Table of Contents

Principal-Agent Problem

The Principal-Agent Problem (also known as the 'Agency Problem') describes a conflict of interest that arises when one person or entity (the “agent”) is hired to act on behalf of another (the “principal”). The problem occurs because the agent's personal interests may not perfectly align with the principal's interests. This misalignment is often made worse by asymmetric information, a fancy term meaning the agent usually knows more about their actions and the situation than the principal does. Imagine hiring a mechanic (the agent) to fix your car (you're the principal). You want a reliable repair at a fair price. The mechanic, however, might be tempted to recommend unnecessary, expensive services because they know more about cars than you do and they profit from the extra work. This fundamental conflict is at the heart of many relationships in business and finance.

The Heart of the Problem

The Principal-Agent Problem isn't about people being intentionally malicious; it's about the natural divergence of incentives. Two core elements create this friction:

The Principal-Agent Problem in the Wild

For an investor, understanding this concept is crucial because it appears everywhere in the corporate world. Spotting and avoiding situations with severe agency problems is a key defensive skill.

Management vs. Shareholders

This is the classic example in investing. The shareholders (principals) are the true owners of a public company. They hire a Chief Executive Officer (CEO) and a management team (agents) to run the company on their behalf and maximize its long-term value. However, management's goals might differ. A CEO might be more focused on:

Fund Managers vs. Investors

When you invest in a mutual fund or an ETF, you (the principal) are hiring a fund manager (the agent) to invest your money. Your goal is the best possible return for the risk you're taking. The fund manager's goal, however, is often to increase the fund's Assets Under Management (AUM), because their fees are typically a percentage of the total assets. This can lead them to chase hot trends to attract new investors with flashy short-term performance, rather than sticking to a sound, long-term strategy that would serve you better.

A Value Investor's Toolkit for Taming the Problem

Value investors, following the footsteps of figures like Benjamin Graham and Warren Buffett, are obsessed with this problem. They don't just invest in businesses; they invest in partnerships with management. Their goal is to find agents whose interests are squarely aligned with their own.

Scrutinizing Management

The best defense is a good offense. Diligently investigate the people running the company before you invest.

Aligning the Stars

Beyond investigating individuals, look for structures that keep everyone's interests in check.