The Role of Incentives, Risks, and Rewards

The interplay between risk and reward and social incentives is often misunderstood. This is partly because determining the risk and reward for taking action is not always clearly seen. In addition, those that try to sell their wares - in any form be it monetary, material, political, ideological, etc. - often obfuscate the real risk and reward of buying in. That is, sales people have an incentive to be deceitful because in the short term they can convince people that greater rewards can be obtained with lower-than-expected risk. In this sense, sales people includes anyone trying to sell you something, politically, socially, ideologically, or materially.

Consider the first time you bought a cheaply made product only to realize later you had made a bad decision. Initially, the lower amount of money you spent, and were able to keep in your pocket, appeared to offer greater value than a more expensive product which may have been assumed to have similar quality. However, soon the product failed and you realized that you traded a lower amount of money for a riskier product. Often, that lesson only has to be learned once before a person understands the difference between the incentives of sales people and the trade-offs of risk and reward.

The role of deceit in the reality of incentives, risks, and rewards is actually more dangerous in areas outside of the exchange of goods and services. For instance, in politics and ideologies, when a policy is enacted by a politician and fails in its application, there is a perverse incentive for the politician or ideologue to conceal the failure and promote a false understanding of the situation. This is because politicians are held to such high standards that acknowledging failure in any area raises the risk of being voted out of elected office. For the politician, the risk of losing an election perpetuates the constant misinforming of the public. It is then required that the public hold all politicians and ideologues accountable to reduce the risk of long term unintended consequences of bad public policy. The perverse incentive of politics increases the risk of voting for the wrong person and reduces the actual rewards gained by the public.

The same economic dynamic is true in the world of investing and money management. Investment bankers, financial advisors, and money managers can have incentives which disproportionately incentivize the self-interest of the investment banker or organization over the interest of the client. In finance, the term for a person that holds the clients well-being in highest regard is called a fiduciary. You may have heard this term when finance is discussed. This is the ideal state, but sadly not the reality. Even those financial professionals that call themselves fiduciaries are subject to incentives and when incentives are formulated in such a way that a financial organization or individual is disproportionately incentivized to be corrupt over being honest, often they become corrupt. 

In the world of fund management, a financial institution charges an expense for actively managing the money of their clients. The ideal state of this relationship would revolve around the money manager seeking out the highest possible returns in exchange for the payment of money management fees. But when the expense fee is not tied to actual performance, then the incentive is no longer to actively manage a fund with the highest possible returns, but rather to find clients to buy into the fund. 

Take this example. In a new fund that is seeking to attract new clients excess profits is a great selling point for more clients. The money manager or financial institution is incentivized to find high returns in the market for clients because that fund will gain more clients if they show success. However, as a fund gains prominence, the incentive changes from fund performance to fund size and perpetuity. This may cause the financial institution to place unknowing or unwitting clients into a poor performing fund to line their own pockets. Here is why: If a small fund has 1 million dollars under management and an expense fee of 1%, then the financial institution stands to make $10,000. The incentive is to produce high profits to attract more clients. However, over time, when the fund becomes institutionalized, and has acquired, say, 500 million dollars under management, then the financial institution stands to make $5,000,000. The incentive to perpetuate the new income of the financial institution or fund manager gains greater weight than the incentive to return high profits for customers. Examples of this type are documented in financial literature where a clear correlation exists between the size of a fund and the returns. Smaller funds tend to return higher returns than larger funds (Swensen, 2009).

The same perversion of incentivizing institutions to lie to the public about actual risk and reward is present everywhere in government. As a government institution becomes memorialized in society, its primary incentive no longer becomes the fulfillment of a mission, but rather to justify its self-perpetuation. The pressure of perpetuating a failed policy institution cause many government institutions to produce data that appears to confirm the need for the institution, but in reality skews the truth of the situation. Thomas Sowell explores a number of instances where this has happened in the past and continues to happen (2018). The risk to those in society is that tax dollars are spent and future policy is formulated to support demonstrably failed laws and initiatives. 

In science it would come as no surprise to anyone that research often conforms to the expectations of those paying for the research. Is it any surprise that when cigarettes began to come under fire in the 1930's and 1950's that research developed showing that smoking was good for you (Helio.com, 2009)? Or is it surprising when vegan backed research finds that the chicken egg is bad for you while non-vegan backed research concludes the opposite? The incentive of the researchers is distorted while the public bears the risk and loss of reward for skewed research results.

How does all this apply to risk and reward in investments? If an individual wants to truly maximize their returns in investments in stock market securities, then they must spend time to understand the risks, rewards, and incentives of the securities they purchase, the financial institutions they engage with and the fund managers they entrust with their money. 

In government? Individuals must examine with a critical eye the incentives of politicians. This means they must temporarily stop seeing the world from their own subjective perspective and ask what are the motivations of politicians and how would such motivations be provable and falsifiable?

In advertising and media? We must remember that news outlets are for-profit organizations. They exist to make money. The money they make primarily comes from advertising. They have very strong incentives to increase their ratings in any way possible in order to maximize their profits. We must ask what kind of programming produces the greatest interest from the watching public because that is their greatest incentive. Not truth in journalism. The answer to that question gives you the answer to your personal risk and reward of believing any such organization. 

For all things where your lifestyle, beliefs, livelihood are at stake three actions should be taken in order to adequately assess incentives, risks, and rewards from any source. 1) What is the data set or information that would objectively prove what I believe about a investments, a politician, the news media, etc.? 2) What set of data or information would be required to falsify that position. 3) Assess both sets of data to form an objective opinion.

Too often we simply take the position of comfort and do not want to be challenged. But a well lived life can only be realized by accepting the challenge to understand incentives, risks, rewards and to challenge all "truth".  

References

Helio.com (2009, March 10). Cigarettes were once "physician" tested, approved. https://www.healio.com/news/hematology-oncology/20120325/cigarettes-were-once-physician-tested-approved

Swensen, D. F. (2009). Pioneering Portfolio Management. Free Press. 

Sowell, T. (2018). Discrimination and Disparities. Basic Books.