How Big Should Stock Market Bonuses Be?

Summary: How do - and more importantly - how should stock market professionals earn their money? What are fair stock market bonuses? This is a very important question that has been brought into greater focus by the collapse of much of Wall Street and the global financial system in late 2008.

Seeing investment banking staff being paid bonuses in the millions of dollars when the companies that they were managing, representing and trading for needed government bailouts was a sobering and quite distasteful sight.

One perfectly good question would be to ask whether a hedge fund manager - no matter how skilled and successful - is worth US$100 million + per year? What do you think?

But, it has to be said that being paid for outstanding results is an attractive model.

However, many in the hedge fund industry seem to be there simply to earn a lot. Perhaps that is the jealous typing of your author, perhaps not. Their system of 2 to 2.5% per annum in management fee plus a performance related bonus that can be in the 20-25% region can provide for massive rewards. Imagine having a good year and outperforming your benchmark index with a billion dollars under management!

The problem is that in the down years, high fees from previous years cannot be clawed back. It is a one way street. This can put the investor at a serious disadvantage. What an amazing compensation package!

In this regard, the investment bankers of the world, hedge fund managers, stockbrokers, M&A; specialists and much of Wall Street really do have an amazing compensation system in place.

In contrast, being paid to not generate results must surely be worse. Perhaps this - and envy - were the real factors making those massive bonuses amongst a stock market collapse seem so distasteful. After all, in the good times, there were far less questions being asked about remuneration...

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It is worth highlighting that bonus pools tend to be higher during a bull market, when things are going very well, which does tend to suggest that the performance of workers in firms surrounding equity markets might not be only related to personal skill.

The book "Binge Trading" by Seth Freedman describes life in 'The City' of London. In it, he interviews a number of former friends and colleagues from the markets.

He speaks to one hedge fund manager, formerly a broker, who says this:

"I have an issue with my old job, because, in difficult markets like we have at present,if I put a hundred grand with a broker, and now the stock market's down 40 per cent, if my broker's performed in line with the market, then my hundred grand's now sixty grand - but the broker's still trading. And I think to myself, he's got clients losing money but he's still earning commission."

He continues,

Some brokers will actually earn more money than me this year, but aren't making money for their clients. I think that's an absolute con. There are brokers out there who will say, "It's the 29th of October, I haven't done much commission this month, so I'll switch my clients out of Invensys and into Vodafone and make five grand commission." That's criminal - we've seen it in full flow. The fact that [a broker friend] is saying he had his best ever month when his clients are losing fortunes means there's something wrong. I think the whole city should be performance-related."

Later in the book, he interviews a City lawyer who says, "The structural error was the reward system in the City. The reward system meant that both the institutions and individuals were never in a position where they personally paid the price for things going wrong. If things went wrong, then the government would come in and bail out the institution, and if you were very unlucky, you might lose your job. But at a personal level,if you have a bonus culture where people get bonuses which are huge irrespective of whether they are performing well, whether they've made disastrous decisions or not, then all the impetus is in maximising that short-term profit, knowing that you will never be in a position where you will have to carry the can."

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Needless to say, there are some pretty amazing stock market salaries before taking any bonus payments into consideration. This is not a sector of the economy where people are struggling to get by. However, these are people that are typically very well educated and work very long hours under exceptional pressure - perhaps they don't do quite so well after all. 

Either way, the numbers are so large and the companies so influential that the overall bonus pools for Wall Street firms will continue to be reported on by CNN, the Wall Street Journal, Bloomberg and many others for a long time to come.

First steps to limit the bonus culture

However, there are many arguments that suggest that these large compensation packages promote short-term thinking and behaviour which is not in the best interests of either the bank or fund in question (the employer), the companies being invested in, shareholders or the economy more generally. There are many arguments that suggest that financial rewards do not even help to motivate creative workers. 

In his book Traders, Guns and Money, former Wall Streeter turned author Satyajit Das explains how he has heard of one investment bank team of prop traders (trading for the bank's own account) that had hit their profit mark for the year and earned their maximum possible bonus by Easter. The team shut up shop and did not make another trade for the rest of the year!

The problems that caused the Wall Street crash of 2008 demonstrated how problematic these can be. When big investment banks like Bear Stearns and Lehman Brothers and the world's largest insurance company, AIG, have found themselves in such terrible trouble there need to be many lessons learned.

Since these collapses, new rules are being put in place that link bonus payments to base salary (in the hope that this will limit the ability of enormous bonuses to skew behaviour) and bonus share options to the long-term performance of a company.

We do not pretend to have the answers to a broken financial system here at StockExchangeSecrets.com, but we think we can at least identify some of the causes. And the huge stock market compensation packages that exist may well be one...

If you would like to read more about the goings-on in the stock market, please follow the links below:

What is a stock exchange and what does it do?

What Is an efficient capital market?

Stock exchanges and national economies

Investment institutions on the stock exchange

Executing a trade on the stock exchange

Stock exchange scandals

Investment in the stock exchange

Learn about the important role of stock rating agencies