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The use and abuse of incentives

Of the many causes of Human Misjudgement, Charlie Munger finds incentives one of the most difficult to understand. In other words, Why do we do what we do? Why are we tempted to do certain things while refraining from others?

Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour.

The power of incentives

There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn't accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck. Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. So maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes.

The abuse of incentives

One of the most important consequences of incentives is what Munger calls "incentive-caused bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who was then in the government, had to go back to Xerox because he couldn't understand why its new machine was selling so poorly in relation to its older and inferior machine. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions.

The story of mutual funds in India is quite similar to that of the Xerox case. Mutual funds that offer the maximum commission to distributors are the best sold funds. Also, consider your own stockbrokers. There will be seldom one who will not lure you to trade too often. And seldom will a management consultant's report not end with an advice like this one: "This problem needs more management consulting services." Such behavioural biases exist in most places and situations. And human nature, bedeviled by incentive-caused bias, causes a lot of ghastly abuse.

Some antidotes for investors

For you investors, we believe it is important to understand the motives and incentives of people and organisations you're dealing and investing with. Everyone ranging from the company you're investing in to your stockbroker, your mutual fund agent and your equity advisor (yes, even we) must pass your scrutiny.

Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor. The general antidotes here are:

  1. Especially fear professional advice when it is especially good for the advisor.
  2. Learn and use the basic elements of your advisor's trade as you deal with your advisor.
  3. Double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

» Next: When in doubt, don't opt out

Homepage: Value Investing with Charlie Munger

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