NEW: John Addis

My experiment with staff bonuses illustrated surprising things about the power of incentives to change behaviour, for better or worse.

The power of incentives

If you wanted to make a lot of money on the sharemarket, what skill do you think would assist you most? Expertise in selecting winners, or proficiency in avoiding losers?

It seems natural to prefer the former, but exceptional skill in picking winners won’t ensure you’ll avert the occasional disaster that may wipe you out.

Avoiding losers, on the other hand, keeps you alive, giving compounding more time to work in your favour. And in the fail-safe stocks you select there’ll probably be some big winners where your skill parlays into luck.

In investing, as in business, staying alive long enough to get lucky is a hugely underestimated factor in success. Through punishing personal experience and my time with The Intelligent Investor  I know this to be a fact. Charlie Munger knows it too.

Sitting alongside his business partner Warren Buffett, Munger looks the archetypal American patrician. With thick-rimmed glasses perched elegantly on the bridge of his nose, slow, precise speech laden with self-deprecation, he’s a reminder of America’s best at a time when it is all too easy to linger on its worst.

Munger has spoken widely and fascinatingly on the subject of human error, a vast landscape upon which to erect one’s easel. In an essay titled “The 24 Standard Causes of Human Misjudgement”, he talks of “…the power of what psychologists call ‘reinforcement’ and economists call ‘incentives’”.

This came to mind when I was reading of the Garuda policy of rewarding pilots for saving fuel and its possible role in the most recent Indonesian aviation disaster. Could it be that a pilot with a reputation for caution was willing to put at risk his own life and those of his passengers simply to put more rupiah in his pocket?

As Munger says, “… I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes I get some surprise that pushes my limit a little farther.”

In subscription publishing, renewal rates are one of the statistics that indicate the health of the business. Once I started paying a company-wide bonus based on the renewal rate, the attention paid to the process improved dramatically, although in reality it was difficult for staff to affect the figure in anything less than an indirect way. But I also did something that many companies don’t.

Instead of dividing the bonus between staff according to their relative position or performance, everyone got the same amount. The receptionist received the same as a senior analyst and the marketing manager received as much as her boss, which was me.

One analyst, who had recently escaped from a major bank, described it as “refreshing” in that it recognised everyone’s value and emphasised a team, rather than an individual, approach to performance. Call it business lessons from the Kibbutz.

But I wasn’t convinced it was right. In a staff meeting I suggested introducing a discretionary component to the scheme. But instead of it being decided by me or each individual staff member’s direct report, I’d make available a total sum from which everyone would receive their bonus. How this was divvied up would not be my decision but would be decided by all staff members.

Each person would receive a list of employees (there were only about 15) and against each name, including their own, they’d write the amount that they felt each person deserved.

As long as the total amount didn’t exceed or understate the total amount I had made available, it was entirely at their discretion. The voting would be held in secret and, using averaging, I’d then come up with the individual bonus for each person.

The basis of my argument was that if we were working as a team, we should be accountable to each other, not just the “big boss”. I also didn’t really believe that I was in a position to know exactly how well every staff member was performing. Those working alongside each person probably had a far better idea than me, so why not use this to develop the individual bonuses?

As I recall, only three people from a total staff of 15 supported the idea. Many rejected the implied accountability and what they saw as the dismantling of the hierarchy, which, to my surprise, offered them some comfort.

It was an interesting experience, teaching me that radical ideas can disturb inherently conservative people. Change should be sure but not necessarily speedy. I also learnt that – and this is rather obvious – different people responded to different things. As a result I developed a lot of other “softer” type rewards and incentives, and performance improved across the board.

So ask yourself what behaviours your incentive system encourages. And if you don’t have one, get going on it – remembering that financial incentives aren’t the only form of inducement, but they’re not a bad place to start. Otherwise you’ll have Charles T. Munger after you.

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