Charlie Munger once said, "show me the incentive and I'll show you the outcome".
Incentives drive nearly everything.
I have come to accept this philosophy as common sense, one of the simplest, strongest ways through which to view nearly everything relating to human affairs.
Nothing I’ve seen in the financial services 'industry' has ever contradicted it.
Before India’s independence, the British government was concerned about the number of venomous cobra snakes in Delhi.
It therefore offered a reward for every dead cobra.
This turned out to be a successful strategy initially, as large numbers of snakes were killed for the reward.
Eventually, however, enterprising people began to breed cobras for income...
When the government became aware of this, the reward programme was scrapped, causing the cobra breeders to set the now-worthless snakes free.
As a result, the cobra population actually increased.
The apparent solution to the problem made the situation even worse.
This is a classic example of the power of ‘incentives,’ and how they shape our actions.
According to Charlie Munger, there are only a few forces more powerful than incentives.
He shared an example in his speech called ‘The Psychology of Human Misjudgment’, that proves how much power incentives exert on us.
The power of incentives
FedEx, the logistics giant, could not figure out how to get the night-shift workers to move packages as quickly as was necessary from one plane to another.
The speed of transfer was integral to the success of their business.
They tried a few solutions, and finally, someone advised that FedEx employees were paid for the night shift by the hour and that maybe if they are paid by the shift, the system would work better.
Can you guess what happened?
The employees moved as quickly as possible to complete the job so they could finish their shift and go home early.
Changing the incentives worked.
The thing about incentives is that even generally good people will do not-so-good things when they are incentivised to do so.
A real estate agent, for example, will push you to accept a bad offer on your house if it will earn them a quick and easy fee.
A salesperson will likely steer you to an inferior product if they earn a higher commission on it.
One of the biggest reasons for the surging number of C-sections is that outwardly trustworthy doctors and hospitals earn three times the money than normal deliveries.
Finally, look at the financial services 'industry', where bankers, stockbrokers, advisers, and relationship managers mis-sell toxic investment and insurance products to poorly informed/gullible people, just because these earn them fat commissions.
(Remember the story of Tracey Dewart, who uncovered evidence of broker misconduct in an account set up at J.P. Morgan to benefit her aging parents?).
When I speak to these individuals, the typical issue isn’t that they are ‘bad’ people but they are highly conflicted in their incentives.
As Upton Sinclair says:
"It's hard to convince someone to understand something when their livelihood depends on them not understanding it."
As a young man I didn't understand conflicts of interest but as I have grown in wisdom, I have come to increasingly understand the powerful impact of incentives, potential conflicts and their possible impact on our futures.
Everyone has conflicts of interest
When seeking any form of investment advice I believe, everybody and everything (yes – even inanimate trading platforms are specifically designed to help you speculate) has conflicts of interest of some kind, and it's best to accept this is the case and to be aware of exactly what these potential conflicts are...
So they can best be managed.
There is no replacement for education on how these incentives work, so you can ensure you get what you pay for, know exactly what you’re paying for, and why.
A trusted financial planner is one who is not measured by how markets perform and is not a commodity, but someone who is valued for talking the truth and always having the clients interests at heart.
This is known as a fiduciary.
And while many may claim to act this way, a genuine one is certified as such and can be found on this register.
On a positive note, incentives have an amazing ability to shape people’s actions and setting the right ones can help ensure the right behaviour.
But setting the wrong incentives can mean things can go very wrong.
Guarding against acts caused by wrong incentives
First, be sceptical about what you hear from others and what you are told.
You never know what incentives are driving that viewpoint.
Second, when you seek advice from someone, always ask what the incentives are for that person.
If the opinion is specifically beneficial for the person delivering the advice, take it with a pinch of salt.
Always double-check much of what you are told (check the register and maybe ask for legal opinion), to the degree that seems appropriate after objective thought.
Just understanding the superpower that is incentives, and how it shapes behaviour, puts you one step ahead of those trying to use it on you.
"Never, ever, think about something else when you should be thinking about the power of incentives.”
- Charlie Munger
"An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation"
- Steven Levitt
The Psychology of Human Misjudgment - Charlie Munger
How mindset affects investment behaviour