Friday, December 21, 2007

Behavioral Finance – Under estimating the Power of Incentives

This is the first in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

1. Under estimating the Power of Incentives
When given the right incentives, people will get things done. This is one of the key driving forces behind almost all human activity.

If something is not getting done like you want, then re-evaluate the incentives. Charlie Munger gives the example of FedEx as one of his favorite cases about the power of incentives.

Its critical to the FedEx system to get packages shifted rapidly in one central location each night. That was not happening and the whole system was breaking down. FedEx then realized that the incentive was wrong – they were paying the night shift by the hour and that maybe if they paid them by the shift, the system would work better. Problem solved.

It was the difference between paying someone by the hour or paying them by the job. When paying by the job, the amount of work is quantified and as soon as the work is complete the worker is done and collects his pay. Whereas, pay by the hour, means the worker is there for a set amount of time regardless of how hard or fast he/she works. They have no incentive to get the job done quickly. In fact, their incentive is to drag it out to collect more hourly wages.

How can we use this information?
If you want something done, the first thing you should do is specify exactly what it is, quantify it, and then form an incentive that will provide motivation to reach that target. When everybody on your team has the same ultimate goal, you are more likely to achieve success.

How does this human misjudgment relate to personal finance?
If you have an investment advisor that works on commission, he/she will advise you to invest in such a way to capture the largest fee possible for him/her. Their incentive is to have you buy and sell a lot of assets. If you have a fee only advisor, he/she will charge you for advice, but not charge anything for transactions. You want good advice and they want to give you good advice, because that will equal good returns and you will pay for more of their good advice in the future.

Now your goals have been aligned, you both want the same thing and
you are both more likely to achieve it.

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