Incentives — A Powerful Lesson In Management

Finance Junkie
Sep 3, 2018 · 5 min read

“Why am I not writing anything frequently?”, I asked myself while I was lying on the bed trying to get some sleep.

Lack of time? No.

I have time to check Facebook. I should certainly have time to write.

Running out of things to write about? Hell, no.

I have not written a lot anyway. Definitely not a valid reason.

Maybe busy on Quora, another place where I write? Not really. In fact, the last time I wrote on Quora was 2 weeks ago.

Could it be the fact that I am doing an internship for 40+ hours a week? Absolutely not. I am thoroughly enjoying my time as an intern and also learning a lot. People at work are warm and friendly. No qualms and no complaints.

Then what is it? Before answering that question, we should look at the things I do and understand why I am doing them.

I work as an intern in an investment advisory firm. I read, research, create and build stuff that I care about and I am getting paid for it.

It is challenging, yes. I work with some of the smartest people I have ever known personally and that keeps me on my toes all the time. Being a small fish in an ocean full of sharks, I have to be acutely aware.

If it is really hard, why am I doing it?

The reason is simple. Incentive.

The fact that I am doing things that I care about and getting paid for it trumps the fact that it is hard. These kind of incentives inspire you. Motivate you to work hard.

Cristiano Ronaldo, arguably one of the two best footballers of our time, said the following words when he was asked what motivates him after all this time.

“I haven’t broken so many records by accident. They are there to be broken, and breaking records motivates me to train and be even better. I have the ambition to always improve.”

Cristiano Ronaldo

That is his incentive. The incentive to become the best football player in the world. Ronaldo is Real Madrid’s all-time top scorer with 450 goals to his name during his 9 years at Madrid.

It was my first week as an intern. My new boss took me to lunch. On our way back to the office, he stopped at Graeter’s, the ice cream shop to buy some $5 coupons that can be redeemed at any of the Graeter’s shops.

I thought he bought that for his kids and it made me curious.

“Why didn’t you buy the ice cream? Why coupons?”, I couldn’t wait to ask.

“Oh, those are not just for my kids. So during this weekend, my kids and I, we are going to play some games with their friends. After the games are over, there will be a lot of waste lying on the field. The kids are not going to want to clean the play ground unless they get something in return. I will give them the coupons if they clean the place. It’s a win-win.”, he nonchalantly replied.

A little incentive goes a long way.

When I thought about it, I realized it is probably one of the most powerful management lessons I have ever come across. The best way to get someone to do something is by offering them rewards of some sort to do so. It can be anything, but should be something desirable. Something that the other person would love to get.

You gotta find the right incentive.

In the second half of the 19th century, the British Government had a contract with ship captains to transport the prisoners to Australia as a way of punishing them. The poor prisoners did not have much of a choice. Elizabeth Beckford, one of the earliest prisoners to travel to Australia, was actually sent down under for stealing 12lb of Gloucester cheese.

Because of the not-so-favorable conditions on the ships, a lot of people died before even reaching Australia. The survival rate stood at a mere 40 percent and this raised a huge concern among humanitarians and the government itself. Despite their concerning voices, there was no improvement in the survival rate.

Edwin Chadwick, an 19th century English reformer, came up with a brilliant idea. Instead of paying the ship captains for every prisoner who walks onto the ships, he recommended paying them for every prisoner who walks off the ships. Apparently, that worked like a charm and improved the survival rate to 98 percent. This was because that the captains had the incentive to keep the prisoners alive. The more prisoners they managed to keep alive, the more money they could make.

Sometimes incentives can lead to bad endings too. For example, hedge funds, a place where rich individuals and institutional investors pool their money to make some unrealistic profits, have this interesting incentive model.

Bill Ackman has nothing to do with this article except the fact that he is an hedge fund manager

It is called Two and Twenty.

Hedge fund managers usually charge a 2% of total asset value as a management fee and 20% of the profits they earn for their clients. It means that a hedge fund manager who oversees a fund worth $10 billion can still make $200 million even if he doesn’t earn any profits for the year. This might make them accumulate more and more money from the investors to manage which in turn could lead to even more losses.

Charlie Munger once said,

“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.”

Charlie Munger and Warren Buffett

He even said the following story.

“Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.”

Wrong incentives can make people do stupid and selfish things.

Creating a correct incentive model is an onerous task. It can be very powerful or quite detrimental based on how you choose to design it. When you decide to give incentives, people often try to find the shortest path to reach their incentives. You can ignore them at your peril or you can control them to your benefit.

Written by

I am a student of Finance, trying to learn as much as I can.

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