“Never, ever, think about something else when you should be thinking about the power of incentives.”

— Charlie Munger

The power of incentives is obvious. Even small children will modify their behavior in response to incentives set by their parents. “Now, Johnny, you must eat your peas or you will not get ice cream for dessert!” When thoughtfully considered and consistently applied, incentives can be used to promote social good, from the micro level at the dinner table to behavior that impacts society as a whole. However, a naive and simplistic understanding of incentives can easily cause much more harm than good.

The Road to Hell is Paved With Good Intentions

On many occasions, poorly thought out incentive structures have caused serious harm. A famous example of this phenomenon is known as The Cobra Effect. When India was under British colonial rule, government officials were alarmed by the number of venomous cobras that infested the city of Delhi. This was an obvious public health menace. The scope of the problem was so great that the government could not hope to catch and exterminate all of the cobras without the help of the public.

A scheme was developed that compensated citizens who turned in cobra skins. Surely enough, this caught the attention of the people. However, the government did not anticipate that industrious citizens would begin farming cobras just to profit from bounties. Eventually, the bounty scheme was abandoned. Without a market for cobra skins, the farmers released the snakes into the city and the problem was worse than it ever had been before.

We can laugh at this today because, in hindsight, it seems so obvious that this would occur. However, the cobra effect is alive and well today. One must consider not only the direct effects of an incentive but the long-run side effects as well. As Howard Marks advocates, we must be sure to give adequate attention to second-order effects. Marks calls this second-level thinking and it’s what the British rulers failed to do.

Recently, there has been a great need for blood plasma from individuals who have survived a COVID infection. Antibody therapy has been useful for treatment of COVID so why not offer incentives for people who have been exposed to make plasma donations? It makes sense until you consider the incentives this creates for people to expose themselves to COVID in order to sell their plasma. Ridiculous, you say! Maybe not, at least not for college students at BYU who found the $100-200 they could earn from plasma donations to be worth the risk of intentionally getting infected.

Incentives in Business

My favorite example of misaligned incentives in business involves the case of the Federal Express distribution system. Charlie Munger uses the FedEx example in a talk on the psychology of human misjudgment, which appears as a chapter in Poor Charlie’s Almanack. FedEx was having a terrible time shifting packages between airplanes at its central distribution site each night. No matter what management tried, the night shift kept failing to complete its task. Of course, this had a cascading impact on delivery times and customers did not receive the service they thought they were paying for.

The problem was that management was paying the night shift an hourly wage. As soon as management switched its pay model to a fixed amount of pay per shift, the problem disappeared. Employees now had an incentive to complete the sorting process as quickly as possible so they could go home. Of course, presumably management had to ensure accountability to prevent sloppy and inaccurate work, but the existential problem disappeared immediately. Without timely delivery, the entire premise of FedEx’s business model would have failed.

Incentive problems extend all the way from the shift worker sorting packages to the very top of an organization. Every year, public companies prepare what is known as a proxy statement that describes, among other things, the compensation program that rewards top executives. Most large companies employ compensation consultants to develop programs that supposedly align the incentives of management with shareholders. Unfortunately, compensation programs often reward undesirable behavior. For example, any compensation scheme that is tied to the short-term price of a company’s stock will inevitably result in executives watching the ticker constantly and they will have a laser-focus on managing Wall Street expectations on a quarter-to-quarter basis.

The intrinsic value of a company depends on its ability to generate free cash flow for years and decades to come, but it is often possible to juice short-term results in a way that is nearly certain to reduce long term value. This is most obvious in matters of capital allocation. If a certain capital investment is likely to depress profitability for several years before it begins to bear fruit, why would a 62 year old CEO three years from mandatory retirement opt for it if his compensation is tied to the stock price over the next twelve months? Compensation arrangements that are complicated can have a cascading series of negative incentive effects that are very difficult to understand. However, no compensation consultant who proposes a simple arrangement is likely to be viewed as earning his or her pay.

Incentive Caused Bias

“The compensation committee relies on its own good judgment in carrying out its duties and does not waste shareholder money on compensation consultants.”

— Daily Journal’s 2020 Proxy Statement

One way to avoid incentive-caused bias is to avoid advisors. This is what Charlie Munger’s Daily Journal does when it comes to arranging compensation agreements with its top executives. However, sometimes you cannot avoid advisors and in these situations Munger suggests the following antidotes:

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; and (3) double check, disbelieve, or replace much of what you’re told, to the degree that seems appropriate after objective thought.

Psychology of Human MISJUDGMENT

Learning and using basic elements of your advisor’s trade is perhaps the most effective antidote. If you approach your auto mechanic speaking the language of someone who understands cars, you are far less likely to be ripped off than if you seem naive and confused. I always make it a point to mention to realtors some detail about the local market that obviously took research to learn, such as the average recent selling price per square foot for comparable properties.

The cash register is an invention that Munger often lauds as one of the greatest moral instruments of its time. As I discussed in a recent article, the invention of the cash register had the effect of reducing the temptation to steal. Those who have ingrained criminal minds would not be deterred from following a morally bankrupt path and would attempt to find ways to defeat the cash register. But those who are basically good people yet have a surface-level incentive to steal can be “kept honest” by the fact that they know theft is likely to be detected. Making dishonest behavior unpleasant and difficult to accomplish is a moral imperative.

Retroactive Bribery

One especially pernicious incentive effect that we have seen all too often is the phenomenon that I think of as “retroactive bribery”. In conventional bribery, someone in a position of authority is offered something of value in order to favor the interests of the briber. This type of bribery is common but can be discovered, especially when the bribe involves money in an age where almost every monetary transaction leaves an electronic fingerprint. In contrast, retroactive bribery is devilishly difficult to detect and often the “bribe” itself is not even discussed; it is instead implicitly assumed.

Consider the case of a member of Congress who serves on committees that have a significant influence on military procurement. The scourge of lobbying is well known in Washington and the stereotype is the explicit bribe: Please vote for this bill and we will give you a suitcase with $100,000 in cash. However, this type of bribery is for amateurs. Instead, lobbyists and members of Congress develop cozy relationships over long periods of time. Members of the committee might see a longtime colleague retire from Congress and then magically end up on the board of directors of a major defense contractor earning a quarter-million dollar sinecure annually. The next time the lobbyist approaches the Congressman asking for support on a bill, the member will understand the incentive effects well enough. Not a word need be spoken. Friends take care of friends.

Trust and Incentives

As I discussed in The Paradox of Trust, it would be truly exhausting to go through life without extending a basic level of trust to others, at least when it comes to routine and low-stakes matters. The power of incentives is present everywhere but it would be exhausting to attempt to study and examine the incentives involved in every small interaction of life. Instead, we rely on the norms and customs of society to function on a day-to-day basis and accept some risk, including the risk that the incentives of someone we are dealing with might lead them to cheat us.

When the stakes are high, however, we are well served to internalize Charlie Munger’s advice regarding the superpower of incentives. When you are buying a car or a home, you should carefully think about the incentives of the seller as well as the intermediaries who are involved in the process because the purchase could have consequences that last years or decades. But do not restrict your awareness just to incentive effects. By going through a list of potential areas of misjudgment check-list style, you will likely spot cognitive errors in time to take corrective action. Failure to do so can be disastrous when the stakes are high.

Note to readers: This article is part of a series on Charlie Munger’s Psychology of Human Misjudgment.