Seeking Wisdom

by Peter Bevelin

  $100. We want to get rid of the bad experiences first. Immediate losses are preferred over delayed ones. Just as we don't like bad experiences, we also don't like waiting for them. We like to get over them fast.

  Mere association and reinforcement are both examples of conditioned reflexes. Charles Munger gives an example how these forces can be used as he describes the invention of non-alcoholic drinks:

  The food value and so forth of the beverage is the reinforcer. And the trade dress, trade name and look of the beverage is the stimulant...

  Then, you go on to the second kind of conditioned reflex- and that's straight Pavlov... Well, how do you get Pavlovian mere-association effects? Obviously, you associate this beverage and its trademarks with every good thing that people like generally: exalting events, sex objects, happy times - you name it.

  How can we lose a conditioned reflex that's working for us? Charles Munger continues:

  Well, the customer tries something else and discovers that it's a big reinforcer. So he shifts brands. We know, in matrimony, that if you're always available, the spouse is less likely to shift brands. And people don't tend to organize marriage to include permanent long separations. Similarly, if you're selling a product and it's always available, people are less likely to shift to some other product and get reinforced by it.

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  Keep in mind

  American statesman, scientist and philosopher Benjamin Franklin tells us that: ''A spoonful of honey will catch more flies than a gallon of vinegar." Praise is more effective in changing behavior than punishment. It is better to encourage what is right than to criticize what is wrong.

  Set examples. Michel de Montaigne said: "It is a custom of our justice to punish some as a warning to others. For to punish them for having done wrong would, as Plato says, be stupid: what is done cannot be undone. The intention is to stop them from repeating the same mistake or to make others avoid their error. We do not improve the man we hang: we improve others by him."

  Don't over-learn from your own or others bad or good experience. The same action under other conditions may cause different consequences.

  Separate between skill and chance. Charles Munger says, "As you occupy some high-profit niche in a competitive order, you must know how much of your present prosperity is caused by talents and momentum assuring success in new activities, and how much merely reflects the good fortune of being in your present niche."

  American novelist Upton Sinclair said: "It is difficult to get a man to understand something when his salary depends upon him not understanding it." Since people do what works, be sure to make the incentives right. Tie incentives to performance and to the factors that determine the result you want to achieve. Make people share both the upside and downside. And make them understand the link between their performance, their reward and what you finally want to accomplish. For example, tie a manager's compensation to gain in business value (of the unit under his control) minus a cost factor for capital that is used to produce this value. The auto insurer GEICO's plan exemplifies Berkshire Hathaways's incentive compensation principles. Warren Buffett says:

  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 m managers.

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  Reward individual performance and not effort or length in organization and reward people after and not before their performance.

  Don't let money be the only motivation. If we reward people for doing what they

  like to do anyway, we sometimes turn what they enjoy doing into work. The reward changes their perception. Instead of doing something because they enjoy doing it, they now do it because they are being paid. The key is what a reward implies. A reward for our achievements makes us feel that we are good at something thereby increasing our motivation. But a reward that feels controlling and makes us feel that we are only doing it because we're paid to do it, decreases the appeal. Blaise Pascal said: "We are generally the better persuaded by the reasons we discover ourselves than by those given to us by others."

  Install systems and rules that encourage the behavior you want. Never let it pay someone to behave in a way you don't want. Have systems that make it hard for people to get away with undesirable behavior. Make undesirable behavior costly. The painful consequences of undesirable behavior must outweigh its pleasurable consequences. For example, the consequences of spending time in jail ought to be more painful than the pleasure of getting away with burglary.

  Systems can be hard to change as Warren Buffett observes, "It's very hard to change a system when the guy whose hand is on the switch benefits enormously and, perhaps, disproportionately from that system."

  Decision-makers should be held accountable for the consequences of their actions. In The Case for Modern Man, American philosopher Charles Frankel defines responsibility: ''A decision is responsible when the man or group that makes it has to answer for it to those who are directly or indirectly affected by it." Charles Munger adds, ''An example of a really responsible system is the system the Romans used when they built an arch. The guy who created the arch stood under it as the scaffolding was removed. It's like packing your own parachute."

  SELF-INTEREST AND INCENTIVES

  "Damn it all, we want to get at the truth" [said Lord Peter Wimsey}"Do you" said Sir Impey dryly. "I don't. I don't care two pence about the truth. I want a case."

  Dorothy Sayers (British writer, 1893-1957)

  The organizers of a tennis tournament needed money. They approached the CEO of TransCorp and asked him to sponsor the tournament.

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  "How much?" asked the CEO. "One million,"said the organizer.

  "That is too much money," said the CEO.

  ''Not if you consider the fact that you personally can p/,ay one match, sit at the honorary stand next to a member of the presidential family and be the one that hands over the prize,"said the organizer.

  "Where do I sign?" said the CEO.

  People do what they perceive is in their best interest and are biased by incentives. For example, when the first Dead Sea scrolls were discovered and the archeologists wanted more fragments of the scrolls to be found, they offered a reward per fragment. The result: the fragments were split into smaller pieces before they were turned in.

  The comedian Groucho Marx once interviewed a U.S. Senator about a miracle cure-all vitamin and mineral tonic that the Senator had invented. When Groucho asked him what it was good for, the Senator answered: "It was good for five and a half million for me last year."

  Incentives for the decision-maker determine behavior. This means that we have to recognize self-interested behavior in others.

  Are advisors always to be trusted?

  There is an old saying: "Never ask the village barber if you need a haircut." We are biased by our incentives as are others including lawyers, accountants, doctors, consultants, salesmen, organizations, the media, etc. What is good for them may not be good for us. Advisors are paid salesmen and may trick us into buying what we don't need.

  For an attorney, litigation is often more lucrative than settlement. Lawyer William F. Coyne, Jr. says in The Case for Settlement Counsel there are "significant incentives for lawyers not to embrace early settlement ... These incentives include the need to market services, the desire not to appear weak, the obligation to represent a client zealously, the thirst for justice, but perhaps not least, the desire to maximize income."

  Warren Buffett tells us that one of Berkshire's compe
nsation arrangements was worked out: "without the "help" of lawyers or compensation consultants. This arrangement embodies a few very simple ideas - not the kind of terms favored by consultants who cannot easily send a large bill unless they have established that you have a large problem (and one, of course, that requires an annual review)."

  Charles Munger tells us about the common tendency of salesmen:

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  All commissioned salesmen have a tendency to serve the transaction instead of the truth.

  ...I put consultants in the same category, sometimes even lawyers - sometimes especially lawyers.

  Many years ago, a Pasadena friend of mine made fishing tackle. I looked at this fishing tackle - it was green and purple and blue - I don't think I'd ever seen anything like them. I asked him "God! Do fish bite these lures?" He said to me, "Charlie, I don't sell to fish."

  Let's look at the brokerage and investment banking business. Brokers have a strong incentive to get us to trade. They advise us what to buy and sell. Volume creates commissions. Investment bankers encourage overpriced acquisitions to generate fees. Investment bankers have every incentive to get initial public offerings (IPO) deals done, regardless of the company's quality. Their compensation is tied to the revenues the deal brings in. Analysts are rewarded for helping sell the IPO. Brokers want to move the stock. What did Groucho Marx say? "I made a killing on Wall Street a few years ago.. .I shot my broker."

  Similarly, in the medical field, some psychologists ensure themselves successive

  paydays by telling their patients that another visit is required. And they don't talk about the limits of their knowledge. Their careers are at stake. As American actor Walther Matthau said, "My doctor gave me six months to live. When I told him I couldn't pay the bill, he gave me six more months."

  Why do bankers approve risky loans?

  People who are rewarded for doing stupid things continue to do them. From their frame of reference, they acted logically based on how they were rewarded. The incentive system paid them to do the wrong thing. So if market share rather than profits pay a banker, he will write as many loans as possible. He is being rewarded every year while the net consequences of the bad loans won't be realized for a long time.

  Charles Munger gives an example of how Lloyd's Insurance rewarded their people:

  They were paid a percentage of the gross volume that went through. And paying everybody a percentage of the gross, when what you're really interested in is the net, is a system - given the natural bias of human beings toward doing what's in their own interest even though it has terrible consequences for other people - that really did Lloyd's in.

  Be carefal what you pay for, you may get it.

  The city of New Orleans introduced a program under which districts that

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  showed improvement in cnme statistics received awards that could lead to bonuses and promotions, while districts that didn't faced cutbacks and firings. What happened? In one police district, nearly half of all serious crimes were reclassified as minor offences and never fully investigated.

  Studies show that teachers help students cheat on standardized tests when their jobs or pay increases depend on the outcome of the tests.

  john knew that if he didn't show good figures, his project wouldn't be fonded so he cooked the books.

  Why do people give a biased picture of reality? Why do they make figures look better than they are or fake data to support something? Behavior that is not acceptable but results from the tendency of people doing what they perceive is in their best interest.

  There may be powerful economic and prestige-related incentives to underestimate costs and overestimate benefits when people try to sell projects. For example, studies based on data from several hundred large transportation infrastructure projects in twenty nations and five continents found evidence that in a number of cases, project promoters and forecasters of billion-dollar projects intentionally misrepresented the costs, benefits and risks of projects in order to get them approved.

  Charles Munger says that projections should be handled with care:

  Mark Twain used to say, "A mine is a hole in the ground with a liar on the top." And a projection prepared by anybody who stands to earn a commission or an executive trying to justify a particular course of action will frequently be a lie - although it's not a deliberate lie in most cases. The man has come to believe it himself. And that's the worst kind. Projections should be handled with great care - particularly when they're being provided by someone who has an interest in misleading you."

  Warren Buffett adds:

  I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections, but we care very much about, and look very deeply at, track records. If a company has a lousy track record, but a very bright future, we will miss the opportuniry... I do not understand why any buyer of a business looks at a bunch of projections put together by a seller or his agent. You can almost say that it's naive to think that those

  projections have any utiliry whatsoever. We're just not interested.

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  If we don't have some idea ourselves of what the future is, to sit there and listen to some other guy who's trying to sell us the business or get a commission on it tell us what the future's going to be - like I say, it's very naive.

  Buffett also gives us a test:

  When they make these offerings, investment bankers display their humorous side: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier. If you are shown such schedules, I suggest that you join in the fun: Ask the investment banker for the one-year budgets that his own firm prepared as the last few years began and then compare these with what actually happened.

  The consultant to TransCorp was hired and paid by the company to advise the CEO on how he should be paid. "If I tell the CEO what he wants to hear, he will pay me well, rehire me and recommend me to other CEOs. And if I make it sound complicated it will be easier to send a larger bill "

  How do we act as an employee? If our boss wants a particular answer, do we give it? To quote the German proverb: "Whose bread I eat, his song I sing." Warren Buffett says:

  I would say that the typical corporate organization is structured so that the CEOs opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants.

  "I don't like to be embarrassed and have my name and reputation threatened with disgrace," said the CEO ofTransCorp.

  How can we change people? Benjamin Franklin said: "Would you persuade, speak of interest not of reason." Since the risk of losing is more motivating than the chance of gaining, we stand a better chance changing people if we appeal to their fear oflosing something they value - job, reputation, status, money, control, etc.

  It is often better to avoid situations where we need to change people. Changing people is hard as Warren Buffett says, "I'd say that the history that Charlie and I have had of persuading decent, intelligent people who we thought were doing unintelligent things to change their course of action has been poor.. . When

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  people want to do something, they want to do something."‌

  Changing people affects their motivation, feelings of responsibility, and tendency to reciprocate. It is better when people act out of their own free will. Warren Buffett illustrates:

  We want the manager of each subsidiary to run their business in the way they think is best for their operation we'll never tell a subsidiary manager which vendor to patronize or

  anything of that sort. Once we start making those decisions for our managers, we become responsible for the operation and they're no longer responsible for the operation. And th
ey're responsible for their operations. That means that they get to make the call, that it's up to them to do what's best for their subsidiary and that it's up to any other company that wants to do business with their operation to prove to them why it's best That's the

  Berkshire approach. I think, on balance, our managers like it that way - because they're

  not going to get second-guessed and nobody will go over their heads.

  Keep in mind

  Don't automatically trust people who have something at stake from your decision. Ask: What are the interests? Who benefits?

  Understand people's motivations. Money, status, love of work, reputation, position, power, envy? What are they rewarded or punished for? Are they benefiting or losing from the present system?

  People's interests are not only financial. They could also be social or moral. For example, public embarrassment, social exclusion, conscience, shame or guilt may cause people to stop some undesirable behavior. For example, by requiring restaurants to post hygiene quality scores in their front windows, the Los Angeles county health department caused a dramatic improvement in restaurant hygiene and a reduction in food-related illnesses.