Self-Interest and Incentives

Self-Interest and Incentives

"Damn it all, we want to get at the truth" [said Lord Peter Wimsey] "Do you" said Sir Impey dryly. "I don't. I don't care two pence about the truth. I want a case." — Dorothy Sayers

The organizers of a tennis tournament needed money. They approached the CEO of TransCorp and asked him to sponsor the tournament. "How much?" asked the CEO. "One million," said the organizer. "That is too much money," said the CEO. "Not if you consider the fact that you personally can play one match, sit at the honorary stand next to a member of the presidential family and be the one that hands over the prize," said the organizer. "Where do I sign?" said the CEO.

People do what they perceive is in their best interest and are biased by incentives. For example, when the first Dead Sea scrolls were discovered and the archeologists wanted more fragments of the scrolls to be found, they offered a reward per fragment. The result: the fragments were split into smaller pieces before they were turned in.

The comedian Groucho Marx once interviewed a U.S. Senator about a miracle cure-all vitamin and mineral tonic that the Senator had invented. When Groucho asked him what it was good for, the Senator answered: "It was good for five and a half million for me last year."

Incentives for the decision-maker determine behavior. This means that we have to recognize self-interested behavior in others.

Advisors and Their Incentives

There is an old saying: "Never ask the village barber if you need a haircut." We are biased by our incentives as are others including lawyers, accountants, doctors, consultants, salesmen, organizations, the media, etc. What is good for them may not be good for us. Advisors are paid salesmen and may trick us into buying what we don't need.

For an attorney, litigation is often more lucrative than settlement. Lawyer William F. Coyne, Jr. says in The Case for Settlement Counsel there are "significant incentives for lawyers not to embrace early settlement... These incentives include the need to market services, the desire not to appear weak, the obligation to represent a client zealously, the thirst for justice, but perhaps not least, the desire to maximize income."

Warren Buffett tells us that one of Berkshire's compensation arrangements was worked out "without the 'help' of lawyers or compensation consultants. This arrangement embodies a few very simple ideas - not the kind of terms favored by consultants who cannot easily send a large bill unless they have established that you have a large problem (and one, of course, that requires an annual review)."

Charles Munger tells us about the common tendency of salesmen: "All commissioned salesmen have a tendency to serve the transaction instead of the truth... I put consultants in the same category, sometimes even lawyers - sometimes especially lawyers."

Many years ago, a Pasadena friend of mine made fishing tackle. I looked at this fishing tackle - it was green and purple and blue - I don't think I'd ever seen anything like them. I asked him "God! Do fish bite these lures?" He said to me, "Charlie, I don't sell to fish."

Brokerage and Investment Banking

Brokers have a strong incentive to get us to trade. They advise us what to buy and sell. Volume creates commissions. Investment bankers encourage overpriced acquisitions to generate fees. Investment bankers have every incentive to get initial public offerings (IPO) deals done, regardless of the company's quality. Their compensation is tied to the revenues the deal brings in. Analysts are rewarded for helping sell the IPO. Brokers want to move the stock. What did Groucho Marx say? "I made a killing on Wall Street a few years ago... I shot my broker."

Medical Field

Similarly, some psychologists ensure themselves successive paydays by telling their patients that another visit is required. And they don't talk about the limits of their knowledge. As American actor Walter Matthau said, "My doctor gave me six months to live. When I told him I couldn't pay the bill, he gave me six more months."

Why do bankers approve risky loans?

People who are rewarded for doing stupid things continue to do them. From their frame of reference, they acted logically based on how they were rewarded. The incentive system paid them to do the wrong thing. So if market share rather than profits pay a banker, he will write as many loans as possible. He is being rewarded every year while the net consequences of the bad loans won't be realized for a long time.

Charles Munger gives an example of how Lloyd's Insurance rewarded their people: "They were paid a percentage of the gross volume that went through. And paying everybody a percentage of the gross, when what you're really interested in is the net, is a system - given the natural bias of human beings toward doing what's in their own interest even though it has terrible consequences for other people - that really did Lloyd's in."

Be careful what you pay for, you may get it.

The city of New Orleans introduced a program under which districts that showed improvement in crime statistics received awards that could lead to bonuses and promotions, while districts that didn't faced cutbacks and firings. What happened? In one police district, nearly half of all serious crimes were reclassified as minor offences and never fully investigated.

Studies show that teachers help students cheat on standardized tests when their jobs or pay increases depend on the outcome of the tests.

John knew that if he didn't show good figures, his project wouldn't be funded so he cooked the books.

Why do people give a biased picture of reality?

There may be powerful economic and prestige-related incentives to underestimate costs and overestimate benefits when people try to sell projects. For example, studies based on data from several hundred large transportation infrastructure projects in twenty nations and five continents found evidence that in a number of cases, project promoters and forecasters of billion-dollar projects intentionally misrepresented the costs, benefits and risks of projects in order to get them approved.

Charles Munger says that projections should be handled with care: "Mark Twain used to say, 'A mine is a hole in the ground with a liar on the top.' And a projection prepared by anybody who stands to earn a commission or an executive trying to justify a particular course of action will frequently be a lie - although it's not a deliberate lie in most cases. The man has come to believe it himself. And that's the worst kind. Projections should be handled with great care - particularly when they're being provided by someone who has an interest in misleading you."

Warren Buffett adds: "I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections, but we care very much about, and look very deeply at, track records. If a company has a lousy track record, but a very bright future, we will miss the opportunity... I do not understand why any buyer of a business looks at a bunch of projections put together by a seller or his agent. You can almost say that it's naive to think that those projections have any utility whatsoever. We're just not interested."

Buffett also gives us a test: "When they make these offerings, investment bankers display their humorous side: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier. If you are shown such schedules, I suggest that you join in the fun: Ask the investment banker for the one-year budgets that his own firm prepared as the last few years began and then compare these with what actually happened."

The consultant to TransCorp was hired and paid by the company to advise the CEO on how he should be paid. "If I tell the CEO what he wants to hear, he will pay me well, rehire me and recommend me to other CEOs. And if I make it sound complicated it will be easier to send a larger bill."

How do we act as an employee?

If our boss wants a particular answer, do we give it? To quote the German proverb: "Whose bread I eat, his song I sing." Warren Buffett says: "I would say that the typical corporate organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants."

"I don't like to be embarrassed and have my name and reputation threatened with disgrace," said the CEO of TransCorp.

How can we change people?

Benjamin Franklin said: "Would you persuade, speak of interest not of reason." Since the risk of losing is more motivating than the chance of gaining, we stand a better chance changing people if we appeal to their fear of losing something they value - job, reputation, status, money, control, etc.

It is often better to avoid situations where we need to change people. Changing people is hard as Warren Buffett says, "I'd say that the history that Charlie and I have had of persuading decent, intelligent people who we thought were doing unintelligent things to change their course of action has been poor... When people want to do something, they want to do something."

Changing people affects their motivation, feelings of responsibility, and tendency to reciprocate. It is better when people act out of their own free will. Warren Buffett illustrates: "We want the manager of each subsidiary to run their business in the way they think is best for their operation - we'll never tell a subsidiary manager which vendor to patronize or anything of that sort. Once we start making those decisions for our managers, we become responsible for the operation and they're no longer responsible for the operation. And they're responsible for their operations. That means that they get to make the call, that it's up to them to do what's best for their subsidiary and that it's up to any other company that wants to do business with their operation to prove to them why it's best. That's the Berkshire approach. I think, on balance, our managers like it that way - because they're not going to get second-guessed and nobody will go over their heads."

Keep in mind

• Don't automatically trust people who have something at stake from your decision. Ask: What are the interests? Who benefits?
• Understand people's motivations. Money, status, love of work, reputation, position, power, envy? What are they rewarded or punished for? Are they benefiting or losing from the present system?
• People's interests are not only financial. They could also be social or moral. For example, public embarrassment, social exclusion, conscience, shame or guilt may cause people to stop some undesirable behavior. For example, by requiring restaurants to post hygiene quality scores in their front windows, the Los Angeles county health department caused a dramatic improvement in restaurant hygiene and a reduction in food-related illnesses.
• The ancient Greek philosopher Plato said: "Do not train boys to learning by force and harshness, but lead them by what amuses them, so that they may better discover the bent of their minds." Pressuring people or giving them orders often doesn't work. It is better to convince people by asking questions that illuminate consequences. This causes them to think for themselves and makes it more likely that they discover what's in their best interest.