Investment Wisdom

50. Charlie Munger Lesson For The Day: Part 4: Perverse Incentive Is Worse Than No Incentive

The “carrot or stick approach” is an old idiom which signifies incentives and punishments to instill good behavior. It is a combination of incentive through the carrot or disincentive via the stick.

This method is used across the myriad spectrums in life ranging from bringing up children to human resource management to matters of geopolitics.

A judicious administration of this is of paramount importance. For example, if you are using just carrot and carrot on your child, you are spoiling him rotten. If you just use stick and stick and more stick, you are being abusive and you may have to pay a lot for therapy in the future.

What then is Charlie Munger’s take on this very important subject?

Charlie Munger:

  1. On Money Management: The general systems of money management [today] require people to pretend to do something they can’t do and like something they don’t. It’s a terrible way to spend your life, but it’s very well paid.
  2. On Bureaucracy: And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I’ve got a department and you’ve got a    department and we kind of share power running this thing, there’s sort of an unwritten rule: “If you won’t bother me, I won’t bother you, and we’re both happy.” So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions, and nimbler people run circles around them. [Charlie Munger liked General Electric’s solution on this.They strategize, decentralize, motivate and they had Jack Welch.]

3. On Getting The Incentives Right: So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.

From all business, my favorite case on incentives is Federal Express. The heart and soul of their system—which creates the integrity of the product—is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product full of integrity to Federal Express customers.

And it was always screwed up. They could never get it done on time. They tried everything—moral suasion, threats, you name it. And nothing worked.

Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift—and when it’s all done, they can all go home. Well, their problems cleared up overnight.

So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what the solution was. But maybe now, it will hereafter more often be obvious to you.

4. On Wrong Incentives: Wrong incentives is area major cause because, as Dr. Johnson so wisely observed, truth is hard to assimilate in any mind when opposed by interest. And, if institutional incentives caused the problem, then a remedy is feasible because incentives can be changed.

5. On Perverse Incentives: Another thing, perverse incentives. You don’t want to be in a perverse incentive system that’s causing you to behave more and more foolishly or worse and worse. Incentives are too powerful a controller of human cognition and human behavior.

6. On Inconsequential Incentives or Pretensions: We should also remember how a foolish and willful ignorance of the superpower of rewards caused Soviet communists to get their final result as described by one employee: “They pretend to pay us and we pretend to work.”