What Is Agency Theory?

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

Understanding Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal financially are made by the agent, differences of opinion, and even differences in priorities and interests, can arise. Agency theory assumes that the interests of a principal and an agent are not always in alignment. This is sometimes referred to as the principal-agent problem.

By definition, an agent is using the resources of a principal. The principal has entrusted money but has little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk because any losses will be borne by the principal.

Financial planners and portfolio managers are agents on behalf of their principals and are given responsibility for the principals’ assets. A lessee may be in charge of protecting and safeguarding assets that do not belong to them. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.

Areas of Dispute in Agency Theory

Agency theory addresses disputes that arise primarily in two key areas: A difference in goals or a difference in risk aversion.

For example, company executives, with an eye toward short-term profitability and elevated compensation, may desire to expand a business into new, high-risk markets. However, this could pose an unjustified risk to shareholders, who are most concerned with the long-term growth of earnings and share price appreciation.

Another central issue often addressed by agency theory involves incompatible levels of risk tolerance between a principal and an agent. For example, shareholders in a bank may object that management has set the bar too low on loan approvals, thus taking on too great a risk of defaults.

Reducing Agency Loss

Various proponents of agency theory have proposed ways to resolve disputes between agents and principals. This is termed “reducing agency loss.” Agency loss is the amount that the principal contends was lost due to the agent acting contrary to the principal’s interests.

Chief among these strategies is the offering of incentives to corporate managers to maximize the profits of their principals. The stock options awarded to company executives have their origin in agency theory. These incentives seek a way to optimize the relationship between principals and agents. Other practices include tying executive compensation in part to shareholder returns. These are examples of how agency theory is used in corporate governance.

These practices have led to concerns that management will endanger long-term company growth in order to boost short-term profits and their own pay. This can often be seen in budget planning, where management reduces estimates in annual budgets so that they are guaranteed to meet performance goals. These concerns have led to yet another compensation scheme in which executive pay is partially deferred and to be determined according to long-term goals.

These solutions have their parallels in other agency relationships. Performance-based compensation is one example. Another is requiring that a bond is posted to guarantee delivery of the desired result. And then there is the last resort, which is simply firing the agent.

What Is an Agent?

An agent, in legal terminology, is a person who has been legally empowered to act on behalf of another person or an entity. An agent may be employed to represent a client in negotiations and other dealings with third parties. The agent may be given decision-making authority.

Two common types of agents are attorneys, who represent their clients in legal matters, and stockbrokers, who are hired by investors to make investment decisions for them. The person represented by the agent in these scenarios is called the principal. In finance, it refers to a fiduciary relationship in which an agent is authorized to perform transactions on behalf of the client and in their best interest.

Understanding an Agent

An agent is someone that is given permission (either explicitly or assumed) to act on an individual’s behalf and may do so in a variety of capacities. This could include selling a home, executing a will, managing a sports career, managing an acting career, being a business representative, and so on.

Agents often have expertise in a specific industry and are more knowledgeable about that industry’s ins and outs than the average person. For example, if you started gaining attention as a musician, you would hire a music agent to help guide you through getting a record deal, signing record contracts, and arranging your touring schedule.

As you would not have any experience with the record industry, you would need an agent to look out for your best interests and take care of a lot of the work that you would otherwise most likely not be able to complete on your own. This would also free up your time so that you can concentrate on making music.

Types of Agents

Agents come in all types depending on their function and the industry in which they operate. In general, there are three types of agents: universal agents, general agents, and special agents.

Universal Agents

Universal agents have a broad mandate to act on behalf of their clients. Often these agents have been given power of attorney for a client, which gives them considerable authority to represent a client in legal proceedings. They may also be authorized to make financial transactions on behalf of their clients.

General Agents

General agents are contracted to represent their clients in specific types of transactions or proceedings over a set period. They have broad authority to act but in a limited sphere. A talent agent for an actor would fall under this category.

Special Agents

Special agents are authorized to make a single transaction or a series of transactions within a limited period. This is the type of agent most people use from time to time. A real estate agent, securities agent, insurance agent, and travel agent are all special agents.

Uses of Agents

People hire agents to perform tasks that they lack the time or expertise to do for themselves. Investors hire stockbrokers to act as middlemen between them and the stock market. Athletes and actors hire agents to negotiate contracts on their behalf because the agents are typically more familiar with industry norms and have a better idea of how to position their clients.

More commonly, prospective homeowners use agents as middlemen, relying on the professional’s greater skills at negotiation.

Businesses often hire agents to represent them in a particular venture or negotiation, relying on the agents’ superior skills, contacts, or background information to complete deals.

Loyalty Responsibilities of an Agent

Duty of Avoiding Material Benefit

During the course of business, an agent may benefit. This is especially true when an agent is paid to perform a task on behalf of the principal. For example, a real estate agent commonly receives a commission for their work in selling a house.

When acting on behalf of another, an agent must ensure they do not unjustly benefit from their agency position. This includes receiving large benefits from the relationship or taking advantage of their position to ensure they receive benefits that would not normally as part of a normal transaction.

Duty Not to Usurp

When an agent acts on behalf of a principal, the agent may receive information it would be able to personally capitalize on for personal benefit. For example, an agent may receive information relating to a potential investment opportunity. The agent owes the principal the duty to not steal or supplant the principal’s ability to transact. In this example, the principal retains the right to decide whether or not to invest; the agent must not take the place of the principal without the principal explicitly declining an opportunity to invest.

Duty to Not Compete

On a similar note, an agent may not enter into transactions or business that compete with a principal. This conflict of interest puts the principal at a disadvantage as the agent may obtain trade or business secrets during the course of the business relationship. For example, imagine if an agent was tasked with shipping specific goods to an agent’s manufacturing warehouse. The agent could obtain information related to the principal’s operations that the agent could then use for its personal benefit.

Duty of Transparency

Formalized agent-principal arrangements often include verbiage that the agent must disclose if it has any other principals in which it is acting as an agent for. This includes disclosing a sworn statement that the agent will act in good faith across all principals and will incur fair dealing with each principal.

Duty to Protect Information

During the course of an agent’s relationship with the principal, the agent may not disclose confidential information to unrelated parties. This may defined through confidentiality agreements or may not be explicitly called out. In either case, the agent must take care to evaluate the sensitivity of information and the necessity for other parties to obtain that information. This includes not using confidential information for the personal benefit of the agent (i.e. exchanging the information for personal benefit to an independent third party).

Performance Responsibilities of an Agent

Duty of Contract

All terms of any written agreement between an agent and a principal define the relationship between the two. For many agent and principal relationships, the contract is not explicitly defined upfront. However, custom or deliberate agreements may call for very specific terms that define what is and isn’t allowed.

Duty of Care

An agent is always tasked with acting with care and competence when handling affairs of the principal. The standard is often held that the agent must act as the principal would, using discretion as if it would incurring the personal gain or loss. Though the level of care may not be explicitly defined, the level of care should be equal to what is reasonably expected by local standards.

The duty of care may be complicated when considering the agent’s personal benefit potential. For example, consider a broker that receives a commission for the sale of certain investment products. For some clients, it may not be in their best interest to buy those investments. Therefore, the broker has the duty of care to not sell such products to those individuals, sacrificing personal gain to uphold the sanctity of the relationship.

Duty of Obedience

An agent must comply with reasonable instruction. Though there may be situations where acting on one’s behalf and following their guidance is not reasonable or legal, the agent may have recourse to not follow instruction. Otherwise, the agent is bound to perform tasks as expected by the agreement. This includes situations where the principal may be disadvantaged but has instructed the agent to act in a specific manner.

Duty of Disclosure

As the agent gains sensitive information that may influence the decision-making process of a principal, the agent has the duty to disclose that information in an accurate, timely manner. Consider the example of Los Angeles Dodgers’ player Freddie Freeman. Freeman’s agent reportedly did not disclose to Freeman that his former team, the Atlanta Braves, wanted to re-sign him. By withholding such information, Freeman reluctantly signed with a different team.

Duty of Separation

An agent also has the responsibility to keep the agent’s and the principal’s affairs separately. This includes ensuring that any transactions entered into on behalf of the principal are still legal property of the principal. This also ensures that any resources or capital used to transact are maintained in separate bank accounts and that separate reporting ledgers are maintained.

Agent Liability

An agent is often liable to their principal if they violate their duty or deviate from a reasonable, expected action performed on behalf of the other party. This may be the result of exceeding the authority they’ve been given, acting in misconduct, being unreasonably negligent, or any other situation where the principal may incur a loss that could have potentially been avoided.

In some situations when the agent performs a task for another without disclosing they are an agent, they may be considered liable because the agent was presumed to be a principal. An agent is also commonly liable when the agent expressly incurs a personal liability by entering into an associated agreement.

Agency by Necessity

There is also “agency by necessity,” in which an agent is appointed to act on behalf of a client who is physically or mentally incapable of making a decision. This is not always a case of incapacitation. Business owners, for example, might designate agents to handle unexpected issues that occur in their absence. For example, if a CEO was on a flight and unreachable yet an emergency business decision needed to be made, agency by necessity could be used.

Agency by necessity is most often executed in times of emergency or urgency when the primary party is not available to make a decision. In these situations, courts would recognize a third party making the decision if that party was given power by the primary party to do so. The third party would be responsible for acting in the primary party’s best interest.

Estate planning often sees agency by necessity. Though an individual may have created a will outlining how an estate should be disbursed at their time of death, there could be situations where the person became incapacitated before needed adjustments to the will were made. Here, agency by necessity could be used by a trusted party.

The Bottom Line

An agent is anyone that has been entrusted to act on behalf of another individual. People usually call upon an agent when they need someone with more expertise or when they don’t have the time to complete a task.

Agents are commonly used in the finance, law, real estate, insurance, acting, and music industries, yet they can be found in almost any situation when advanced knowledge on a topic is needed. Agents can save people a lot of time, money, and headaches in getting important tasks done.

What is an Aggressive Investment Strategy?

An aggressive investment strategy typically refers to a style of portfolio management that attempts to maximize returns by taking a relatively higher degree of risk. Strategies for achieving higher than average returns typically emphasize capital appreciation as a primary investment objective, rather than income or safety of principal. Such a strategy would therefore have an asset allocation with a substantial weighting in stocks and possibly little or no allocation to bonds or cash.

Aggressive investment strategies are typically thought to be suitable for young adults with smaller portfolio sizes. Because a lengthy investment horizon enables them to ride out market fluctuations, and losses early in one’s career have less impact than later, investment advisors do not consider this strategy suitable for anyone else but young adults unless such a strategy is applied to only a small portion of one’s nest-egg savings. Regardless of the investor’s age, however, a high tolerance for risk is an absolute prerequisite for an aggressive investment strategy.

Understanding Aggressive Investment Strategy

The aggressiveness of an investment strategy depends on the relative weight of high-reward, high-risk asset classes, such as equities and commodities, within the portfolio.

For example, Portfolio A which has an asset allocation of 75% equities, 15% fixed income, and 10% commodities would be considered quite aggressive, since 85% of the portfolio is weighted to equities and commodities. However, it would still be less aggressive than Portfolio B, which has an asset allocation of 85% equities and 15% commodities.

Even within the equity component of an aggressive portfolio, the composition of stocks can have a significant bearing on its risk profile. For instance, if the equity component only consists of blue-chip stocks, it would be considered less risky than if the portfolio only held small-capitalization stocks. If this is the case in the earlier example, Portfolio B could arguably be considered less aggressive than Portfolio A, even though it has 100% of its weight in aggressive assets.

Yet another aspect of an aggressive investment strategy has to do with allocation. A strategy that simply divided all available money equally into 20 different stocks could be a very aggressive strategy, but dividing all money equally into just 5 different stocks would be more aggressive still.

Aggressive Investment strategies may also include a high turnover strategy, seeking to chase stocks that show high relative performance in a short time period. The high turnover may create higher returns, but could also drive higher transaction costs, thus increasing the risk of poor performance.

Aggressive Investment Strategy and Active Management

An aggressive strategy needs more active management than a conservative “buy-and-hold” strategy, since it is likely to be much more volatile and could require frequent adjustments, depending on market conditions. More rebalancing would also be required to bring portfolio allocations back to their target levels. Volatility of the assets could lead allocations to deviate significantly from their original weights. This extra work also drives higher fees as the portfolio manager may require more staff to manage all such positions.

Recent years have seen significant pushback against active investing strategies. Many investors have pulled their assets out of hedge funds, for example, due to those managers’ underperformance. Instead, some have chosen to place their money with passive managers. These managers adhere to investing styles that often employ managing index funds for strategic rotation. In these cases, portfolios often mirror a market index, such as the S&P 500.

What Is an American Option?

An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.

An American-style option allows investors to capture profit as soon as the stock price moves favorably, and to take advantage of dividend announcements as well.

How American Options Work

American options outline the timeframe when the option holder can exercise their option contract rights. These rights allow the holder to buy or sell—depending on if the option is a call or put—the underlying asset, at the set strike price on or before the predetermined expiration date. Since investors have the freedom to exercise their options at any point during the life of the contract, American-style options are more valuable than the limited European options. However, the ability to exercise early carries an added premium or cost.

The last day to exercise a weekly American option is normally on the Friday of the week in which the option contract expires. Conversely, the last day to exercise a monthly American option is normally the third Friday of the month.

The majority of exchange-traded options on single stocks are American, while options on indexes tend to be European style.

American Call and Put Options

A long call option gives the holder the right to demand delivery of the underlying security or stock on any day within the contract period. This feature includes any day leading up to and the day of expiration. As with all options, the buyer does not have an obligation to receive the shares and is not required to exercise their right. The strike price remains the same specified value throughout the contract.

If an investor purchased a call option for a company in March with an expiration date at the end of December of the same year, they would have the right to exercise the call option at any time up until its expiration date.

American put options also allow the execution at any point up to and including the expiration date. This ability gives the buyer the freedom to demand the seller takes delivery of the underlying asset whenever the price falls below the specified strike price.

One reason for the early exercise has to do with the cost of carry or the opportunity cost associated with not investing the gains from the put option. When a put is exercised, investors are paid the strike price immediately. As a result, the proceeds can be invested in another security to earn interest.

However, the drawback to exercising puts is that the investor would miss out on any dividends since exercising would sell the shares. Also, the option itself might continue to increase in value if held to expiry, and exercising early might lead to missing out on any further gains.

When to Exercise Early

In many instances, holders of American-style options do not utilize the early exercise provision, since it’s usually more cost-effective to either hold the contract until expiration or exit the position by selling the option contract outright. In other words, as a stock price rises, the value of a call option increases, as does its premium. Traders can sell an option back to the options market if the current premium is higher than the initial premium paid at the onset. The trader would earn the net difference between the two premiums minus any fees or commissions from the broker.

However, there are times when options are typically exercised early. Deep-in-the-money call options—where the asset’s price is well above the option’s strike price—will usually be exercised early. Puts can also be deep-in-the-money when the price is significantly below the strike price. In most cases, deep prices are those that are more than $10 in-the-money. With lower-priced equities, deep-in-the-money might be characterized as a $5 spread between the strike price and market price.

Early execution can also happen leading up to the date a stock goes ex-dividend—the cutoff date by which shareholders must own the stock to receive the next scheduled dividend payment. Option holders do not receive dividend payments. So, many investors will exercise their options before the ex-dividend date to capture the gains from a profitable position and get paid the dividend.

Advantages and Disadvantages of American Options

American options are helpful since investors don’t have to wait to exercise the option when the asset’s price rises above the strike price. However, American-style options carry a premium—an upfront cost—that investors pay and which must be factored into the overall profitability of the trade.

Examples of an American Option

Say an investor purchased an American-style call option for Apple Inc. (AAPL) in March with an expiration date at the end of December in the same year. The premium is $5 per option contract—one contract is 100 shares ($5 x 100 = $500)—and the strike price on the option is $100. Following the purchase, the stock price rose to $150 per share.

The investor exercises the call option on Apple before expiration buying 100 shares of Apple for $100 per share. In other words, the investor would be long 100 shares of Apple at the $100 strike price. The investor immediately sells the shares for the current market price of $150 and pockets the $50 per share profit. The investor earned $5,000 in total minus the premium of $500 for buying the option and any broker commission.

Let’s say an investor believes shares of Meta Inc. (META), formerly Facebook, will decline in the upcoming months. The investor purchases an American-style July put option in January, which expires in September of the same year. The option premium is $3 per contract (100 x $3 = $300) and the strike price is $150.

Meta’s stock price falls to $90 per share, and the investor exercises the put option and is short 100 shares of Meta at the $150 strike price. The transaction effectively has the investor buying 100 shares of Meta at the current $90 price and immediately selling those shares at the $150 strike price. However, in practice, the net difference is settled, and the investor earns a $60 profit on the option contract, which equates to $6,000 minus the premium of $300 and any broker commissions.

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