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.
Many of the immature investors seek advice from the investment advisers to improves their returns on investment.
Immature investors have to be knowledgeable and experienced to pass an independent judgment for any of the investment opportunities communicated by others. Investors need to analyze the services provided to him by the consultant or advisers are of benefits to them or him, whether they are involved to generate commission/brokerage or true advice, etc. Intelligent investors look at the recommendation provided by reputed firms but they decide by themselves. So that we can have safety rather be sorry for the decision. It is always a question that should we manage our portfolio independently or should we seek for the help of others? It depends on to them how we have performed during the market cycle, better than the market or not, whether we can easily meet our financial goal or does we require to take help.
Before trusting any of the advisers, we need to make our due diligence and check whether any complaints, fine, a penalty against him or not. Before selecting an adviser, we need to ask a few questions –
Answers of the above questions provide us clarity of selecting or rejecting an adviser. It is difficult to find a genuine adviser so that we also need to do due diligence from our side. I have experienced that no investment strategy outperforms in every period so that we should analyze the performance of the adviser over a market cycle, does adviser changing his process frequently? does he behave rationally with his investment or get emotionally trapped by market moods? We need to analyze all such aspects. And the most important aspect is to have an investment process and investment philosophy. If the adviser does not have it then we do not have to be in help of him.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.