05 Sep 2016

Don't Eat the Marshmallow: Why Investment Managers Should Eat Last

Adam Geha

05 Sep 2016

positioner

Of the many and variegated attributes of sustained success, perhaps the least celebrated is the capacity to resist eating marshmallows - or to put it more conventionally, the ability to delay gratification. 

I am referring of course to the seminal "Marshmallow Study" - a series of experiments first conducted in the late 1960's by Walter Mischel, a psychology professor at Stanford University. 

In these experiments, pre-school kids were placed in a room, one at a time. An adult came in and placed a marshmallow in front of them and said: “I have to leave for a while. If you don’t eat the marshmallow while I’m gone, I will reward you with a second marshmallow when I return.” The adult then left the room and returned in 15 minutes.

It turns out that the ability to delay gratification, of your own free will, is a highly reliable predictor of long term success

That’s a 100% return for a 15-minute wait. But to pre-schoolers (and, sadly, to many of today’s adults) 15-minutes is an eternity. Only 30% of the kids had the will power to resist eating the first marshmallow.

In follow-up studies, the researchers discovered that kids who didn’t eat the marshmallow—and even those who resisted for a longer time—achieved higher SAT scores, had a healthier body mass index (BMI), got along better with others and managed stress better than the children who ate the marshmallow shortly after the adult left the room. In other words, the marshmallow-resisters turned out to be vastly more successful than the marshmallow-eaters. If you haven’t already seen it, check out this TED talk on the “Marshmallow Study”.

It turns out that the ability to delay gratification, of your own free will, is a highly reliable predictor of long term success. And since will power is a muscle, it can be strengthened with regular practise. That’s why, ever since I learned about the Marshmallow experiment, I’ve regularly offered my kids an opportunity to practise marshmallow resistance.

Recently, my son was in the grip of an impulse purchase. “I’m happy to buy it for you”, I said, “but if you say no, I will deposit double the purchase price into your long-term savings account.” He grappled with the dilemma for a few minutes and finally took me up on my offer. Then I upped the ante by saying I would add his favourite chocolate bar to the toy if he changed his mind – and this time, he instantly and triumphantly rebuffed me. “Good”, I said, “now let’s go to the bank and deposit the money.”

I can’t help wondering if I would have passed the marshmallow test as a pre-schooler, but by the time I became an investment banker (of all things) I seem to have developed the habit.

“To be honest, I’m not all that interested in how much I get paid in the next 2-3 years, I’m much more interested in the experience that I gain.”

I was fortunate to start my career 20 years ago at Macquarie Bank, which at the time (perhaps even more so than it is today) was a highly entrepreneurial and ambitious workplace. It was typical in those days for the analysts to stay back working until 10:00pm every night, and on one such night we got to talking about our respective career goals.

The talk soon turned to promotions, pay and perks – so there was an audible gasp of bemusement when I confided: “To be honest, I’m not all that interested in how much I get paid in the next 2-3 years, I’m much more interested in the experience that I gain.”

Not the (politically) smartest thing to say perhaps – but I was merely repeating a proposition long drummed into me by my father that the right experience acquired at an early age would repay me tenfold later in my career. Dad was in effect telling me to play the long game … not to eat the marshmallow.

What holds true for individuals, also holds true for corporations.

When the AFR ran a story a couple of weeks ago about EG, it made passing mention of our Absolute Alignment® model. Many readers subsequently contacted me to ask me what Absolute Alignment® was all about, and I replied “it’s all about playing the long game … and resisting the marshmallow.”

In funds management: the marshmallow is the base fee; the long game is the performance fee. So here at EG:

1. We never quote our base fee as a percentage of funds raised, but rather link our base fee to cost recovery. That means our base fee is quoted as a fixed amount and varies little with the quantum of funds raised. Be very wary of an investment manager who quotes a percentage base fee, such a fee encourages fund raising and empire building, far more than it does sound investing.

2. We back-end our performance fees, such that we get paid from the last cheque once all assets have been disposed and investors have received all their funds plus the agreed benchmark return. In other words, we are happy to eat last. We are not wanting to get rich quickly – we are happy to get rich slowly along with our investors.

3. We co-invest in all our funds in a first loss position. That means if, for any reason, our investors don’t receive at least $1.00 for each $1.00 invested – we lose all our money first. This ensures that we remain focused on downside risk protection, and don’t feel tempted to take undue risk in the pursuit of a higher performance fee.

In a financial world starved of trust, investors need to know with absolute certainty that the people investing their money are not in it for the first marshmallow. That’s the philosophy behind Absolute Alignment®, and we sincerely hope (and indeed expect) that our alignment model will one day become standard market practice. ‘Tis a consummation devoutly to be wished, if for no other reason than to rid our industry of its profiteers.

And so back to the Marshmallow Study, and to purloin the poetry of Cecil Day Lewis: I’ve read many studies, but none that so gnaws at my mind still. Perhaps it is roughly saying what Life alone could perfectly show: how principle begins with a walking away and success is proved in the letting go.