Power of Incentives

Charlie Munger told a story that FedEx solved a logistical problem where employees couldn’t turnaround parcels fast enough until they paid workers by shifts instead of by the hour. China life insurance companies find it difficult to sell better priced risk products because their agents prefer to sell cheaper, easier to sell but loss making products. A parent offers to a buy a sports car for his irresponsible teenage son if he performs well at his university exams.

Incentives (or the lack of them) drive positive or negative action.  Self help guru Tony Robbins over-simplified when he stated humans are driven by pleasure and avoiding pain.  If an adult version of the famous marshmallow test is repeated in the workplace, both employer and employees will struggle to agree on a plan, decide and act rationally. Even if the smartest people in the business are hired and clear goals are identified, poorly structured incentives will drive wrong action. To make matters worse, an irrational or misguided long term corporate strategy will drive wrong action for that specific long period of time.

As a junior investment banker once, I learned the rite of passage was to work late and be on standby for any deal. Bonuses were rewarded based on effort as it was difficult to attribute value add to junior bankers.  Productivity was of limited concern and often poor. I couldn’t change incentives from the bottom up and  I was losing sleep unnecessarily.

From my buy side experience, I was once rewarded based on individual profit earned and to a lesser extent, discretionary bonus based on firm performance. We were encouraged to hunt for our own best investment ideas alone.  As such, when team work was required, teamwork amongst peers seldom function properly as employees continue to focus on their own transactions.

If you tell a broker you are happy to pay fees for XYZ, you should expect him to come back with proposals. If you never believe or plan to support XYZ  but told the broker anyway because there are many conflicting objectives that happen in corporate life, 2 things happens – the broker will work hard on XYZ and realize later you wasted their time, and over time, they conclude you don’t respect them or know what you are doing and ignore you. This is adverse to business if not properly managed, and it happens all the time.

Every organization should define its goals and values clearly and transparently, and structure incentives to reward employees for right behaviour and action. Employees are rational when they act to maximize their return on effort notwithstanding that management may be marching them off a cliff.

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