A high water mark is a financial term used to describe the peak performance of an account or investment. Borrowing the term from the terminology of flooding, a high water mark is often used to determine the pay structure and bonuses for financial managers. It is important to understand how a high water mark theory is applied, to be sure that a financial manager is getting paid based on real performance.
The term comes from the measurements of flooding water. A water mark indicated the highest point at which physical evidence, such as staining or a sudden change in vegetation, showed that water had risen. By finding the highest water mark, the exact height of a previous flood could be determined.
Generally, the term is used to describe the previous high performance peak of an account. For instance, if an investment account was worth $50 US Dollars (USD) and rose to $75 over the course of a year, the high water mark would then be $75 USD, and the financial manager might be awarded performance bonuses on the $25 USD increase from the previous standard. In the next year, if the account value dropped to $70 USD, no bonus could be awarded for performance.
Using the same example, it is important to note that the $75 USD would remain the high water mark even if losses occurred that changed the annual value of the account. Imagine that the value of the account dropped over three years down to $60 USD. In the fourth year, if the value rose to $80 USD, the performance bonus would only include the $5 USD increase from the old high mark to the new one, not the $20 USD increase from the lower annual value to the new water mark. If the losses were factored into the equation, managers could get bigger bonuses by having major losses and marginal gains, as opposed to through gains only.
The goal of this bonus strategy is to protect investors by carefully linking the salary of the manager to the gains of the investor. By doing so, managers have a vested interest in the performance of the account, since their bonuses are attached to their performance. Using high water marks instead of basing bonuses on simple annual gains prevents managers from collecting extra money on accounts that have lost money overall. As long as the account remains below the water mark, it has technically not made any money, even if gains have been made since the previous year. Until it surpasses the high water mark, the account is only making up for losses rather than providing net profits.