Incentive Caused Bias

I am starting this post with an Excerpt From “Seeking Wisdom From Darwin To Munger

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. I encountered this when I was in high school. Some of the teachers in the school I studied, offered private classes to their students. The money they got by taking private classes sometimes exceeded their salary. Now you can imagine what could have happened to those students who did not join the private classes? They were given impositions, insulted in front of others and were graded poorly in the exams. Those who took the private classes got good grades and did not encounter any issues. I always wondered why this practice was allowed.

Charlie Munger in his famous speech – The Psychology of Human Misjudgment explains

The power of incentives to cause rationalized, terrible behavior is also demonstrated by Defense Department procurement history. After the Defense Department had much truly awful experience with misbehaving contractors motivated under contracts paying on a cost-plus-a-percentage-of cost basis, the reaction of our republic was to make it a crime for a contracting office in the Defense Department to sign such a contract, and not only a crime, but a felony.

Real Estate

I often see this practice in real estate property management business. Every time the owner of the property incurs an expense, he gets billed for the cost-plus-a-percentage-of cost. This scares me since the property management company is operating under the influence of incentive caused bias. What is good for the company is not good for the owner.

Do you remember the real estate crash of 2008. Why did the borrowers default on their loans? Why did the bankers approve these loans? Most of these loans are subprime in nature. Bankers were paid for the market share/volume of the loans and not based on the net profits these loans generated. Hence the crash was inevitable.

Caesarian section(C-sections)

C-sections accounts for 9% of all births in India. Why? It is very simple. Caesarean delivery costs an average of Rs 30,000 more than normal delivery. Some estimates say C-sections have risen from 5% to almost 65% in some private hospitals in India. The doctors are operating under the influence of incentive caused bias and hence they prefer C-sections over normal delivery.

I often wonder how could there be a relationship between a retail investor and his stock broker/financial advisor. The goal of the investor is to buy low cost financial products like index funds, trade less often and there by paying less in transaction costs and taxes. The goal of the stock broker is to maximize his returns by selling high cost financial products and make you trade more as his commissions depends on the volume. The goals are orthogonal. How is this relationship favorable for both?

What should I do

Do not automatically trust people who have something at stake from your decisions. Ask What are their interests? Who benefits?