Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #2)

Let me begin by thanking all the readers for their appreciation of the previous article on ‘availability bias’. And a special thanks to a particular reader, who indirectly gave me the idea about how I wanted to present this next nugget of wisdom by Munger.

This goes on in form of a conversation over a coffee. So without any further delay, here is a transcript of the conversation.

It’s a conversation between me and my friend (a senior HR manager for a reputed firm and a retail investor), from here on referred to as CM (Curious Manager). I advise you to get your own cup of coffee at this point, as this may go on for long time.

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CM: Hey, It was nice reading your post on availability bias.

There were lot of things which I could relate to and surprisingly, there were few things which helped me in my area of work, which has nothing to do with investing.

Me: Thanks CM. I am glad it helped you in some way. Though, it’s not surprising that it helps you in your profession. The beauty of learning from Charlie is that his teachings are based on multiple disciplines interacting with each other and are tenets for worldly wisdom which are applicable to any profession.

CM: Hmm, yes, I understand. So what is it that you are writing about now? Which psychological bias are you going to discuss?

Me: Well, the next psychological tendency is the one considered most crucial by Munger in his speech. I am sure you have heard of it.

It’s what economists refer to as ‘Incentives’.

CM: Huh, tell me about it! It’s very elementary and probably the most common psychological tendency. I deal with it almost on a daily basis.

After all, as an HR manager, it forms a central theme to most of my policies directed towards employees. In fact, I have a poster on my desk which reminds me of what Steven Landsburg writes in his book, ‘The Armchair Economist’, as the summary of most of the economics – “People respond to incentives. The rest is just commentary.”

Anyways, I am not sure if there is much to be talked about incentives. In fact, I am curious and slightly surprised that Munger gives it so much importance.

For a man of his intellect and vision, ‘incentives’ seems to be a rather elementary topic to discuss. What is that he talks about in his speech?

Me: I am actually excited to have this conversation with you now. You definitely have a good grasp about incentives. I can also learn a lot from you here, but according to Munger (and I agree with him), the power of incentives is often under-recognized.

This is what he says in his speech…

Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.

And never a year passes but I get some surprise that pushes my limit a little farther.

He emphasized this point very strongly that incentives are superpower and there are numerous examples where its wise application yielded amazing results and its neglect caused great loss.

CM: Hmm…I am not sure why he says it’s underestimated. So what are Munger’s guidelines about incentives and what bias is he talking about?

Me: His general guideline here is that one should give enough thought to the power of incentives and then look somewhere else. In his own words…

Never ever think about something else when you should be thinking about incentives.

He also says…

Perhaps the most important rule in management is: Get the incentives right.

But more importantly, Munger is trying to put across another very important point – We are often aware that incentives matter and people can be incentivized to do required things. But the real power of incentives lies in its ability to manipulate the cognitive process at a subconscious level.

In other words, an otherwise decent man can act immorally because he is driven by incentives at both conscious and subconscious levels. Once this immoral behaviour starts and it pays this man well, he gets further inclined to repeat this kind of behaviour.

This modification of ‘voluntary behaviour’ was called Operant conditioning, term coined by B.F. Skinner.

Combining this with other biases like ‘social proof’, he gets a way to rationalize this immoral behaviour.

Robert Heinlein hits the nail on the head when he said – “Man is not a rational animal, he is a rationalizing one.”

CM: That really makes sense. Reminds me of a friend of mine who is now into selling of mutual funds. He is a wonderful guy, but every now and then he tries to sell me something which is not very beneficial for me.

Now I know, he doesn’t mean bad for me. He genuinely believes what he is selling is helpful for me. May be, he has rationalized it.

So I understand that incentives are powerful and they can be used to create a desired behaviour. Can you give me some examples which can help me understand as to how to look at incentives and what can be done to design right incentives?

Me: Sure, but before I go to that point I want to ask you this – What do you think is the key objective of a corporate entity?

Is it to produce innovative products, increase sales, and employ a lot of people? What is the ultimate aim for the existence of such an entity?

CM: Let’s see. A corporate is established by the owners to earn profit. Mostly, to maximize these profits, the company does all the things you mentioned.

They make an innovative product to get a first mover advantage and pricing power (at least till the point of no competition) so that they can make more profits.

They expand into other territories and other product lines to expand profitability so that whatever money is being employed in the business is chasing the maximum return.

So I guess the objective is to produce maximum profit for every rupee invested by the owners of the business. Or in the financial parlance, you may call it ‘return on equity’

Me: Bingo! You remember what Buffett wrote in his 1977 letter to shareholders and on numerous other occasions…

Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.

Now, coming to your previous question on how to create right incentives, let me give you the answer in a slightly different way.

One of my favourite books is called ‘Ten Commandments of Business Failure’ by Donald Keough (former Coca Cola president).

As the title suggests, it discusses the way businesses fail rather than succeed. Taking cues from this, before we learn how to create the right incentives, let us first study a few wrong ones.

After all, you learn more about success from studying losers and what not to do rather than studying winners and what to do.

So let’s first look at some of the incentive structures which are fundamentally flawed. Here let me take your inputs. Since it’s a crucial aspect of your job and you track the compensation methods in the industry, what kind of incentives for senior management you find prominent in various corporations?

CM: Well, the most common way to incentivize the managers to perform so that stockholders also benefit is to link their bonuses to the profit of the company.

Stock options are also extremely common. But in certain cases the bonuses can be linked to other key parameters of the business like Revenues, EPS growth, ROCE etc.

I think ESOPs and profit-linked incentives are better compared to the others. They help the managers to put themselves in the shoes of the stockholder and help to align the incentives in right direction.

Me: Hmm…do they? Let’s evaluate the measures you told me.

Incentives linked to size of revenues are obviously foolish. You can increase revenues by countless methods and never make money.

EPS or EPS growth related incentives don’t serve the purpose as EPS and its growth profile can vary according to the dividend policy. A very profitable company may have low EPS growth because of a relaxed dividend policy and vice versa and hence you incline the management interest towards retaining of capital even if they can’t deploy it profitably.

Incentives tied up to return on capital may lead you to reject the projects which are value creators even though the ROCE is less than the company’s current ROCE.

Then comes the more common ones. Let’s look at incentives linked to profits. Now remember that a company can increase its profits if the project earns more than the post tax cost of debt. But the project creates value for the owners only when it earns more than the total capital cost and not only cost of debt.

Stock options in their most common form are also fundamentally flawed. Let’s refer to the master again.

Warren Buffett discusses stock options in great detail in his 1985 letter to shareholders.

In theory, stock options are great as they put managers and stockholder at the same level. But as Buffett explains very well, that is not the case.

There are two aspects of stock options that make them an ineffective way to incentivize the management.

Firstly, it’s a capital cost. For a manager with a fixed price option, retained earnings are ‘free of cost’ capital.

Secondly, there’s a downside risk. Managers don’t bear downside risks, whereas stockholders do. Hence it’s more like a free lottery ticket for managers.

But surely, with some improvements, stock options can act as powerful incentives.

CM: Interesting, but is there a better way of doing this? So much research goes into studying and improving these systems in the biggest and prominent universities, there must be something better in place.

How do Buffett or Munger take care of this? Can you give me some examples?

Me: You are absolutely right in thinking that there must be better methods, and there are. They are just uncomfortable for managements to implement. But there is surely an answer to this.

Buffett has given the compensation structures for some of the subsidiary companies in his letters. The key to understand here is that there cannot be ‘one-fit-all’ solution to an optimum incentive system.

In fact, in his 1996 letter to shareholders, Buffett explained Berkshire Hathaway’s incentive compensation principles which beautifully capture the essence of incentive creation

According to him…

Goals should be (1) tailored to the economics of the specific operating business; (2) Simple in character so that the degree to which they are being realized can be easily measured; and (3) directly related to the daily activities of plan participants.

As a corollary, we shun “lottery ticket” arrangements, such as options on Berkshire shares, whose ultimate value – which could range from zero to huge – is totally out of the control of the person whose behavior we would like to affect.

In our view, a system that produces quixotic payoffs will not only be wasteful for owners but may actually discourage the focused behavior we value in managers.

So it’s important to study the business and understand what the key value drivers for the business are. And then the alignment of the incentives has to be done accordingly. Let us try to understand this.

For example, the problem with linking incentives to the profitability is that it doesn’t take in account total capital cost but only debt cost of capital. But if while calculating the profits for incentives purpose we deduct a charge for the cost of equity capital too and hence the equity capital is not considered free by the managers of the business, we can fix that issue.

This is exactly what HH Brown (a wholly owned subsidiary of Berkshire Hathaway) does. And this keeps the incentives intact.

Another efficient way Buffett describes is to bind incentives with the company’s value drivers like what Berkshire has done with GEICO.

The incentives are aligned to two key variables of the business: (1) Growth in voluntary auto policies and (2) underwriting profitability on “seasoned” auto business (meaning policies that have been on the books for more than one year).

CM: Hmm…that’s interesting. It’s a very different and effective way of looking at incentive structures.

Now, I have a question here. It’s based on something I learnt from the mathematician Jacobi who is famous for saying “Invert, always invert”. We, so far, discussed how we can use incentives to get the desired actions. But what about the actions we want to discourage?

Me: It’s a very interesting and important question. In fact, a big problem with most incentive structures is that they encourage good (or profitable) behaviour but there are very few that discourage the bad ones.

Nassim Taleb calls them “dis-incentives”.

He made a very interesting and strong case for using incentives and dis-incentives as a better risk management tool than the existing statistical methods like VaR (value at risk).

He gives an interesting example of the implementation of what was called Hammurabi’s code.

Romans used this to create disincentives for the engineers to avoid cutting corners and cheat while construction of the bridge.

The idea was simple; the engineer who builds the bridge was made to spend few nights under the bridge. Simple and powerful!

This simple lesson has been ignored in the usual compensation structures in 21st century and the results have been disastrous. The mortgage crisis is a very recent and vivid example of what happens when the incentives are skewed and are asymmetrical. The losses are mostly socialized.

Hence, these disincentives/ negative incentives/ punishments are extremely important to be incorporated in the incentive structures. And don’t forget what we discussed in the previous article – the more vivid the thing, the more available it is to our minds.

George Washington used this vividness to make the negative incentives stronger. He used to hang farm-boy deserters forty feet high as an example to others who might contemplate desertion.

But here is a very important point in the speech. It’s not only important to have symmetrical incentives, but it’s most crucial to NOT have incentives to cheat.

It’s better to miss rewarding a desirable behaviour than to produce an incentive system which promotes cheating behaviour because bad behaviour once rewarded is habit forming. And human beings have the tendency to game the system for their benefit.

Munger says…

Anti-gaming features constitute a huge and necessary part of system design. Also needed in the system design is an admonition: dread.”

Andrew Grove (effective leader for Intel) once said, ”For every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal.” (Out of context here, but I think you should read his book, “Only the Paranoid Survives”)

CM: So what are these ‘anti-gaming’ features or antidotes one should have? Can you explain them in a bit more detail?

Me: Of course! In his speech, Munger gave the example of cash registers which were developed long back by Patterson. On the similar lines of cash control, while discussing the antidotes for ‘rationalization of immoral behaviour by employees’, Munger discussed the importance of having a sound accounting theory and practice.

This should be obvious. We have numerous examples where corporations have used ambiguous accounting rules to create false picture of their operating businesses and the management made money but stockholders lost everything. One should read ‘Smartest Guys in The Room’.

This book (based on the Enron scandal) is a wonderful account of immoral behaviour, perverse incentives, operant conditioning and all other biases like social proof, commitment and consistency coming together to create a what we all know was one of the biggest and quickest corporate bankruptcy in the history of capitalism.

If I have to give few general guidelines to save ourselves from this bias and benefit from understanding it, these will be following:

1. Be skeptical about what you hear from others and what you are told. You never know what incentives are driving that viewpoint. It’s especially true when you are watching news. To take everything on face value can be dangerous. Even if you find it to be objective enough, you should always seek views from other sources.
2. When you seek advice from someone, always ask what the incentives are for that person. If the advice is specifically beneficial for the advisor, take it with a pinch of salt. As Buffett says, “Never ask a barber, whether you need a haircut.”
3. While investing in a particular company, always give importance to the incentive structures of the top management. Some of the more significant mistakes I have avoided are by looking at the compensation structures of the top management.

CM: Wow, that’s really interesting! I am actually surprised that we had such a long chat on a topic I never thought to be that crucial. I am wondering how other professions are affected by this bias.

Me: Almost every profession gets affected by this. Let me give you some examples and some articles to refer to, so that you can appreciate the extent of this bias existing in various professions.

Here are few of the examples:

1. Medical profession: This article was shared by one professor in my college, which talks about a man in medical profession who came out to expose the bias caused by incentives in profession.

We should appreciate the courage of this professional because often one is subjected to Serpico treatment for such a behaviour.

2. Accounts auditioning: There have been numerous cases in the past like that of Enron and WorldCom, where the auditors have been blamed (rightly so) for overlooking various irregularities in financial statements.

3. Sales: We all have some kind of experience with the sales people who push products on the basis of commissions, whether these are beneficial for the user or not. And they do it brilliantly. One of my favorite examples of salesman at work is very well captured in this scene from the movie Boiler Room.

4. Banking: We have seen what happened in the mortgage crisis in the West. The banks are in the business of selling products and when the incentives are skewed, it eventually ends up bad for the customers. Here is an article you should refer to.

We all are aware of the mis-selling activities in India and all the media hype about that.

In case you are unaware of that, you can read a recent article by Moneylife here.

CM: That’s really scary! Well, it’s certainly some knowledge that can save us a lot of money and unpleasant experiences.

But I have learnt in my life that where there is adversity, there is opportunity. May be we can learn to benefit from it in some way. Anyways, it was nice to have this conversation.

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P.S: As a lot of readers would have figured out by now that this is not an actual conversation but just a figment of my imagination. But the idea certainly struck me by a conversation which went something like this:

CM: Hey, it was nice reading your article on availability bias. There were lot of things which I could relate to and surprisingly, there were few things which helped me in my area of work, which has nothing to do with investing.

Me: Thanks CM! I am glad it helped you in some way. Though it’s not surprising that it helps you in your profession. The beauty of learning from Charlie is that his teachings are based on multiple disciplines interacting with each other and are tenets for worldly wisdom which are applicable to any profession.

CM: Hmm, yes, I understand. So what is it that you are writing about now? Which psychological bias you are going to discuss?

Me: You better read it on Safal Niveshak on Wednesday 🙂