People respond to incentives by doing what is in their best interests. What is noteworthy is, first, how quickly and radically people’s behaviour changes when incentives come into play or are altered and, second, the fact that people respond to the incentives themselves and not the grander intentions behind them.
We all seek self-interest; our efforts get changed with incentives. We act for getting back something. Proper incentives can improve performance but improper incentives can spoil the performance. We assess the risks and the associated rewards and respond in a way that seems to best serve us.
Business – For example, incentives for selling every single loan will spoil credit quality but if we keep negatives incentives on every NPAs then performance will get improves with safety in nature. The sub-prime housing crisis in the US is one example of incentive bias.
Investment – There will be incentives on different products to marketing personnel and due to that incentives, they sell products where they get higher incentives. The same happens with the stock market products. We have experienced Franklin mutual fund debt scheme example where distributors have decent commission available. And distributors have aggressively sold scheme to the investors.
Many a time, management focus on their performance incentive over an above of long-term benefits of shareholders. That is the reason to provide ESOP to top management (aggressive ESOP has its disadvantage, which we will discuss later on).
When we study pieces of advice given to us by others than 90% of cases having incentive effects hidden into it. We need to study the given pieces of advice thoroughly before accepting it. If we work on anyone’s advised without putting our efforts then that will become our fault.