Most of economics can be summarized in four words: "People Respond to incentives." The document discusses several examples that demonstrate how incentives can lead to unintended and sometimes harmful consequences. It discusses how industries like tobacco, fast food, pharmaceuticals, and investment banking have exploited incentives to push products and services that are not always in the best interests of consumers. It emphasizes the importance of being aware of incentive structures and their potential to cause bias. Financial independence is presented as a way to avoid being unduly influenced by other parties' incentives.
3. âPeople
Respond to
incentives.â
The rest is
commentary
Most of economics can be summarized in four words: âPeople Respond to
incentives.â The rest is commentary- Steven Landsburg
5. Read the book (and its sequel Superfreakonomics), watch the movie.
YouTube - Freakonomics - Official Trailer [HD]
http://www.youtube.com/watch?v=56k1xVAq290
These two guys have done some wonderful work on âincentives.â
Subscribe to their old blog:
Opinion - Freakonomics Blog - NYTimes.com
http://freakonomics.blogs.nytimes.com/
And the New one:
http://www.freakonomics.com
7. Price and Demand are inversely related.
Provide two exceptions where to increase
demand, you should increase price.
1. Price associated with quality
2. Bribe the customerâs agent to push the product - invoking one the most
post powerful psychological tendencies - the superpower of incentives
12. Are there
âfunctional
equivalentsâ of
boiler room
operations?
cocaine, mutual fund units, penny stocks in boiler rooms, medical drugs,
time shares, insurance - ANY product with a fat commission behind it. No
matter how toxic, it WILL get pushed.
Micro-lending in Andhra Pradesh.
13. Yes!
âAny time you
create large
differences in
commissions where
the guy gets X% for
selling A, which is
some mundane
thing, and 10 times
X for selling B,
which is something
toxic, you know
whatâs going to
happen.â
14. Youâll get lots of
B despite its
toxicity.
Moreover it will
get rationalized.
Man is not a
rational animal,
rather man is a
rationalizing
animal
15. I-C Bias is so pervasive it occurs in all professions.
Lawyers make clients litigate more than its necessary.
17. Read this blog post I did in 2007:
Fundoo Professor: Incentive-caused Bias in the Medical Profession
http://fundooprofessor.blogspot.com/2007/11/incentive-caused-bias-in-
medical.html
Read original article from:
http://www.nytimes.com/2007/11/25/magazine/25memoir-t.html?
18. Auditors would overlook accounting irregularities and so onâŚ
Client: How much is 1+1?
Auditor: How much do you want it to be?
22. The process of converting something toxic to something pureâŚ
This is the alchemy of ďŹnance.
23. Read this:
Op-Ed Columnist - All Fall Down - NYTimes.com
http://www.nytimes.com/2008/11/26/opinion/26friedman.html
24. âWhose bread i eat, his
song i singâ
âFear professional advice especially when it is good for the advisor.â
âDouble check, disbelieve, or replace much of what youâre told, to the
degree that seems appropriate after objective thoughtâ
25. Michael
Aronstein
I love this quote...
âOf the many advances in the long history of commerce, the advent of sausage stands
out as one of the greatest...
26. âThe idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping
and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in
the annals of business thought. Sausage making is the prototype for an entire class of merchandising technique that has become particularly
common in modern ďŹnance. The ďŹnancial marketer who uses commingling as an approach is responding to the same general conditions that
drive the sausage stuffer: an abundance of lower grade ingredients along with hungry and credulous public.â â Michael Aronstein
Be Wary of Financial InnovationâŚ
The guys who do it keep on re-inventing the wheel and hoodwink you into believing that what they are doing âthis time, its different.â
Galbraith once wrote: âAll ďŹnancial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by
real assets ⌠All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying
means of payment.â
He was right as youâll discover when you read âThe Great Crash 1929â
29. Scene from âThank you for smokingâ
YouTube - Thank You For Smoking Movie (1/9)
http://www.youtube.com/watch?v=4HC3xwlfcFM
This is a great movie which highlights a man who is a lobbyist for the
tobacco industry, does a brilliant job, and faces no cognitive dissonance
because he is doing it âfor the money.â
However everything changes in the last scene...
30. Scene from âThank you for smokingâ
YouTube - Thank you for smoking part 4/9
http://www.youtube.com/watch?v=Ft9kOLfd0Vs&feature=related
See from 6:55 onwards
31. Scene from âThank you for smokingâ
Experiencing Cognitive dissonance
http://www.youtube.com/watch?v=3Quv3ZYf72Q&feature=related
See from 5:42 onwards
And
http://www.youtube.com/watch?v=h9n-UdMhBNQ&feature=related
When you take up a job, you will have the same problem. All professions have this problem of
incentive-caused bias, when you fool yourself into believing that whatâs good for you is also
good for your client. And so, you will ďŹnd yourself selling overpriced and unsuitable insurance,
addiction, unsuitable products (e.g. tech mutual funds on the top of a tech boom to widows
and orphans) just for the money...
I-C Bias is very pervasive. Whatâs the solution?
According to Munger, the solution is ďŹnancial independence.
32. âWhose bread i eat, his
song i singâ
âAny time you create large differences in commissions where the guy gets X
% for selling A, which is some mundane thing, and 10 times X for selling B,
which is something toxic, you know whatâs going to happen.â
âFear professional advice especially when it is good for the advisor.â
âDouble check, disbelieve, or replace much of what youâre told, to the
degree that seems appropriate after objective thoughtâ
34. rather go
to bed
supperless
than rise
in debt -
Ben
franklin
This is the story of a founding father of one of the greatest nations - USA,
and the subsequent behavior of its citizens and its businesses.
This is the story of debt, and how it got pushed like a drug because there
was âmoney in itâ
All you MUST read the following books by Franklin.
Poor Richardâs Almanak
The Way to Wealth
35. Frankin gave some very valuable advice to his citizensâŚ
look what they did and look how they were pushed into this by the
âextremes of capitalismâ
36. "But what madness must it be to run in debt for these superďŹuities? We are offered by
the terms of this sale, six months' credit; and that, perhaps, has induced some of us to
attend it, because we cannot spare the ready money, and hope now to be ďŹne without
it. But, ah! think what you do when, I you run I in debt you give to another power over
your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you
will be in fear when you speak to him; you will make poor, pitiful, sneaking excuses,
and, by degrees, come to lose your veracity, and sink into base, downright lying; for
The second vice is lying, the ďŹrst is running in debt, as Poor Richard says.â
The love of debt, like any addiction, WILL result in breakdown of morality.
37. its hard
for an
empty sack
to stand
upright -
ben
franklin
42. Watch this documentary:
http://topdocumentaryďŹlms.com/maxed-out/
How are the credit card companies any different than Shakespeareâs Shylock in âThe Merchant of Venice?â Also
see:
Super size Me
http://freedocumentaries.org/ďŹlm.php?id=98
And think about the cognitive dissonance faced by managers of McDonalds if they see this ďŹlm...
43. Maxed Out | Watch Free Documentary Online
http://topdocumentaryďŹlms.com/maxed-out/
45. since The
borrower is a
slave to the
lender and the
debtor to the
creditor, disdain
the chain,
preserve your
freedom; and
maintain your
independency. -
benjamin
franklin
Who says slavery has gone?
Its here - alive and kicking. All those people who will work all their lives for
their credit card companies? Who are these people? If they are not slaves
then what are they?
46. silk and
satins,
scarlets
and
velvets,
put out the
kitchen
fire- ben
franklin
47. Maxed Out | Watch Free Documentary Online
http://topdocumentaryďŹlms.com/maxed-out/
48. Maxed Out | Watch Free Documentary Online
http://topdocumentaryďŹlms.com/maxed-out/
Role of ďŹnancial independence- Makes you see things as they really are.
Its very tough for someone who is not ďŹnancially independent to escape from the clutches of incentive-
cased biasâŚ
49. Its difficult to
get a man to
understand
something,
when his
salary depends
upon his not
understanding
it - Upton
sinclair
50. âWhose bread i eat, his
song i singâ
âFear professional advice especially when it is good for the advisor.â
âDouble check, disbelieve, or replace much of what youâre told, to the
degree that seems appropriate after objective thoughtâ
65. Why potential buyers even look at projections prepared by sellers baffles me. Charlie and I
never give them a glance, but instead keep in mind the story of the man with an ailing horse.
Visiting the vet, he said: "Can you help me? Sometimes my horse walks just ďŹne and
sometimes he limps." The vet's reply was pointed: "No problem â when he's walking just ďŹne,
sell him." ... At Berkshire, we have all the difficulties in perceiving the future that other
acquisition-minded companies do. Like they also, we face the inherent problem that the
seller of a business practically always knows far more about it than the buyer and also picks
the time of sale â a time when the business is likely to be walking "just ďŹne." â WB
66. âThis fishing tackle
manufacturer I knew
had all these flashy
green and purple
lures. I asked, âDo fish
take these?
âCharlie?â he said, âI
donât sell these lures
to fish.ââ â Munger
67. Game-able systems
leading to
unintended
consequences
(Peltzman effect)
68. Take a look at this commercial. It has all the attributes of an effective
commercial. See for yourself:
YouTube - Awesome "Buckle Up" PSA Commercial
http://www.youtube.com/watch?v=m6ZKVdKTWww
69. The PSA commercial on previous slide was persuasive, but was it right?
Take a look at this:
YouTube - Sam Peltzman on the Peltzman Effect
http://www.youtube.com/watch?v=7IB2xRfRHOA
Peltzman effect - Wikipedia, the free encyclopedia
http://en.wikipedia.org/wiki/Peltzman_effect
The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are correlated with the number of
vehicle registrations per capita, and differing safety standards do not appear to be signiďŹcant.
Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewarded
students a $1 for catching a rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding ratsâŚ
People not only respond to incentives, sometimes oneâs well-intentioned decisions result in perverse outcomes. We call that âperverse incentives.â Read more
about this from:
http://en.wikipedia.org/wiki/Perverse_incentive
70. are there
âfunctional
equivalentsâ of the
peltzman effect?
73. Jim Rogers
âYou can either
control the
price, or the
supply, but not
BOTH!â
See âWill Indian
Steel Disappear?â
Black Markets
License raj
Ration shops
http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm
If you ďŹx price too low, supply will vanish!
If you ďŹx the supply (e.g. license raj) and then try to impose price controls
also, you will see a black market emerge.
Low price of diesel vs petrol
Smugglers and black marketeers vs. Arbitrageurs
77. Pitched as an âinsurance productâ
What happens when CDS are bought by hedge funds with no insurable
interest?
i.e. who have nothing to lose from the demise of the corporation, are not
âinsuranceâ in the true sense of the word.
78. Leaking bad news to
media
Planting false stories
Pressurizing bankers
to recall their loans
etc..
79. Example 9:
Carol loomis on
âThe risk that wonât
go awayâ
80. The risk that wonât go
away
The risk that STILL
wont go away
Law of conservation
of risk
http://money.cnn.com/2008/09/25/magazines/fortune/
loomis_swamp.fortune/index.htm
http://money.cnn.com/2009/06/22/news/economy/
derivatives_regulation_risks.fortune/index.htm
http://fundooprofessor.blogspot.com/2005/09/carol-loomis-risk-and-
law-of.html
86. âIn setting compensation,
we like to hold out the
promise of large carrots,
but make sure their
delivery is tied directly
to results in the area
that a manager controls.
When capital invested in
an operation is
significant, we also both
charge managers a high
rate for incremental
capital they employ and
credit them at an equally
high rate for capital they
release.
âThe product of this money's-not-free approach is deďŹnitely visible at Scott
Fetzer. If Ralph can employ incremental funds at good returns, it pays him
to do so: His bonus increases when earnings on additional capital exceed a
meaningful hurdle charge. âBut our bonus calculation is symmetrical: If
incremental investment yields sub-standard returns, the shortfall is costly
to Ralph as well as to Berkshire. The consequence of this two- way
arrangement is that it pays Ralph - and pays him well - to send to Omaha
any cash he can't advantageously use in his business.â
88. âThe bonuses received by
dozens of top executives,
starting with Tony, are based
upon only two key variables:
(1) growth in voluntary auto
policies and (2) underwriting
profitability on âseasonedâ
auto business (meaning
policies that have been on the
books for more than one
year).â
90. âA distinguishing
characteristic of H. H.
Brown is one of the most
unusual compensation
systems Iâve encountered -
but one that warms my
heart: A number of key
managers are paid an
annual salary of $7,800,
to which is added a
designated percentage of
the profits of the company
after these are reduced by
a charge for capital
employed. These managers
therefore truly stand in
the shoes of owners.â
âIn contrast, most managers talk the talk but don't walk the walk, choosing
instead to employ compensation systems that are long on carrots but short
on sticks (and that almost invariably treat equity capital as if it were cost-
free). The arrangement at Brown, in any case, has served both the company
and its managers exceptionally well, which should be no surprise: Managers
eager to bet heavily on their abilities usually have plenty of ability to bet
on.â
98. Looking for trends when there arenât any
Associating Trend with Destiny
Will this stock keep going up? vs. Has this stock been going up?
Mind looks for patterns in things that are random.
99. Michael Shermer: Pattern Seeking Video
http://www.ted.com/talks/
michael_shermer_on_believing_strange_things.html
105. Advertisers demonstrate the power of
positive associations by constantly
connecting their products with the things
we like.
Advertisers demonstrate the power of positive associations by constantly connecting
their products with the things we like.
Girl Models next to Car Models
Lending positive traits of beauty and desirability
You wonât see Coke advertised alongside some account of the death of a child. Instead,
Coke ads picture life as happier than reality.
106. âThrowing the baby out with the bathwaterâ
âIf Satyam Computers is a fraud, then all IT companies are frauds, so I am
going to dump them all.â - Mr. Market
Under what circumstances, Mr. Market would be wrong?
107. Painting
Everythin
g with the
same
brush
âPainting everything with the same brushâ
A drop in price of steel is bad news for ALL steel companies, so I am going
to dump them all.â - Mr. Market.
Under what circumstances, Mr. Market would be wrong?
108. âOur inferential machinery, that we use in daily life, is not made for a complicated environment in
which a statement changes markedly when its wording is slightly modiďŹed. Consider that in a
primitive environment there is no consequential difference between âmost killers are wild animalsâ
and âmost wild animals are killers.â The error here is almost inconsequential.
âOur statistical intuitions have not evolved for a habitat in which these subtleties can make a big
difference.â
109. between 1983 and 1993, when butter
production was up 1%, the S&P 500 was up 2%
the next year. Conversely, if butter
production was down 10%, S&P 500 DECLINED
BY 20%.
Co-relation and causation
110. Insensitivity
to Base Rates
(Probability
unconditioned
on featured
evidence)
Base rate is the probability unconditioned on featural evidence, frequently also
known as prior probabilities. For example, if it were the case that 1% of the
public are "medical professionals" and 99% of the public are not "medical
professionals," then the base rates in this case are 1% and 99%, respectively.
111. âIn all free-enterprise attitudes there is a strong tendency to believe that
the more money, either as income or assets, of which an individual is
possessed, the deeper and more compelling his economic and social
perception, the more astute and penetrating his mental processes. In a
world where for many the acquisition of money is difficult... the possession
of it in large amount seems a miracle. Accordingly, possession must be
associated with some special genius.â- Galbraith
112. Mis-associating good outcomes with skill (stock market swindle, massively
outperforming fund etc.)
Mis-associating bad outcomes with bad process
Under-appreciation of role of luck
118. Simone Tata,
Chairperson of
Trent &
Stepmother of
Ratan Tata,
Chairman of the
Tata Group
http://
en.wikipedia.org/
wiki/Simone_Tata
119. 2002
1.In 2002, a class-project report on a company called Trent landed on my table and when I opened it my eyes
popped out again!
2.Lakme, a highly valued cosmetics company had, some time back, sold off its brands to Unilever. Lakme was
controlled by the Tataâs one of Indiaâs largest business groups.
3.The lady who was running the company, in her own wisdom decided to not distribute the money to the companyâs
stockholders. Instead, she announced a foray into retail business of running departmental stores - TRENT -
WESTSIDE
4.That market hated that decision - NEXT SLIDE
120.
121. Trentâs Stock Price Chart
1.Over the next few years, as retail boom took off, so did the stock - what we
bought for Rs 68 was now quoting at Rs 800.
2.When someone asks me when will I buy a retail stock, my favorite answer is
âwhen its free!â
3.Value investing does have a tendency to spoil you!
4.The key lesson here is that while we may try to be catalysts in unlocking value, to
succeed here is not a precondition - there may be OTHER catalysts in place will will
give you a very nice exit.
124. I love what Taleb has
to say about
inventions, how
almost all of the
discoveries that have
had tremendous
impact on our
culture were
accidents in the
sense that they were
discovered while
searching for
something else.
Arlene Goldbard, Blogger
âBecause of hindsight bias, he says, histories of economic life and scientiďŹc discoveries are written
with straightforward story lines: someone set out to do something and succeeded, itâs all about
intention and design. But in truth, âmost of what people were looking for, they did not ďŹnd. Most
of what they found they were not looking for. Penicillin was just some mold inhibiting the growth
of another lab culture; lasers at ďŹrst had no application but were thought to be useful as a form of
radar; the Internet was conceived as a military network; and despite massive National Cancer
Institute-funded cancer research, the most potent treatmentâchemotherapyâwas discovered as a
side-effect of mustard gas in warfare (people who were exposed to it had very low white blood cell
counts). Look at todayâs biggest medical moneymakers: Viagra was devised to treat heart disease
and high blood pressure.â
125. Chains of habit
are too light to
be felt ...
... until they are
too heavy to be
broken -
Warren Buffett
Donât take the same route to office, donât listen to same type of music, donât read papers from front
page, donât order from a menu from starters to desserts, expose yourself to different cultures - you
donât know what you idea might stumble uponâŚ
and when u get that ďŹash of inspiration - your idea - JOT it down - some of the best business plans were made
on napkins
Allow one thing to lead to another (serendipity)
Be connected- Linkedin, Facebook, etcâŚ
126. âGo where
events ďŹow
fastest.
Surround
yourself with a
churning mass
of people and
things
happening.â
127. âBut why is she in
the right places at
the right times?
Because she has
made the effort to
be in many places
at many times. Fate
has given her a
lucky break, but
she has earned it.
She has positioned
herself for it.â
Drop what youâre doing when you get an interesting opportunity, call etc - DONT IGNORE IT!
128. âIt is a fundamental assumption
of the Work Ethic that people
ought to have goals and should
struggle toward them in a
straight line. We are counseled
to ďŹx our eyes on our goals,
looking neither to the right nor
to the left, refusing to be
distracted.
Max Gunther
This is supposed to be the sure route to success. But here is a puzzling fact. It turns out
that lucky men and women, on the whole are not straight-line strugglers. They not only
permit themselves to be distracted, they invite distraction. Their lives are not straight lines
but zigzags.â
129. Herb Simon
"I have encountered many
branches in the maze of
life's path, where I have
followed now the left
fork, now the right. . . .In
describing my life as
maze-like, I do not mean
that I have a large
number of deliberate,
wrenching decisions to go
off in one direction or
another.
On the contrary, I have made very few. Obvious responses to opportunities and
circumstances, rather than studied decisions, have put me on the particular roads I have
followed."
130. âThe lucky... are
aware that life is
always going to be
a turbulent sea of
opportunities
drifting randomly
past in all
directions.â
âIf you put blinders on yourself so that you can see only straight ahead, you will miss nearly
everything. This is what the unlucky typically do. They stick to preplanned life routes even
when they are going nowhere or are actually plodding downhill to disaster.â- Max Gunther
131. Search strategy - I do not ignore serendipity
The Rabbit Runs
Faster than the Fox
because the Fox is
only running for his
dinner while the
rabbit is running for
his life.
Ideas can come from screens, company management interaction, reading ânewsâ - ignore
macroeconomic, focus on company speciďŹc - management interviews or make up ur own
news by looking at fundamental, slow but long-term changes happening to companies.
ideas come from reading books from multiple disciplines, even Aesop fables.
Rise in the price of a raw material leads to the idea of looking at the company which supplies
the raw material
133. âExcuse me. I have
ďŹve pages. May I
use the Xerox
machine?â
Compliance Rate:
64%
Reason Respecting Tendency
The word âbecauseâ is one of the most powerful words in English.
134. âExcuse me, I have ďŹve
pages. May I use the
Xerox machine because
I am in a rush?â
Compliance Rate: 94%
135. âExcuse me. I have ďŹve
pages. May I use the
Xerox machine because
I have to make some
copies?â
Compliance Rate:93%
Implication for us:
Because people want reasons which explain why something happened, there are people who
materialize to offer reasons even when there isnât any.
137. I call this the âDam Foolsâ Model - Pain Reducing Psychological Denial. This from Jared Diamond:
âThe last reason that I shall mention for irrational failure to try to solve a perceived problem is psychological denial. This is a technical term with a
precisely deďŹned meaning in individual psychology, and it has been taken over into the pop culture. If something that you perceive arouses an
unbearably painful emotion, you may subconsciously suppress or deny your perception in order to avoid the unbearable pain, even though the
practical results of ignoring your perception may prove ultimately disastrous. The emotions most often responsible are terror, anxiety, and sadness.
Typical examples include refusing to think about the likelihood that your husband, wife, child, or best friend may be dying, because the thought is
so painfully sad, or else blocking out a terrifying experience. For example, consider a narrow deep river valley below a high dam, such that if the
dam burst, the resulting ďŹood of water would drown people for a long distance downstream. When attitude pollsters ask people downstream of the
dam how concerned they are about the dam's bursting, it's not surprising that fear of a dam burst is lowest far downstream, and increases among
residents increasingly close to the dam. Surprisingly, though, when one gets within a few miles of the dam, where fear of the dam's breaking is
highest, as you then get closer to the dam the concern falls off to zero! That is, the people living immediately under the dam who are certain to be
drowned in a dam burst profess unconcern. That is because of psychological denial: the only way of preserving one's sanity while living immediately
under the high dam is to deny the ďŹnite possibility that it could burst.â
There is much denial in the world of business. Witness whatâs happening in the banking sector right now.
141. Refusal to look at stock
market pages when
facing massive losses
vs. doing frequent
marking to market of
portfolios during bull
runs
142. âI think its in the
nature of things
for some
businesses to die.
Its also in the
nature of things
that in some cases,
you shouldnât
fight it...
âThereâs no logical answer in some cases except to wring the money out
and go elsewhere. And thatâs very tough for managements to do. In fact,
they almost never face up to that. Itâs very rare.â â Munger.
146. âI don't want you to think we have any
way of learning or behaving so you won't
make mistakes. I'm just saying that you
can learn to make fewer mistakes than
other people - and how to ďŹx mistakes
faster when you do make them...
147. âBut there's no way you can live an
adequate life without making many
mistakes.
148. In fact, one trick in life is to get so you
can handle mistakes. Failure to handle
psychological denial is a common way
for people to go broke...
149. âYou've made an enormous commitment to
something.The more the effort and money
youâve poured in, the more the whole
consistency principle makes you think: "Now
it has to work, If I put in just a little more,
then it'll work.â [Contrast- boiling frog]
150. And deprival super-reaction syndrome also comes
in:You're going to lose the whole thing if you don't
put in a little more. People go broke that way -
because they can't stop and rethink and say: "I
can afford to write this one off and live to ďŹght
again. I donât have to pursue this thing as an
obsession - in a way that will break me...
151. Part of what you must learn is to handle
mistakes and new facts that change the
odds. Life, in part, is like a poker game,
wherein you have to learn to quit sometime
when holding a much-loved hand.â