Incentives Matter. Indeed, They’re Everything.

Show me the incentives and I will show you the outcome. – Charlie Munger

Munger, Warren Buffett’s wise partner, thinks incentives matter; indeed, he thinks they’re everything. I wish I’d understood this at an earlier age. If I had, then I probably would have understood better myself and others and been more effective at my endeavors. And life would have been just a bit easier to navigate.

Patrick O’Shaughnessy wrote about misguided incentives.

In Vietnam, under French colonial rule, there was a rat problem. To solve the rat infestation, the French offered a bounty on rats, which could be collected by delivering a rat’s tail as proof of murder. Many bounties were paid out, but the rat problem didn’t improve. Officials soon noticed rats running around without tails–people were cutting off the tails and releasing the rats to breed, so as to increase the pool of potential bounty revenue for themselves.

The same thing happened in Colonial India: a bounty was offered on cobras because they were attacking people, which caused people to breed cobras for more bounties, and ultimately resulted in a higher cobra population when the bounty system was abandoned and the breeders released their now worthless snakes.

Implicit in Charlie’s claim (which I think is spot on) is an indictment of free agency. In the main, people react; they don’t choose. The good news is, this makes human behavior predictable and enables us to elicit from others those behaviors we want. And to gain from our knowledge of what others are likely to do. The bad news is, it undermines our sense of individuality and independence and, further, can undermine our own happiness and well-being.

We’re not entirely helpless though. Once aware of the power of incentives, we can assess the situation and counter our natural tendency if we determine it’s in our best interest to do so. But it’s not easy. Incentives are powerful. They’re not easily overruled.

Often — no, usually — incentives involve money. Which brings me to another adage that serves most situations well: follow the money.

If you want to know what’s really going on in a particular situation, it’s usually productive to follow the money. The money trail nearly always yields key insights. Money is that powerful. (Jesus understood this well.)

The one thing that perplexes me, however, is the power of money versus the power of happiness. Money routinely trumps happiness. Install an incentive system that rewards wealth creation and I guarantee you people will respond. Install an incentive system that fosters happiness and I can’t offer the same guarantee. Happiness simply lacks the power of money; it’s motivating force looks weak alongside the power of money.

One of the reasons Munger and Buffett have been so successful in the investment and business worlds is because Charlie is so wise. He understands human behavior as well or better than anyone I’ve encountered. He takes those insights and works to avoid incentive systems that encourage the wrong behaviors — wrong from an owner’s perspective, that is. Hence, their companies don’t compensate executives with stock options. If they did (as most public companies do), their executives would react in predictable ways — they’d make decisions based on their short-term impact on the stock prices instead of long-term value creation.

Flawed incentives systems permeate our schools, too. Its one of the reasons why so many students can’t critically analyze situations and develop solutions. In short, we get what we reward: compliance and test taking. We should think more about what we want and what’s really in the best interest of our kids and our society, and adjust our incentive system accordingly.

Flawed incentives systems also result in dysfunctional politics and the media. In media, clicks count; depth and insight, not so much. In politics, fundraising and votes are all that matter. Politicians get richly rewarded for raising money and outspending  their opponent; hence, that’s their number one priority.

Our economy rewards financial engineering, so each year many of our best and brightest head off to Wall Street, where they’ll make loads of money but contribute nothing of value to society. Many of these young people could be engineers, doctors or scientists and actually do something of value to society. But the incentive system calls them in a different direction.

People react. Incentives matter. And money is powerful.

So what’s the point of all this, Vera?

It’s really quite simple: endeavor to understand human behavior and try to be conscious about assessing your options and making decisions that truly are in your best interest.

Sometimes the incentive system may push you in the right direction. But that won’t necessarily be the case. Often, the incentive system will push you in the direction that’s in the best interest of the person or persons who designed the system. And sometimes your interests and theirs are not the same.

The other point is to take a long-term perspective. Don’t overweight the immediate impact. Consider the long-term impact. If you do, you’ll be less likely to make decisions that yield small immediate results but undermine your long-term prospects.

Finally, remember that money incentives have inordinate power, even though we all know that money doesn’t equate to happiness. We know it, but usually we don’t act like we know it.

That’s not to say that poor equates to happiness. It doesn’t. Rather, it’s simply a gentle reminder that happiness can’t be bought. It’s far more complex than that, and at the same time far simpler.

In any event, always consider the incentives. There is always an incentive system at work. Don’t think for a minute there isn’t. Look for it. Consider whether the values and outcomes embedded within the system are aligned with your values and desired outcomes. If they’re not, then exercise independent thought and decision making and choose what’s best for you. Claim the free agency that systems seek to overrule.

It sounds easy. It isn’t. Incentives matter. Indeed, they’re everything. Almost.

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