CEO compensation plans should be simple.

Berkshire Hathaway’s is among the simplest. Warren Buffet gets paid the same way as every other Berkshire shareholder - when the stock goes up. Other then his modest $100K salary, that’s all there is. It’s simple, shareholder aligned, and you could write it on the back of a table napkin.

Contrast that with today’s overly complex, unwieldy, misaligned CEO comp plans. Take the ever popular 10 year, fixed-price options plan (who wouldn’t). This plan locks in the value of stock options at a fixed price over time. On the surface this seems reasonable - to get a bigger payout, the CEO needs the stock to increase in price.

The problem is that the CEO can increase the stock price without delivering any value.

With fixed price options, many CEOs are taking the easy way out and simply using the company’s retained earnings to buy back stock at the end of the year, thus reducing the number of shares outstanding. Simultaneously, this increases the price of the company’s stock, while delivering no value to the shareholder (in what might have otherwise been dividends). This manager owner conflict is also never mentioned in proxy materials that request approval of a fixed-price option plan.

Getting fired today can also be particular bountiful for CEOs. Save for Bob Nardelli of HomeDepot, I can’t think of too many jobs that pay $210 million for a job poorly done.

Warren’s point is many of the models used today to compensate CEOs are misaligned with shareholders (fixed price options being one of them).

Warren feels that a shareholder revolt is necessary to bring back sanity to what is increasingly becoming a crazy world when it comes to CEO comp plans. By shining a light on the issues plaguing the industry, we can hopefully soon see real change in how CEOs are compensated and aligned with shareholder interests.

From 1983 to 1998 investors experienced one of the greatest bull markets in stock market history. From this golden era, three mantras emerged to become accepted as conventional wisdom:

• buy and hold
• the market always goes up
• you can’t time the market

As someone who used to subscribe to these truisms, I will explain why this conventional wisdom no longer holds and how following them in today’s market will lead to financial ruin.

Building the myth

While the myths themselves have been with us for several generations, my generation first came in contact with them during the bull market of 1983 - 1998 (note: by market I am referring to the Dow Jones Industrial Average).

Anyone who in invested $1000 in 1983 would see their money multiply almost 9 times by the time 1998 rolled around. This bull market gave investors an annual average return of 15.7% over 15 years.

Helping entrench these myths were the mutual fund companies. It dovetailed nicely with the industry’s rallying cry at the time - asset accumulation. Marketing a fund became just as important as managing the money.

With graphs, charts, and lots of historical data, mutual fund companies painted a pretty compelling picture for why investors could count on the market to go up. And when the inevitable bumps did come, the market always recovered which made timing the market moot.

But perhaps the greatest reason people subscribed to these myths was that they worked. For this market, buy and hold gave people a great rate of return for doing absolutely nothing.

It was the doing nothing that attracted a lot of investors. They didn’t have to think. With history and the numbers on their side, it was easy to abdicate responsibility and have faith that the market would always go up. And for over 15 years it did.

All myths are local

There is nothing wrong with conventional wisdom. As Jerry Seinfeld once said, ‘Sometime the road less traveled is less traveled for a reason.’

Unfortunately, conventional wisdom breaks down when applied outside of the context and boundaries from which they were formed. This is especially true of financial markets. There are no rules that work in all cycles.

Investors get in trouble when they apply one set of market myths to a completely different market cycle. When you look at markets over 100 year periods, the trend is indeed up. When you look at markets in 10 to 20 year cycles however, things look quite different.

For one, the market doesn’t always go up. From April 1930 - July 1932 the market lost 86% of its value.

Secondly the market can go side ways and deliver no returns for upwards of 20 years. Look at the returns investors received over these market cycles of the last century.

For many 20 year periods the market returned little no capital appreciation. Not only would buy and hold have put peoples capital at undo risk, they would have lost the opportunity to put that capital to use else where. The market does not always rise, nor are you guaranteed a return of 11% per annum.

If you think these crashes are things of the past, ask Japanese investors how the felt buying and holding stocks on the Nikkei index from 1989 - 2003.

It took 14 years for the bear market to bottom after a market peak in 1989. And this is Japan - one of the most prosperous, hardworking, industrialized nations of the world.

What does this all mean?

I don’t want to give the impression that people should not invest in the stock market. I believe the stock market is a wonderful vehicle of investment. And when treated with respect, it is a wonderful way for people to get a decent return on capital.

But as someone who grew up applying these myths, I was jarred when I read Maggie Mahar’s excellent book, Bull! A history of the boom and bust, 1982 - 2004, to learn that not only were these myths not always true, but that applying them in today’s market could be disastrous.

Does this mean a crash in the stock market is pending? I don’t know.

But I do know that the strategies that served us so well for the last 20 years will require changes for the next 20. With the market recently punching through an all time high of 13,000, the real estate market beginning to cool, and consumer debt at one of its highest levels, many wonder if the market can go much higher.

While it is certainly beyond most of us to predict, we can make educated guesses. And after enjoying one of the great bull markets in history, the tide may be heading out.