After years of saving, Sudarshan was going to buy his first hatchback car. He had accumulated enough money to fulfill his dream of owning a car. Finally, his dream was coming true. As he entered the showroom, a young salesman greeted him. Sudarshan requested for the car and asked the salesman to start the formalities. In an ideal world, with no incentives to the salesman, Sudarshan would have taken his hatchback car home. But, salesman requested him to take a look at an entry level sedan which was recently launched by the company and was only a little more expensive than the hatchback. As Sudarshan started to think about the car, salesman offered him to have a look into the company’s tie up with a bank for a car loan which will make his car affordable at a lower interest rate. This forced Sudarshan to realise the dream of buying a sedan after 10 years to now, he could not believe the fact that he could buy a sedan for his family. He immediately bought it as it would fulfill the dream of him and his family, not to mention that he could be able to prove the society that he was making some money.
Though the story looks good for Sudarshan. But in the hindsight, it is important to understand that whose dream was realised. Why did the salesman show a sedan when Sudarshan wanted to buy a hatchback? Why was the banker so interested in giving lower interest rates? And finally the most important question, did Sudarshan actually need a sedan? Well, these are the questions we sometimes forget to seek an answer for. Let’s look at this from the point of view of the salesman, firstly, selling a bigger car meant that he would be able to get more commission and meet his sales target for the month. Sudarshan who was not a potential customer for the bank to obtain a car loan, had now suddenly become one, so offering a lower interest rate to him could advance his chances of publicity or transacting more with the bank. As per Sudarshan’s financial budget, a hatchback would have suited well but sedan would give him more recognition so now from a necessity it turned to luxury. That’s what we call as Power of Incentives which are obtained in cash or kind. Infact, Charlie Munger who is the vice chairman of Berkshire Hathaway founded by Warren Buffet famously talks about ‘incentive caused bias’ as the most influential bias of our times.
Incentive caused bias is also termed as a weapon of mass destruction in the world governed by capitalistic form of economics. Incentives when given for performance is termed as bonus, commission or reward, but when given for destroying the opponent is often termed as corruption or lobbying. Though it has broader implications, currently let’s look at how it influences a person’s decisions when it comes to making an investment.
Usually, people tend to avoid appointing a personal financial / investment advisor as they feel that he / she charges too much fees for a specific kind of work which can be done by them. Plus, it’s a matter of huge trust for taking an advise for personal money from someone who is not a part of the family. Even historically, it has always been the case that such advises have been received either from direct blood relations or someone who is very close to the family members. With changing times, there are tonnes of investment products that have entered the market, but the problem of trust deficit has not been adhered to. At such times, an investor would usually consult a financial products distributor as the investor wont need to pay any fees directly, so he is not making an expense out of his pocket. Therefore, in a very subtle way, the distributor will make money through the commissions of the financial products which he is willing to sell. Politely, the distributor is now under incentive caused bias.
- Financial distributor’s alignment of interest is now with the financial product which he will sell to make money. He has very low interest in whether that will be the correct product for the investor. Whereas, a financial advisor who charges fees to the investor, is now biased towards the investor and will only worry about the investor making money as that would justify his fees.
- Financial distributor usually talks about how good the product is and why an investor should buy the product whereas a financial advisor always talks about what the goals are of the investor so that a particular product can be bought. For example, it doesn’t make sense to buy a Ferrari on a small Island, however great the car is but there is not enough road to drive.
- Higher the commission from a product, more are the chances of a financial distributor to sell it to the investor. Whereas a financial advisor does not have to worry about the commission, for him it would make sense that an investor actually creates wealth so that there could be references as incremental business opportunity.
To sum it up, an investor must think which form of incentives he would want to deal with. A transaction based incentive of a financial distributor or a relationship based incentive of a financial advisor. As creating wealth is finally in the hands of the investor and by being on the positive side of incentives will help him advance his life in a much better way.
Image from behaviorgap.com