Why Smart People Make Stupid Decisions

They’re not stupid. Their incentives are.

Incentives are what determine behavior. Not intentions. Not intelligence. And, for most people, not character.

Incentives.

When you want to understand why an institution, a government, a corporation, or a person does something that seems irrational, stop asking what they were thinking and start asking what they were rewarded for. The answer will be obvious in retrospect.

The Three Flavors of Bad Incentives

A malincentive is a reward for doing something harmful. The scientist whose funding and promotion depend on producing the politically favored conclusion rather than valid science. The rating agency paid by the banks whose bonds it is rating. The hospital compensated based on the number of diagnoses of COVID it makes as opposed to honest scientific assessment of whether COVID was actually present. The regulator whose post-federal-retirement job will be in the industry he is supposed to regulate. The doctor who earns additional money by ordering lots of lab tests. In each case someone is being paid to do something that encourages fraud, destroys wealth or causes harm. That damage is not incidental. It is the predictable result of some human being choosing to incentivize harm. Malincentives are countered by good morals, but malincentives often win out.

A misaligned incentive is subtler and more common. The reward structure leads to actions that diverge from the intended goal. The salesman who gets a commission for selling products in a way that most rewards him, not in the way that best serves the company’s customers, its other employees, or its profits. The fund manager paid on assets under management rather than returns. Paying lazy people by the hour instead of by the job. The behavior that results is rational from the individual’s perspective and destructive from the system’s perspective. It’s the result of poor management decisions combined with individual character insufficient to do the right thing despite the misaligned incentive. Doug Casey defines stupidity as an unwitting tendency to self-destruction. Misaligning an organization’s incentive structure is stupid, and avoidable.

A perverse incentive arises when government rewards the opposite of what it intends. This is the law of unintended consequences. Cobra bounties in colonial India, offered to reduce the cobra population, produced cobra farming. Government-subsidized flood insurance results in beachfront development in flood zones. Federal student loan guarantees intended to improve access to education produced a tuition bubble that priced out the students they were meant to help. Subsidizing people who produce no goods and services while taxing those who do leads to fewer producers and more people on the dole. And then pretty much all policy in the “health insurance” realm is perverse.

When a system produces outcomes that seem irrational, those outcomes often result from individual rational responses to incentives developed by either stupid people or evil people. There’s no shortage of such people, so no shortage of predictably bad outcomes.

Why This Matters to You

Intentions are what people want to do. Incentives determine what people actually do.

There are many ways to benefit from awareness of bad incentives.

When you examine a company’s investment deck, listen to a sell-side guy on a phone call, or get convinced by a promoter, stop to think about the incentives of those who provide the information. Are their incentives aligned with you making money? If they are, groovy. But if their incentives are to make money from you, as opposed to with you, be careful.

In your own organization, start paying attention to your colleagues’ incentives, not just in your department, but throughout the organization. Every organization has good people. Every organization also has problems. To solve the problems, start by fixing the bad incentives. Then the efforts of the inventive people and hard workers will be directed to accomplishing organizational missions.

Government is in the unique position of forcing its bad incentives on us. We won’t get into solving problems caused by government. But screwed-up incentives lead to all sorts of market distortions.

One definition Doug uses for a speculator is someone who identifies where government actions pervert the market and then positions capital to benefit from that. In government, perverse incentives are the norm, layered on top of malincentives and misaligned incentives. Fertile ground in which to carefully plant some capital. Because government is now so pervasive in so many corners of the economy, most stock market activity is now speculation, not investment (the subject of a future letter).

Watch out for screwed-up incentives. Being aware of them will help you protect yourself, help you avoid problem investments, help you solve organizational problems, and help you find rewarding speculations.

At Crisis Investing, we are always looking at incentives, and as we find bad incentives, we decide whether to fight them or profit from them.

Usually, the second option pays better.

This is one of those letters that we in the trade refer to as evergreen: industry shorthand for material that stays relevant beyond the news cycle. Everyone needs to understand the role incentives play, yet it isn’t taught in school. The world could be a far better, wealthier, and more productive place if people learned these simple concepts. So, consider forwarding or sharing this note with anyone who’d benefit from seeing it.

Sincerely,

John Hunt, MD