The Mental Model of Incentives
Charlie Munger wrote in Poor Charlie’s Almanack:
“Perhaps the most important rule in management is to get the incentives right.”
Charlie argues that people respond most strongly to what they view as their incentive or disincentive.
In business, there is almost always someone else involved in whatever you are trying to do. Munger recommends that you always reflect on:
“What is someone getting out of this.”
Charlie gives a few business examples of incentive bias (source: Poor Charlie’s Almanack).
FedEx — he said that they couldn’t get the planes to shift packages from plane to plane in a timely manner.
The problem was that the workers were being paid per hour. When FedEx changed to paying the workers per shift, the workers were able to to shift packages faster.
Xerox — Joe Wilson had to return to Xerox to help figure out why their older, inferior copy machines were outperforming their newer, better machines. Wilson found the explanation in a perverse commission structure that incentivized selling the older machines more than the new machines.
Munger has talked about incentive bias related to two clients his father (an attorney) had:
- Grant McFayden — McFayden owned a Ford dealership and was a brilliant man of enormous charm and integrity and who made excellent decisions.
- Mr X — Mr. X (Munger leaves out his name) was a blowhard, overreaching, pompous, difficult man.
Charlie, when he was 14, asked his dad why he did so much work for Mr. X, the blowhard, instead of doing more work for wonderful men like McFayden.
Charlies says his father told him:
“Grant McFayden treats his employees right, his customers right, and his problems right. If he gets involved with a psychotic, he quickly walks over to where the psychotic is and works out an exit as fast as he can. Therefore, Grant McFayden doesn’t have enough remunerative law business to keep you in Coca-Cola. But Mr. X is a walking minefield of wonderful legal business.”
Translation: lawyers have a much stronger financial incentive to represent clients who get in trouble and even break the law and will likely see less financial gain from working for highly ethical clients.
“That’s what partly drove me out the profession,” Charlie wrote in Poor Charlie’s Almanack.
Disincentives are equally important. Charlie suggests, in Poor Charlie’s Almanack, that a “very significant fraction of the people in the world will steal if:
- A) it’s very easy to do and
- B) there’s practically no chance of being caught
To succeed in business, you need to disincentevize/discourage a negative behavior such as stealing by, for example, making it extremely difficult to do and likely to be detected (that’s usually accomplished through systems and controls)
The Law of Large Numbers (Another Mental Model)
The law of large numbers indicates that the higher the number of times something is performed, the more likely it will receive something close to the average of the results.
For example, if you rolled a six-sided die, the average results you can expect is the average of the 6 outcomes is a 3.5 ( (1 + 2 + 3 + 4 + 5 + 6)/6. The law of large numbers indicates that your average roll will get closer and closer to 3.5 the more you roll the dice!
That’s why when you’re winning at a casino (or anywhere else where “the house” takes its cut), you should quit early — otherwise, the law of large numbers will eventually kick in: the more bets you make the closer you will get to netting a loss (since a casino is designed to have a greater than 50/50 edge over you).
But don’t fall victim to what’s called the “gambler’s fallacy”. In the gambler’s fallacy, if you flip a coin 5 times, and it comes up heads, some folks falsely believe that then the 6th toss is more likely to come up tails. That’s not really true. Each single event is still a 50/50 probability. The law of large numbers instead says that the more you flip the coin the closer the average result will be to heads/tails being at a 50/50 split.
For example, if you tossed a coin just 10 times, you could easily get 8 heads (80%) and 2 tails (20%); but if you tossed a coin 1,000 times, the law of large numbers smooths out the results so that the heads/tails results would be closer to the average of 50%.
As you take more and more samples, the average of that sample will converge to the expected value.
The law of numbers is also used to explain how the larger the number you have the more you have to work to grow that number.
For example, if Facebook has $1 billion in profits and Berkshire Hathaway has $10 billion in profits, the law of numbers indicates that Facebook will have an easier time growing profits 10% per year over the next 1o years than Berkshire could (all other things equal) because Berkshire’s starting base is so much larger.
The Law of Scale (the benefits are “Ungodly Important”)
In his epic commencement speech to the USC law school grads in 1994, Charlie Munger mentions “scale” 24 times.
The advantages of scale are “ungodly important”, he points out.
Benefits of Scale = Lower Costs, Higher Prices & Bets on New Markets
Benefits of scale include reducing costs, raising prices and testing new markets.
In a beer business, for example, Anheuser-Busch operates at such a higher volume than Anchor Steam beer (based in San Francisco), thatAnheuser-Busch can buy bottles and cans for much cheaper than Anchor Steam (and thus charge less for their beer). Anheuser-Busch’s scale allows them to lower their costs significantly.
The Law of Scale can also allow for charging higher prices.
One of Charlie’s favorite examples of higher prices is this Wrigley gum example in which I paraphrase Charlie:
If you’re given a choice of paying $.30 for a pack of Wrigley Chewing Gum versus $.20 for “Schlotz’s Gum,” you’re likely going to choose to pay $.10 more for Wrigley because you’ve heard of it before.
The law of scale also allows a business to test new customer acquisition.
Charlie, in his USC speech, gives the example of how scale allowed Proctor and Gamble to enter the TV advertising market in the 1950′s and ’60s:
“…in the early days, we had three networks that had whatever it was—say 90% of the audience.
Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn’t. And there was no way of buying it in part. Therefore, he couldn’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising which was the most effective technique.
So when TV came in, the branded companies that were already big got a huge tail wind.”
The law of scale can also have a “network effect” (see Google and other examples ), providing the business who who wields it with an ever-growing advantage to other parts of its business.
The law of scale is also related to social proof. As a product becomes dominant (think Google, Coca Cola, Visa, Apple, etc.), then most humans will feel at a sub-conscious level that those products are superior.
The Drawbacks to Scale
A major drawback to scale — and this is also the downside of another mental model, The Law Of Large Numbers, — is that the larger you get the harder it is for you to grow at the same levels as smaller businesses.
And with bureaucracy comes territoriality which then leads to you ignoring opportunities outside your territory.
A Rule of Human Systems: Leadership Will Always “Pass the Baton”
Charlie Munger frequently emphasizes that anyone in a position of dominance will inevitably “pass the baton” of leadership.
Below are some examples Charlie has mentioned in talks:
Transcript from the 2003 Wesco Annual Meeting, May 7, 2003 *
“The loss of dominance rate is 100%. Every great civilization that was dominant eventually passed the baton. Similarly, the greatest companies of yore are not the great companies of hence. I like looking back and seeing who would have predicted what happened to [formerly great companies like] Kodak, Sears and General Motors.”
Transcript from Wesco Annual Meeting, May 6, 2009*
“Where is Egypt or Athens or London? It is nature of things that we do baton passing. It is state of nature that baton gets passed, to someone who tries harder and cares more.”
Transcript from the interview with Charle Munger by CNBC
“The reality as it is is that Michigan is not again going to dominate the world in autos the way it once did.
The baton has been passed.
Athens is never again going to be the leader of all civilization. Nor is Rome. Nor is London.
The baton passes.
The iron rule in life, in a historical sense, is that if you’re lucky enough to be in a leadership position eventually you have to pass the baton.
That’s the rule of human systems.
Biologically we all have to die.
And as successful systems, we eventually have to pass the baton
Those are the rules.
And if you don’t like them, you’re on the wrong Earth.”
Those Who Live Dominance Live on in the New Leader
Charlie applauds the leadership passing of the baton concept because each subsequent leader borrows from its predecessor.
I haven’t found any of Charlie’s examples of this, but an example I think he’d approve of is the British Empire contributing the English language to the United States and other countries throughout the world.
A business example of this would be that the new dominant iPhone and Android mobile devices both borrowed much of their email capabilities from predecessor Blackberry.
*Special thanks to Whitney Tilson and his The Best of Charlie Munger compilation of notes from Charlie’s speeches.
The Network Effect
The network effect is defined as an entity getting more valuable the more people who use it. This can equate to a “winner-takes-all” position for businesses and a “moat”, as Warren Buffett and Charlie Munger like to say, to defend your castle (business).
Let’s look at a few examples of The Network Effect:
Amazon
A key to Amazon’s success is that it:
- Prices products super low
- That attracts many customers
- Customers generate sales as well as write product reviews
- The growing customer base attracts 3rd party sellers (expanding the product selection)
- The growing customer base also generates more product reviews (making Amazon the commerce site with the most content)
- Amazon pours the growing revenue into more efficient fulfillment centers which helps further lower their prices.
- The lower prices attract even more customers
Thus, the more people who use Amazon the more valuable it becomes to buyers (lower prices and more reviews) and to 3rd party sellers (who are attracted to the high level of buyers).
The more people who search Google the more data Google has (search queries) to help make its search even better.
And then the more users Google attracts (along with the data Google knows about them) the more attractive Google becomes to its paying customers: the advertisers willing to reach those searchers.
The more people who use Facebook, the more likely a Facebook user will choose to add their latest content (photos, videos, articles, etc.) to Facebook which in turn makes it the go-to place to see what’s up with your friends.
Similar to Google, Facebook then has a larger audience to sell ads to and more data on each user to help advertisers target their ads better (which Facebook can charge more money for).
Microsoft
Microsoft gained a network effect by providing the operating system (first DOS and later Windows) to 80% of computer users (interestingly, this was done through personal computer manufacturers (not directly). Because DOS/Windows became the dominant OS, it became the first OS that most application software companies (Lotus, Wordperfect, Autodesk, etc.) would write their software for.
The more application software on DOS/Windows there were, the more people there were who wanted to buy a DOS/Windows-based computer to use that software.
Microsoft eventually jumped in and provided software applications itself on their own DOS/Windows platform, providing further advantage.
The Telephone
The phone itself was an early opportunity for the network effect — the more people who used it, the more valuable it became. But the winners weren’t the phone manufacturers — it was the company connecting all the phones: AT&T — they were able to create a monopoly through owning the connections of the most phone users.
The Network Effect is closely related to “The Law of Scale”.
The Mental Model of Confirmation Bias (aka Goal Seeking or My Side Bias )
Confirmation Bias is the tendency of people to favor information that confirms their own beliefs, goals or desired outcomes (and ignore what doesn’t fit).
A definition of confirmation bias from the book Consumer Behavior:
“The tendency of consumers to interpret ambigious evidence as consistent with their current beliefs.”
A business example of confirmation bias is the hugely popular personality-type quizzes (e.g. which ‘Beatle member are you?’ or ‘What type of Ice Cream are you?’). When people take those quizzes they are typically reaffirming the opinion they already have in their mind (“I’m Mick Jagger of course”).
A trick of those quizzes is that most of the successful ones return you results that are positive (you’re unlikely to find one that asks ‘Which mass murderer are you?).
Why do people do this?
“In an uncertain world, people love to be right because it helps us make sense of things. Indeed some psychologists think it’s akin to a basic drive.”
Another example: let’s say I heard from my nephew that all his friends are using Facebook and so I go out and buy Facebook stock. And then the next day Facebook announces its $19 billion acquisition of What’sApp, and I see the following two headlines:
1) “Facebook Buys What’sApp to Further Its Mission to Connect the World”
2) “Facebook Acquires What’sApp: Investors Uncertain Over High Price Tag”
All other things equal, which headline/opinion do you think I’m going to favor?
Answer: The first one — because it more closely reinforces my own beliefs that Facebook is on the rise.
“Selective memory” is a variant/example of confirmation bias: in which someone remembers only the information that confirms whatever they’re desired outcome at the moment is.
According to Tren Griffin, Charlie Munger is quoted as saying an ancient Greek philosopher once said
“As a man wants, so shall he believe.”
How do you counter your own confirmation bias? Warren Buffett mentioned in this old Fortune Magazine article how Charles Darwin dealt with his own confirmation bias:
“Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”
That might explain why Buffett invited a frequent critic of his Berkshire Hathaway company to join him on stage at Berkshire’s 2013 shareholders meeting. Forbes explained why Buffett did this:
“Because heretics challenge the status quo, see things others cannot see, introduce new concepts and ideas that keep the world alive for decades and centuries.”
In other words, Buffett was trying to challenge (not confirm) Berkshire’s own biases. In doing so, Buffett was using another mental model, inversion, to take a bad habit (confirmation bias) and try to invert it to generate some potentially constructive new information.
The Mental Model of Cumulative Advantage (“The Matthew Effect”)
The Principle of Cumulative Advantage, as noted on Thwink.org, states that:
“…once a social agent gains a small advantage over other agents, that advantage will compound over time into an increasingly larger advantage.”
Cumulative Advantage is sometimes known as The Matthew Effect or Accumulated Advantage or “the rich get richer, the poor get poorer”.
A common example of Cumulative Advantage is that a prize will almost always be awarded to the most senior researcher involved in a project, even if all the work was done by a graduate student. The senior researched has accumulated that advantage.
In the board game of Monopoly, all players begin with equal resources. Yet equal opportunity at the start soon gives way to extreme inequalities in the distribution of resources. Though there may be ups and downs along the way, the richer players tend to get richer, and the poorer players poorer, until eventually the richest player has monopolized all resources and the poor are left with nothing at all.
As successful players accumulate income-producing property through a combination of skill and luck, their cumulative advantages allow them to reinvest new income in accumulating still more property, producing still more new income. This snowballing pattern of self-amplifying accumulation results in a Matthew effect that ultimately allows the most advantaged player to crush all opponents.
The sociologist Leonard Beeghly (1989) invites us to imagine a slight variation on the game of Monopoly that more nearly resembles real life. In Beeghly’s version, each player begins with a different sum of money. Let us suppose hypothetically that some players begin the game with $5,000, others begin with $1,000, and still others with only $500.
Those who begin with $5,000 enjoy a considerable head start on the competition. They can well afford to acquire every property they land on, and they soon own a disproportionate share of the income-producing properties on the board. Those who follow after them are less able to afford properties of their own, and instead usually find themselves spending their limited resources in rent payments, enriching the large owners and impoverishing themselves in the process.
The laws of probability virtually ensure that under these conditions, the rich will get richer and the poor poorer, and through no special virtue or vice of their own. Initial advantages are parlayed into greater advantages, creating a widening gap between haves and have-nots—or, more precisely, between have-mores and have-lesses—through time.
“This means that if one object happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory.”
The Mental Model of Compound Interest
Munger calls compound interest “one of the most important models there is on Earth.”
It arises when interest is added to the principal.
If you don’t know how to use compound interest on a calculator, there are a couple of excellent online compound interest tables/calculators that do all the work for you here:
- The Calculator Site
- GiniFab Compound Interest
- NCalculators Compound Interest Calculator
For example, If you start with $1,000 as your principal and earn 10% per year then you would have $1,100 after the first year. That’ easy enough: 10% on $1,000 is an extra $100. $100 interest per year seems alright.
However, things get much more interesting when you apply an interest rate return like 10% to both the principal (the original $100) and the interest each year (e.g. the initial $10 interest from year 1).
In year 2, for example, your value doesn’t just reach $1,200 ($1,000 plus $100 for 2 years in a row), it reaches $1,210 in total value ($1,100 * ($1,100*10%)).
The growth may still seem incremental, but if you take it out a much longer period of time it gets real interesting.
Let’s say you could invest that $1,000 starting amount and earn 10% every year for 20 years — that would leave you with 6,727.50 (over 6X your starting value).
And if you could somehow grow that same $1,000 starting principal at 20% per year, your ending value is not just double the value of the 10% interest example above, it’s 5x+ the amount ($38,337.60).
The stock market has tended to produce about 8% returns per year if you buy into the general indexes.
If you wanted to produce a million dollars over 30 years, you would simply have to pick a typical index fund and put $99,378 into it…and sit back and watch it compound.
Now that’s compound interest!
Rajiv Soni 