Practical analysis for investment professionals
24 March 2020

On Paper Clips and Shareholder Value

Imagine an artificial intelligence (AI) that was built to do one task: Manufacture as many paper clips as possible.

In the beginning, the AI uses the existing resources of metal, electricity, and machinery to make as many paper clips as it can. Of course, it learns quickly what works and what doesn’t and soon optimizes paper clip manufacturing. Before long, it is far more efficient than any human worker could be.

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Then the AI starts diverting resources from elsewhere in the factory to its machines to produce more paper clips. A little while later, it learns how to order raw materials from the mills and buy new machines to further fuel its paper clip production.

The AI becomes so efficient that it makes way too many paper clips. The factory owners try to shut it down. But that would interfere with the AI’s goal, so the AI won’t let humans turn it off. In fact, the AI recognizes that people are its competition for both energy and materials. So the AI starts to kill them to keep them from diverting resources away from paper clip production.

The paper clip maximizer allegory was originally developed by Niklas Boström to show the potential unintended consequences of artificial intelligence. The AI was never programmed to hurt humans, yet because it was pursuing an unbounded goal, it turned into a killing machine. This is called instrumental convergence and though our example is extreme, it is a dilemma worth pondering.

Think, for example, about the ultimate goal of the corporation. It is commonly accepted that a corporation should maximize profits in order to increase shareholder value. That is all fine and well until a corporation starts harming society in pursuit of this goal.

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While a renewable energy advocate, I am not opposed to fossil fuels and believe that driving the fossil fuel industry out of business is a pipe dream of the eco-mentalists. Just think about the many positive uses of crude oil and natural gas. Practically every pharmaceutical that exists today originated as a barrel of crude oil, and it would be impossible to feed the planet’s current population without chemical fertilizers, the production of which requires fossil fuel.

No, we need the energy industry and we need crude oil and natural gas for decades to come.

Nevertheless, drilling for these resources and then setting them on fire is about the worst thing we could do with them. But that’s essentially what happens when they’re used to produce electricity or run our cars.

And that’s where the energy companies that act to maximize shareholder value fall into their own paper clip trap. They extract oil and gas and sell it to make a profit. They make more profit when they sell to the people who burn it because they keep coming back to buy more to burn.

We know burning fossil fuels contributes to climate change, smog, and rising sea levels. So we’ve tried to rein in fossil fuel production and promote renewable and clean energy sources. This threatens the efforts of energy companies to maximize shareholder value, so they respond by discrediting their critics and claiming that climate change is a hoax.

The energy companies’ own scientists agree that climate change and rising sea levels pose a threat. But they keep these findings out of the public eye and build taller offshore drilling platforms to counter the rising seas. Finally, the energy companies get their corporate leadership onto the boards of major banks. This ensures a steady flow of financing for their projects and will help them generate even higher profits and greater shareholder value in the future.

If this sounds like fiction, it isn’t. Driven by the goal of shareholder value maximization, the energy companies are, quite logically, behaving like Boström’s paper clip AI despite the larger costs to society and the planet.

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Financial markets and economies are complex dynamic systems, yet traditional finance theory is based on a linear, non-complex view of the world. This traditional view is so disturbing to me that I dedicated an entire chapter in my book to a primer on complex dynamic systems thinking.

Complex dynamic systems thinking highlights the flaws of shareholder value maximization as an end goal. Instead, stakeholder value maximization emerges as the optimal solution to running a company. If the highest possible share price comes at the expense of employees, suppliers, clients, or society as a whole, a backlash will eventually arrive in the form of lawsuits or regulation. In the worst case, the company will be nationalized or regulated out of business.

Yet, many companies continue to pursue shareholder value maximization. As a result, they have come to accept lawsuits and fines as the price of doing business. But complex dynamic system thinking suggests that if lawsuits fail to address the problem, social forces will inspire a larger backlash. Support for such leftist politicians as Bernie Sanders or Jeremy Corbyn, with their plans to institute a wealth tax, or regulate, tax, and even nationalize some corporations, therefore, is not some temporary aberration, but a warning.

I cannot find the source of this quote, but someone once said:

“You have to give people a little bit of socialism to prevent them from asking for a lot.”

Companies and business leaders would be well-advised to heed this advice.

For more from Joachim Klement, CFA, don’t miss 7 Mistakes Every Investor Makes (And How to Avoid Them) and Risk Profiling and Tolerance, and sign up for his Klement on Investing commentary.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Thanrath Pinigpreecha / EyeEm


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About the Author(s)
Joachim Klement, CFA

Joachim Klement, CFA, is a trustee of the CFA Institute Research Foundation and offers regular commentary at Klement on Investing. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland, and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

2 thoughts on “On Paper Clips and Shareholder Value”

  1. Joachim,

    With all due respect, this sounds like fiction because it is. Your definition of the shareholder-value-maximizing company is one that seeks profit without regard for any impact it may have on anyone or anything else. This is a cartoon. Companies pursue profits within the context of the laws and mores of their societies. If they go too far, there will be lawsuits, adverse regulation, and social condemnation.

    Case in point: The major oil companies you see as villains have high Environmental, Social and Governance scores. They know they face big penalties if they act irresponsibly. Your idea that a little socialism would make things better is belied by the appalling environmental record of socialist economies.

    Who cares more about the environmental impact of their actions, an executive from an oil company in our relatively free market or a government bureaucrat who will never be sued or fired for any mistake he makes?

  2. Francois says:

    I’ve never understood why people present shareholder value and stakeholder value as opposing forces. Treating stakeholders poorly will inevitably lead to poor outcomes for shareholders. Maximizing shareholder value thus implies maximizing stakeholder value.

    Is there really much of a distinction between the two?

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