A man visits a second hand car dealer and sees a car he likes priced at £20,000.
He offers £18,000.
The salesman says he can do the deal for £19,000. Not a penny less.
The man says he'll think about it and goes away.
Two days later the salesman telephones him and says he can have the car for £18,500.
The man hesitates, but he reckons he can get the car for £18,000 if he holds out so he says he'll think about it some more.
Another two days later the salesman calls him again and says he's discussed it with his boss and he can accept £18,000.
The man scents blood and promptly lowers his offer to £17,000.
The price falls to £17,500.
A week later the man buys the car for £16,000.
True story? Who knows. But it's been doing the rounds in one form or another for the last 20 years or longer. And it illustrates Goodhart's Law which states that:
"When a measure becomes a target, it ceases to be a good measure."
In other words, if you give people an incentive to meet a target, they will often meet the target by bending the rules.
If you reward a car salesman by giving him a bonus for selling a certain number of cars in a month, he will meet the target to get his bonus regardless of the profit margins - since he is being rewarded on sales not revenue. (Sometimes the best time to buy a car is near the end of the month, or just before the new registration plates come in.)
Goodhart's Law is a compelling reason for investors to examine a company's income statements and balance sheets with plenty of cynicism, especially with regard to EPS (earnings per share). If the management board of a company is rewarded by EPS - as is often the case - they will often do whatever is necessary to inflate the EPS by various accounting tricks. Some people call it creative accounting, others just call it fraud. Enron was a great example of this sort of accounting.
Goodhart's Law
A man visits a second hand car dealer and sees a car he likes priced at £20,000.
He offers £18,000.
The salesman says he can do the deal for £19,000. Not a penny less.
The man says he'll think about it and goes away.
Two days later the salesman telephones him and says he can have the car for £18,500.
The man hesitates, but he reckons he can get the car for £18,000 if he holds out so he says he'll think about it some more.
Another two days later the salesman calls him again and says he's discussed it with his boss and he can accept £18,000.
The man scents blood and promptly lowers his offer to £17,000.
The price falls to £17,500.
A week later the man buys the car for £16,000.
True story? Who knows. But it's been doing the rounds in one form or another for the last 20 years or longer. And it illustrates Goodhart's Law which states that:
"When a measure becomes a target, it ceases to be a good measure."
In other words, if you give people an incentive to meet a target, they will often meet the target by bending the rules.
If you reward a car salesman by giving him a bonus for selling a certain number of cars in a month, he will meet the target to get his bonus regardless of the profit margins - since he is being rewarded on sales not revenue. (Sometimes the best time to buy a car is near the end of the month, or just before the new registration plates come in.)
Goodhart's Law is a compelling reason for investors to examine a company's income statements and balance sheets with plenty of cynicism, especially with regard to EPS (earnings per share). If the management board of a company is rewarded by EPS - as is often the case - they will often do whatever is necessary to inflate the EPS by various accounting tricks. Some people call it creative accounting, others just call it fraud. Enron was a great example of this sort of accounting.