitude of the defeat was severe - Switzerland were down 0-5 until late in the game. 

Italy 0-1 Uruguay. The Italian market fell by 0.5%, while the world market was flat. Italy were eliminated from the World Cup.

Japan 1-4 Colombia. The Japanese market fell by 0.7%, while the world market was flat. Japan were eliminated from the World Cup. A win would have seen them through against an already-qualified Colombia team that rested several players.

Korea 0-1 Belgium. The Korean market fell by 0.3%, while the world market was up 0.2%. Korea were eliminated from the World Cup by a Belgian side that rested several players and was down to ten men for half of the match.

Nigeria 0-2 France. The Nigerian market rose 0.3%, while the world market rose 0.7%. Nigeria were eliminated from the World Cup. 

France 0-1 Germany. The French market fell by 1.4%, while the world market fell 0.5%. Clash of two leading nations in the quarter-finals, both of which harbored hopes of winning the competition.

However, not every result has been consistent with the theory. Some losses have been accompanied by stock market increases, perhaps because these losses actually boosted national mood:

Croatia 1-3 Brazil. The Croatian market rose 0.4%, while the world market rose by 0.3%. This result did not worsen Croatian national mood, as they were believed to have played well and lost to unlucky refereeing decisions. 

Bosnia 1-2 Argentina. The Bosnian market rose 0.5%, while the world market was flat. This was Bosnia's first appearance in a World Cup and the consensus was they played very well.

Australia 2-3 Netherlands. The Australian market rose 1.5%, while the world market rose 0.9%. Australia's performance was widely praised by the press afterwards, in contrast to the significant negative coverage of the team before the tournament. 

Greece 1-1 Costa Rica (3-5 on penalties). The Greek market rose 0.4%, while the world market rose 0.1%. This was the first time Greece advanced through the group stages and so the nation was happy with the team's performance in the overall World Cup. 

However, there were a couple of losses that did lead to a decline in national mood, yet still were accompanied by stock market increases. Clearly, football results aren't the only factor that drives stock returns, because there may be some major economic news. For example, when Spain lost 2-0 to Chile, the market went up by 0.7% the next day (while the world market rose 0.5%), due to news of a new king. 

In addition, there have been losses that were accompanied by stock price declines and thus consistent with the theory, but likely these declines were caused by other factors. For example, when Nigeria lost 3-2 to Argentina, the market fell 0.6% the next day. However, Nigeria had already qualified so the loss wasn't particularly painful; the market decline was likely due to the terror attack in the capital on the same day.

While there might be particular occasions where economic news overshadows the mood impact of a football result, these idiosyncratic events will even out in a large sample. Thus, the initial paper studied 1,100 football matches (plus 1,500 matches in rugby, cricket, basketball, and ice hockey) to find the average effect of football defeats on the stock market. A football loss won't lead to a stock market decline in every single case, but it does on average, and this has been borne out by the 2014 World Cup so far. 

(Thanks to LBS PhD student David Schoenherr for his help in gathering the data for this World Cup.)

World Cup fever: Why an England loss will wipe billions off the stock market

(This article was originally published in CityAM. A brief, humorous, five-minute talk on the paper is here.)

THE WORLD Cup, which starts today, will spark a huge range of human emotions, from the excitement of victory to the despair of defeat. The effect of football results on national mood is so strong that it can spill over into the stock market and cause swings of billions of pounds. Why?

While the World Cup pits arch-rivals against each other, raring to settle scores of decades past (did Geoff Hurst’s shot cross the line in 1966? Frank Lampard’s in 2010?), there are also long-standing feuds in the halls of academia. The equivalent of England-Germany is the debate over what drives financial markets. The “efficient markets” camp argues that the price of a share incorporates every single piece of relevant information: management quality, product mix, growth options, and so on. Prices end up at the theoretically “correct” fundamental value, as if calculated by an infinitely powerful computer.

The “behavioural finance” team points out that traders aren’t computers, but humans. They’re prone to mistakes and psychological biases. Thus, share prices are affected not only by fundamentals, but also by emotions. Internet shares were wildly expensive in the late 1990s, not because these companies’ prospects were stellar, but because investors had become irrationally exuberant.

Refereeing the “efficient” versus “behavioural” match is extremely difficult. One way to settle the tie would be to compare actual prices against the theoretical “correct” value based on fundamentals. But we don’t know what the “correct” value is. It could be that, based on information at the time, internet shares were fairly valued in the late 1990s, and the subsequent crash only occurred because bad news unexpectedly came out afterwards.

But there is another tactic we can use – study whether prices are affected by emotions. Previous papers looked at whether weather affects the stock market. However, weather isn’t correlated across a country. If it’s sunny in Bristol but cloudy in Manchester, it’s not clear what will happen to the overall stock market. Moreover, the effect of weather is unlikely to be strong enough to drive your trading behaviour, particularly since traders work in insulated offices.

That’s why I chose to look at sports. Sports have huge effects on people’s emotions, these are far stronger than the effects of weather, and they can’t simply be neutralised by the office environment. When England lost to Argentina in the 1998 World Cup, heart attacks increased over the next few days. Suicides rise in Canada when the Montreal ice hockey team loses in the Stanley Cup, and murders go up when the local American Football team loses in the playoffs. International sports, like the World Cup, affect the whole nation in the same way, and lead to a large effect on national mood that is correlated across a country.

Together with co-authors Diego Garcia and Oyvind Norli, I investigated the link between 1,100 international football matches and stock returns in 39 countries in our paper Sports Sentiment and Stock Returns. The results were striking. Being eliminated from the World Cup leads to the national market falling by 0.5 per cent on the next day – controlling for everything else that might drive stock returns. Applied to the UK stock market, this translates into £10bn wiped off the market in a single day, just because England loses another penalty shootout.

The effect is stronger in the World Cup than the European Championship, which makes sense because the World Cup is the bigger stage and conjures up even more emotion. It’s stronger in the elimination stages than the group stages, because if you lose you’re instantly out. It’s also stronger in football-crazy countries like England, France, Germany, Spain, Italy, Argentina and Brazil. We also studied 1,500 other international sports matches and found a similar effect in one-day cricket, rugby, and basketball. We ruled out the explanation that the market declines are due to the economic effects of losses (e.g. reduced sales of replica merchandise, or reduced worker productivity).

Depressingly, we found no effect of a win in any sport. One reason could be that sports fans are notoriously over-optimistic about their team’s prospects. If fans go into each game expecting they’ll win, there’s little effect if they do win, but they become depressed if they lose. Another is the asymmetry of the competition: winning an elimination game merely sends you into the next round, but losing leads to instant exit. 

Let’s hope the Three Lions not only give us some cheer on the pitch, but also help to maintain the value of our portfolios.

Underperformance of Companies Holding Meetings in Remote Locations

If a company has bad news that it wishes to hide, where will it hold its shareholder meeting? As far away as possible! That’s the hypothesis of an ingenious paper entitled “Evasive Shareholder Meetings”, by Yuanzhi Li (Temple) and David Yermack (NYU Stern) that I saw at the Rotterdam Workshop on Executive Compensation and Corporate Governance yesterday.

Companies are forced to hold shareholder meetings once a year. But, such meetings can be notoriously inconvenient for management. For example, at McDonald’s 2013 shareholder meeting, a 9-year old girl was famously planted to tell CEO Don Thompson "it would be nice if you stopped trying to trick kids into wanting to eat your food all the time". Thompson's spontaneous response, "we don't sell junk food", went viral and was ridiculed by the media. 

Thus, if the company expects trouble brewing, it can choose to hold its meeting at an inconvenient location, to deter shareholders or the press from attending.  This in turn implies a trading strategy for astute investors – short companies with remote meetings.

70% of shareholder meetings are non-evasive, occurring within 5 miles of the headquarters.  But at the other extreme, Li and Yermack found 34 meetings that took place overseas. General Cable is headquartered in Kentucky but has held its annual meetings in Spain, Costa Rica, and Germany; a mining company held a meeting at one of its mines. Even for domestic meetings, the company can choose to hold it hundreds of miles from a major airport. For example, TRW Automotive held its 2007 meeting in McAllen, Texas, at the Southern tip of the continental United States near the Mexican border - 1,400 miles from the company's headquarters outside Detroit, and 300 miles from the nearest major airport (Houston). 

Particularly suspicious are companies that hold the meeting at the same location every year, but make a one-time deviation. For example, 9 out 10 years, the regional bank KeyCorp held its annual meeting close to its Cleveland headquarters, but in one hear it held it at an art museum in Portland, Maine. The authors found that firms that hold these exceptional meetings - that involve one-time deviations -  underperform their peers by 11.7% over the next six months.  Similarly, companies that hold their meetings at remote locations (defined as 50 miles from their headquarters and 50 miles from a Tier 1 airport) underperform by 6.8%.  Moreover, the future underperformance goes up with both distance measures. 

Most shareholder meetings take place in May. Thus, the subsequent 6-month period typically includes the firm’s Quarter 2 and Quarter 3 earnings announcements.  Over the whole sample, the average return to an earnings announcement is +0.41%, because firms typically meet or beat their earnings target.  However, firms that hold exceptional meetings (a one-time deviation from the standard location) suffer returns of -2.24% at future earnings announcements, suggesting that they miss their targets.

The idea of evasive management is related to this earlier post on a paper showing that companies who avoid questions from pessimistic analysts (during earnings calls) subsequently underperform.  Both papers are very clever ways to identify shifty managers with something to hide, and use this to form a profitable trading strategy.

Profiting from momentum strategies - Part 2

The previous post concerned momentum - a strategy of buying past winners and selling past losers. It discussed how this strategy does well on average, but on rare occasions (recent market downturns and high market volatility) does very poorly.

Another reason why momentum may perform poorly is because other investors are chasing the same strategy. One of the "behavioral" explanations for momentum is underreaction, and goes as follows. Suppose a company experiences good news, which increases its true value by 10%. However, the stock price may only rise by 6%, because (a) only some investors notice the news, due to limited attention - they follow hundreds of stocks, and cannot notice what happens to every single stock on a particular day, and/or (b) investors do notice the news, but have stubborn prior beliefs - an investor may have a long-standing belief that the stock is of low-quality, and may cling to this belief even after receiving the news. 

Regardless of the explanation, momentum works. You should buy a company that has risen by 6% over the past six months, because its true value has increased by 10%, and so it may gain the final 4% over the next six months.

However, what if all investors think like that? Then, they may pile into a stock that has risen by 6%. This extra buying pressure causes it to rise another 5% - so that the total increase is now 11% and so it has overshot. How does a would-be momentum investor ensure that he hasn't bought a stock that has overshot?

Christopher Polk and Dong Lou of the London School of Economics study this question in an interesting paper entitled "Comomentum". The idea is as follows. If investors are trying to exploit momentum (causing stocks to overshoot), they would have piled into many past winners, and equivalent sold many past losers. Then, the stock returns of past winners will covary with each other (i.e. move up together), and similarly the stock returns of past losers will covary with each other. They introduce a new measure, comomentum, which is the abnormal correlations among past winners and past losers - the stocks the momentum trader will trade on. When comomentum is high, this suggests that lots of investors are piling into momentum trades, and so the trades are less profitable. 

Indeed, they find that their comomentum measure significantly predicts the future profitability of momentum. The effects are economically large. When comomentum is in the top 20% of its range, the momentum strategy earns 10.4% lower returns in its first year than when it is in the bottom 20% of its range.  Simply put, when comomentum is high, other investors are pursuing the momentum strategy. This strategy is now crowded, so you should get out. 

Profiting from momentum strategies - Part 1

Momentum is arguably the most well-known trading strategy. A simple strategy of buying stocks that have done well over the past 6 months ("winners"), and shorting stocks that have done badly ("losers"), earns a 1%/month return over the next 6 months. While other trading strategies stop being profitable once they have been discovered (because investors start exploiting them, removing the profit opportunity), momentum has remained surprisingly lucrative ever since Jegadeesh and Titman (1993) first documented it. 

A momentum strategy is attractive because it is market-neutral - since you're buying some shares and shorting others, it can make money in up markets and down markets. Thus, it is relatively immune to market risk. The Sharpe Ratio (a measure of the risk-adjusted return to a trading strategy) of momentum is about 0.6, compared to 0.3-0.4 for just holding the market. I attempt to exploit momentum myself, through the AQR Momentum ETF (ticker AMOMX).

Momentum is also pervasive - it works not only in stocks, but also bonds, commodities and exchange rates as shown by Asness, Moskowitz, and Pedersen (2013). That we see it in so many assets suggests that momentum is due to investors making mistakes - popularized by a branch of research known as "behavioral finance". The main psychological explanation is that investors are slow to react to information - thus, good news takes time to be incorporated in prices, and ditto for bad news. 

However, even though the momentum strategy does well on average, there are some periods where it does very badly, such as in the recent hedge fund crisis - some hedge funds went under because they followed momentum strategies that tanked. For example, between March and May 2009, the "losers" generated 163% returns, but the "winners" generated only 8% returns. Thus, a momentum strategy is somewhat like selling options - it makes money on average, but sometimes does really badly.

This new paper by Kent Daniel of Columbia GSB, a former Managing Director in Sachs Asset Management and Toby Moskowitz of Chicago Booth, a former winner of the Fischer Black Prize for outstanding contributions to finance research by someone under 40, shows you when to get out of momentum strategies - and thus how to make momentum even more profitable. 

The answer is surprisingly simple - get out of the momentum strategy in times of market stress, when 1) the market has recently declined, and 2) market volatility (measured by the VIX volatility index) is high. Here's a simple intuition. If the market has recently declined, the "loser" portfolio must have declined much faster than the broader market. Thus, it has a high beta (= sensitivity to the market). The "winner" portfolio has a relatively low beta, which is why it didn't decline so much. After times of market stress, the market typically recovers. Thus, the "loser" portfolio, which has high beta stocks that are sensitive to the market, does especially well in the market recovery, and so you want to get out of the momentum strategy. Kent and Toby find that this surprisingly simple enhancement to the momentum strategy doubles the Sharpe ratio from 0.6 to 1.2.

Does corporate social responsibility improve firm value?

Below is an article I wrote two months ago for the World Economic Forum. Since it's posted on the password-protected section of the WEF website, I reproduce it here.

Does corporate social responsibility (“CSR”) improve firm value? When companies make decisions, should they care only about shareholders or should they take other stakeholders (e.g. employees, customers, the environment) into account? This is a decades-old debate, but despite many cogent views on both sides, there’s surprisingly little hard evidence. 

In 1970, Milton Friedman famously wrote that “the social responsibility of business is to increase its profits”. This view isn’t as hard-hearted as it may sound. Friedman argued that a company can only increase its profits by taking other stakeholders into account – producing high-quality products, treating its employees fairly, and having a good environmental reputation. Under this view, firms should focus exclusively on profits, and everything else will fall into place.  Considering other stakeholders beyond the profit implication is at the expense of shareholders: a dollar spent on reducing pollution (beyond the level that will avoid an environmental lawsuit) is a dollar that cannot be paid as dividends. 

However, advocates of CSR argue that the Friedman view only holds in theory. In practice, it’s extremely difficult to quantify the profit implications of most socially responsible actions. A company could decide whether to grant an employee compassionate leave by trying to calculate the potential loss in morale and productivity if the leave was withheld, but these consequences are very hard to quantify. The CSR approach would be to grant the leave simply because it’s the right thing to do – because the goal of the company isn’t only to maximise profits, but to treat stakeholders with compassion. Treating employees fairly will eventually manifest in greater staff retention and future productivity. However, these long-run effects are difficult to quantify, so a firm focused exclusively on profits will not invest in its stakeholders.

Whether CSR improves firm value has been studied extensively by management scholars. Most studies find a positive correlation between CSR and measures of firm performance, such as profits. However, correlation doesn’t imply causation. It may not be that CSR causes a firm to perform better, but instead that firm performance causes CSR – only firms that are performing well can afford to spend money on its other stakeholders. In addition, some studies consider only one industry, or a short time period, and so are hard to generalize.

I decided to tackle this long-standing management question using a methodology from a different field – finance. This approach involves linking CSR not to profits, but to future stock returns, which reduces reverse causality concerns. If it was high profits that caused CSR, then the high profits would mean the company’s stock price would already be high today, and so we shouldn’t expect higher stock returns going forward. 

The next decision is how to measure CSR. The main challenge is that CSR is extremely difficult to measure objectively, as it’s intangible. Tangible measures do exist – for example, one could measure workplace diversity by whether there’s a minority on the board. However, tangible measures are relatively superficial and thus easy to manipulate. For example, a company that cared little about workplace diversity could put a token minority on the board to “check the box”. A separate challenge is that CSR comprises of many different dimensions – responsibility to employees, customers, the environment, etc, and it’s unclear how to weight these different constituencies. 

I thus focused on one particular dimension of social responsibility – employee satisfaction. I chose this dimension as a very thorough measure of it exists. Since 1984, there has been a list of the “100 Best Companies to Work for In America”.  This list is compiled by surveying the employees themselves – it’s the ultimate in fundamental, grass-roots analysis. Two hundred and fifty employees are randomly selected in a firm and asked 57 questions on various aspects of employee satisfaction (credibility, respect, fairness, pride/camaraderie), which had been developed through extensive discussions with managers, employees and workplace experts. As a result, it’s arguably the most respected measure of employee satisfaction.  Equally importantly, it has been available since 1984, and thus I have a long time-series which comprises both recessions and booms. 

The first list came out in a book in March 1984, then another book in February 1993, and then in the January edition of Fortune magazine every year from 1998.  My methodology involves buying a the Best Companies in April 1984, rebalancing the portfolio in March 1993 to take the new list into account, and then rebalancing it every February from 1998.  The one month delay is because I wish to test not only that employee satisfaction improves firm value, but also whether the market recognizes this link.  Even if employee satisfaction improves firm value, my strategy should earn no returns if the market recognizes this link.  As soon as a company appears in the Best Companies list, its stock price should go up, so I shouldn’t be able to generate returns by buying it one month too late. 

I compare the returns of the Best Companies not only to the overall market, but also to companies in the same industry.  For example, Google is frequently in the Best Companies list, but its high returns could be due to the tech industry doing well, rather than its employee satisfaction.  I also compare each company to peer firms with similar characteristics (e.g. size, dividend yield, recent performance, valuation ratios).  In short, I try to control for as much as possible, to isolate the effect of employee satisfaction.  I also remove the effect of outliers, to ensure that any superior performance of the Best Companies isn’t due to a few star performers such as Google.

I find that the Best Companies beat the market by 2-3%/year, over a 26-year period from 1984-2009.  This outperformance is highly statistically significant, and also economically meaningful – a fund manager who beats the market by 1%/year for 5 years is considered to be skilled.  Moreover, this outperformance is based on a very simple trading strategy using public information on large firms.

The results have three main implications.  First, they suggest that employee satisfaction is beneficial for firm value.  While it may seem natural that companies should do better if their workers are happier, this is far from obvious.  Indeed, the 20th century way of managing workers is to view them as any other input – just as manager shouldn’t overpay for or underutilize raw materials, they shouldn’t do so with workers. High worker satisfaction may be a sign that workers are overpaid or underworked.  However, the world is different nowadays.  Human capital is the main asset in many firms, and employee welfare can improve productivity, retention, and recruitment.

Second, even though employee satisfaction may be beneficial in the modern firm, the market doesn’t recognize this link. Even though I wait a month before forming my portfolios, the strategy generates superior returns.  Similarly, the Best Companies typically report earnings that beat analyst expectations – analysts aren’t aware of the benefits of worker welfare.  Indeed, I show that it takes 4-5 years before the market fully incorporates the value of employee satisfaction.  This may be because traditional methods of valuing companies are based on the 20th century firm, and emphasize tangible factors such as short-term profits.  This result has broader implications for firms’ incentives to invest for the long-run.  If investors continue to value companies based on short-term profit, then managers will pursue short-term profit rather than long-run growth.

Third, Socially Responsible Investing (SRI) – incorporating social considerations into portfolio choice – can add value.  The traditional view is that SRI is costly to investment performance, as it involves screening out good investments and screening in bad investments.  However, the Best Companies strategy generates high returns while supporting companies who treat employees responsibly – investors can do well and do good.  This result is a consequence of the first two implications – employee satisfaction is beneficial (the first implication) but the market doesn’t recognise that it’s beneficial (the second implication).

In concluding, it’s worth highlighting some caveats to my study.  First, I’ve only shown a link between stock returns and employee satisfaction, and not other dimensions of CSR.  Further research must be done to study whether there’s any link with environmental protection, animal rights, etc.  However, since the traditional view is that no dimension of CSR should add value, the results are an important first step towards demonstrating the benefits of CSR more broadly.  Second, while I control for many observable factors (industry performance, firm size, dividend yield, etc.), I can’t rule out the explanation that an unobservable variable (e.g. good management) causes both employee satisfaction and superior returns.  If so, my first implication is no longer causal – improving employee satisfaction (without changing management) won’t improve stock returns.  However, the other two implications remain.  It remains the case that the stock market misvalues intangibles – just that the intangible being misvalued is good management rather than employee satisfaction.  It also remains the case that a socially responsible investor could have bought companies that treat their employees well and earned superior returns.

Further reading:

Edmans, Alex (2011): “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices”. Journal of Financial Economics 101(3), 621-640

Edmans, Alex (2012): “The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility.” Academy of Management Perspectives 26(4), 1-19

Trading Strategies Based on Analyst Conference Calls

The idea from this blog came from the "Extra-Curricular Topics" I teach in my MBA classes, a 10-minute interlude where I teach an academic paper with significant real-world relevance. This expanded to an opt-in Google Group where I wrote to former students summarizing an interesting paper that I come across in a seminar or conference, and from there came this blog. However, the first few blog posts ended up being on different topics - this is the first post on the intended theme. 

One very interesting paper I saw presented at the LBS external seminar series is http://www.people.hbs.edu/cmalloy/pdffiles/malcolou.pdf by Lauren Cohen (HBS), Dong Lou (LSE), and Chris Malloy (HBS). It uses analyst conference calls to form a trading strategy. After Regulation FD, firms are no longer allowed to disclose information selectively to certain groups of investors and not others, so analyst conference calls are an important way in which they disseminate information. All analysts are allowed to participate. 

However, what I didn’t know until I saw the talk, was that firms can choose which analysts they would like to speak and ask questions in the meeting. Analysts can signal if they would like to ask a question, but the firm has full discretion on which analysts to call upon. The paper shows that certain firms will selectively choose optimistic analysts (i.e. those who give them high ratings) and prevent pessimistic analysts from doing this. Such a strategy is bad in the long-run, because analysts that are not allowed to speak may end up dropping their coverage of the firm (and analyst coverage is useful for boosting stock liquidity). However, myopic firms who are focused on boosting the short-term stock price may engage in this strategy – indeed, these are firms that are just about to issue equity (so they want to prop up the short-term stock price) and end up announcing earnings that just meet the earnings forecast or beat it by 1 cent (suggesting they’ve done something myopic like cut R&D to meet the target).

The conference call information is public information which can be used to form a long-short strategy: sell the firms that engage in such manipulation and buy the firms that don’t. This strategy earns 95 basis points per month, nearly 12% per year, which is huge alpha. The manipulating firms also end up having negative earnings announcements in the future, having to restate previously announced earnings (implying that the previous earnings were falsified), and using discretionary accounting accruals to artificially boost earnings. This paper is a great example of using a clever institutional detail (the fact that it’s the firm who gets to decide who speaks on a conference call) to find an extremely profitable trading strategy.

You might think - shouldn't the SEC ban companies from being allowed to selectively pick and choose who speaks? Well, actually there's a good reason for allowing companies this discretion. It allows them to stop Bruce Wayne from Wayne Enterprises from calling in (see p13 of http://dealbreaker.com/uploads/2013/05/ARCHER_OL-Transcript-2013-05-30T12_001.pdf). 

Top Ten TED Talks

London is a great city, but one of its downsides is that it takes a long time to get to most places. The TED Talks app has significantly enriched my commutes. Here are my top ten TED talks:

1) The Family I Lost in North Korea, and the Family I Gained (Joseph Kim). Perhaps the most poignant TED talk I've heard, about a boy who list his family in North Korea. About how simple acts of kindness can transform someone's life.

2) Are We In Control Of Our Decisions? (Dan Ariely). On how "nudges" (e.g. by companies selling products, or policymakers) can radically affect people's behavior. One of the leading lights in behavioral economics; his other TED talks are also excellent.

3) Perspective Is Everything (Rory Sutherland). Fascinating talk on "framing" (a concept in behavioral economics on how you present a concept). By a top advertising professional, as knowledgeable as any top behavioral economist on this field; his other TED talks are also excellent.

4) The Puzzle of Motivation (Dan Pink). How intrinsic motivation is much more powerful than extrinsic motivation (using rewards). I thought I already knew this idea, but this went into far greater depth than what I'd heard before. 3 million views.

5) How Great Leaders Inspire Action (Simon Sinek). Leadership and inspiration doesn't require you to do superhuman feats (what you do), but stem from how and why you do something. 2.5 million views.

6) Your Body Language Shapes Who You Are (Amy Cuddy). How adopting particular body language has a causal effect on your performance. This is something I was naturally skeptical about, being an dull economist, but this was an illuminating talk based on scientific evidence.

7) The Way We Think About Charity is Dead Wrong (Dan Pallotta). We often think that charities shouldn't spend on advertising, on hiring good managers - but such investment pays many times over.

8) Teach Every Child About Food (Jamie Oliver). The critical importance of nutrition for health. You may think that you've heard it all before, but this is powerfully and cogently argued, and has the potential to change your everyday life.

9) Building US-China Relations By Banjo (Abigail Washburn). The power of music to create community and cross boundaries - that diplomats, politicians and economists couldn't cross.

10) The Surprising Science of Happiness (Dan Gilbert). We spend our whole lives chasing after happiness, but we can actually manufacture it ourselves.

Davos in a Nutshell (Non-Economics Sessions)

Perhaps the most illuminating sessions in Davos were ones unrelated to economics, and thus gave me insights into topics that I would not normally get the chance to learn about. Here is a short summary.

While these sessions were on quite different topics, one common theme to many was the "neuroplasticity" of the brain. The brain is not fully formed after childhood, but you can keep developing it, e.g. through meditation, mindfulness (paying attention rather than being distracted).

Meditation

A Buddhist monk led a session on "compassionate" meditation, which is quite different from standard meditation:

• Picture a loved one in suffering, and being relieved of this suffering. Then, move to acquaintances, strangers, enemies, and dictators. This simple practice helps us show compassion in our everyday life
• A little bit of meditation every day is better than 8 hours once a week. You water plants every day rather than throwing a bucket once a week.

Exploring Our Limits: Workshop on Creativity

• Jeremy Balkin (Karma Capital, Give While You Live, 5x marathon runner)
• Modern society tells kids to conform, to color within the lines, but we need risk
• For each of us, there's one thing we haven't done because we're scared. Think what this is, and do it
• We're all born as naked vulnerable beings, and we'll all die as naked vulnerable beings. What matters is what we do in between. And we don't know at what point death will come
• We're told that running 26 miles is physiologically dangerous. But, humans used to run to get food. And technology is evolving (e.g. better shoes) to help us. The world has changed a lot in the past 5 years, even in the past year. There's almost nothing we can't do
• Lewis Pugh (first person to swim across the North Pole)
• Jeremy Clarkson doesn't get his ideas for Top Gear by sitting in the BBC studio, but going to the pub, having a few beers and allow his imagination to get wild
• Lewis himself decided to swim the North Pole and Everest in creative moments, on a whim
• Creativity and imagination never takes place in the office, but with friends. You don't make a wild decision based on an economic cost-benefit analysis, but on a whim
• Use the "4am test". If a crazy idea makes sense to you at 4am in the morning, it's probably a good idea
• Bobby Ghosh (TIME magazine World Editor)
• 10 years from now, you'd like to think "I'm proud I did this wild and dangerous thing", but also "I'm proud I did not do this wild and dangerous thing". We often extol the virtues of being wild and crazy, but judgement is also required. Sometimes not doing something wild is the boldest decision
• Ask yourself: "When is the last time you did something for the first time?" Hopefully, the answer is "recently"
• Celine Cousteau (granddaughter of Jacques Cousteau)
• You need a team of people to help you - you can't do it alone. We like to promote the "self-made millionaire". No-one is self-made. Entrepreneurs have customers, employees
• Must connect with the hearts and guts with everyone in your team. This principle also guides you on choosing your team-mates: are they in?
• You need to give yourself space for creativity to happen. We're obsessed with doing things. Don't do, just be
• Tina Seelig (Stanford, moderator)
• Privilege.  If you're an MBA student (or professor) at a top business school, you're privileged, There are others who should be here who aren't here
• Platform. We are lucky to have a platform - use it to help those in need
• Perseverance. Nothing comes for free
• In baseball, if you hit 0.300, you're a great hitter. Encourage people to make mistakes when stakes are low: don't be a perfectionist on small things

Making Better Decisions

This was the session that I served as a discussion leader (on behavioral finance). Sendhil Mullainathan of Harvard was one of the co-facilitators (with Eldar Shafir of Princeton, his coauthor on a book called "Scarcity"). He talked about two topics: bandwidth and scarcity:

Bandwidth

• We talk a lot about time management, but what's more important is "bandwidth" management. You only have a limited capacity for difficult tasks
• The biggest predictor of a plane crash is whether the pilot is in a bad relationship
• Tools to manage bandwidth
• Delegate unimportant decisions to others
• Manage expectations. If others know that you may not reply to email instantly, this removes the mental burden of having to constantly check email
• Don't pack every item in your schedule. You can't go from one meeting on a hard topic to another meeting on a hard topic. Your mind will wander and you will lose focus. You need to build in "bandwidth breaks" during a day, else you'll be ineffective
• Respect other people's bandwidth. We think it's unacceptable to charge kids $100 to apply for a scholarship, but it's OK to make them fill in a 40-page form
• Listen to hear the other person, rather than to prepare your reply to the other person. You can't do both, as you have limited bandwidth

Scarcity

• If you're overcommitted, you may think you should drop everything from your schedule so that you have lots of time. But, then you'll take on unnecessary commitments
• A woman with lots of debt still keeps spending. She's a bad debtor of money, spending money she doesn't have
• We're often bad debtors of time, spending time we don't have
• The tagline of their book "Scarcity" is "Why having too little means so much". When we experience scarcity, we focus on the one thing to make ends meet right now
• Sometimes it works: we can be super-productive when you have a deadline
• But, long-term consequences: spending money you don't have involves taking payday loans
• Thus, there's an optimum amount of scarcity - not too much, nor too little

Mindfulness (Goldie Hawn)

• For further color, read the TIME Magazine article "The Mindful Revolution", http://sfinsight.org/MindfulRevolutionTIME.pdf.
• The more attentive you are, the more your brain circuits wire together and fire together. Mindfulness has been scientifically proven to change the neuroplasticity of the brain
• Mindfulness - focusing on one thing - teaches self-control, and ensures that you can control your emotions rather than being reactive
• Hot cognition: you make decisions based on emotion
• Cold cognition: you can distance emotion from decisions
• The "Stanford marshmallow experiment" showed that, whether kids were able to resist eating a marshmallow, was a significant predictor of future success
• Being distracted (e.g. checking phone during dinner, or doing urgent stuff over important stuff) is like eating a marshmallow or not controlling your hot cognition
• Psychology used to be about fixing broken things. Nowadays, positive psychology is about building on the good things in people. This involves attentiveness and focus

Mindfulness Dinner

• Otto Scharmer (MIT): the success of an intervention depends on the internal state of the interviewer 
• For someone to be a good leader or teacher, the people he's leading or teaching must be mindful
• Tania Singer (Max Planck Institute): mindfulness isn't just attention (like being a sniper). It doesn't just make you more efficient
• Mindfulness has an ethical dimension. Being present and aware of what it exists, and accepting what exists: compassion for others, self-acceptance for yourself
• Buddhist monk: mindfulness isn't just being aware of your thoughts, but also countering bad thoughts
• People are born with traits. However, by accumulating moods, you scientifically modify your traits by changing the neuroplasticity of the brain.
• Being a restless monkey all the time is bad. Be deeply aware of what's going on 
• The founder of Twitter mediates for 10 minutes a day, even though Twitter seems the opposite of mindfulness

Should Drugs Be Legalized?

• Governor Rick Perry (Texas): I'm the only one on this panel against the legalization of drugs, but I come to this debate with an open mind
• Kenneth Roth (Human Rights Watch): decriminalize drugs, so that we can regulate them like alcohol, tobacco
• Treatment is key, but treatment is undermined by criminalization, so victims run away from treatment
• Kofi Annan: drugs have destroyed many people, but government policies have destroyed many more. 
• The US spends more money on prisons than education
• We don't need to legalize drugs, but we should decriminalize them - there's an important difference. You can decriminalize possession, but still keep supply illegal (as in Colorado)
• Juan Manuel Santos (President of Columbia): drug policy is currently decided by law enforcement people, but it should be discussed by public health people
• Criminalization creates drug cartels and the potential for huge profits. This leads to murders - profits are so high that people are literally willing to kill for them
• Tobacco and alcohol firms make normal profits because these substances are legalized
• The Surgeon-General of the US said 8 million deaths have been prevented by the legalization of tobacco
• Roth: decriminalization doesn't mean throwing your hands up and giving carte blanche. Use education, drug substitutes
• Perry: I won't jump in front of the parade just because this is the way public opinion is going. Instead, science should lead us
• In the 5 years since decriminalization of drugs in Portugal, the murder rate has risen 40%
• Marijuana today is much more potent than in the past - it's genetically modified
• The fact that Texas is stricter than other states doesn't mean that Texas is too strict, or that the other states are too lax. The 10th Amendment was to give states authority to set laws, and then people can choose where to live. We shouldn't have the "one-size-fits-all" mentality that seems to come out of DC.
• Perry: something must certainly be done, but there are other steps we can take besides criminalization
• Go after the money. Crack down on banks who allow money laundering 
• Science can create drug substitutes. Decriminalization dissuades drug users from moving off drugs onto substitutes.
• Annan: decriminalize consumers, stay harsh on suppliers
• Audience question: does it apply to all drugs?
• Santos: we need a different approach for each different drug, since each drug is different
• Perry: the others on this panel have used economic arguments for legalizing drugs - that legalization will remove cartels. But, if so, the economic argument would apply to all drugs. This exposes the fallacy of a purely economic argument. Instead, we should look at the science of each drug. We should also think about the medical cost of sending the message that it's OK to smoke marijuana
• Roth: but we're not sending the message that tobacco is OK. Packets say "smoking kills"
• Perry: but that used to be the message. Films, celebrities portrayed the image of smoking being cool. We haven't spent enough since then to reverse this image. 

Closing Address

• Pope Francis: humanity should be served by wealth, not ruled by it
• Jim Wallis: Hope is believing in spite of the evidence, and then seeing the evidence change
• When we return home, we will be confronted by the tyranny of the urgent - but we need to be mindful of what's morally urgent
• Think about: what's the one thing I will commit to right now to help support the World Economic Forum's mission to improve the state of the world?