Aligning incentives with desired outcomes
Aligning incentives with desired outcomes
Incentives drive behaviour
Lehman Brothers' collapse during the 2008 financial crisis illustrates the Principal-Agent Problem. The company’s executives (agents) were incentivised with bonuses tied to short-term profits. This led them to make increasingly risky bets on mortgage-backed securities. Meanwhile, shareholders (principals) desired long-term growth and stability. This misalignment in incentives caused executives to prioritise short term gains, neglecting the high risks involved. When the US subprime mortgage market collapsed, Lehman Brothers went bankrupt with massive losses for shareholders; the executives had already profited. This highlights how misaligned interests between principals and agents can lead to disastrous outcomes.
Principal-Agent Problem
Show me the incentive and I will show you the outcome. - Charlie Munger
The Principal-Agent Problem arises when an agent, who is supposed to act on behalf of a principal, has incentives that diverge from the principal's interests. This leads to potential conflicts. The principal expects the agent to act in their best interest. However, due to information asymmetry and differing motivations, the agent is inclined to prioritise their own goals. This misalignment often results in the agent pursuing actions that benefit themselves, e.g. short-term profits or career advancement, rather than focusing on the principal's long-term objectives. This problem occurs in many fields, e.g. business governance, as illustrated by the Lehman Brothers’ collapse.
Perspectives and solutions
A lot of corporate decision making isn’t about maximising returns; it’s about minimising risk of blame - Rory Sutherland
Three business thinkers provide their perspectives and solutions:
Rory Sutherland highlights the psychological drivers of the Principal-Agent Problem. Agents often focus on short-term metrics to minimise personal risk which may conflict with long-term goals. Rory advocates for cultures that reward long-term thinking and innovation to better align agents' actions with principals' objectives.
Nassim Taleb argues that the Principal-Agent Problem worsens when agents don't face the consequences of their actions. He advocates for skin in the game, where agents share both the risks and rewards, ensuring accountability. Without this, agents take excessive risks that benefit them but harm principals, as seen during the 2008 financial crisis. Nassim believes true alignment happens when agents bear personal risks.
Naval Ravikant focuses on entrepreneurship and decentralisation to solve the Principal-Agent Problem. He advocates for personal ownership, where decision-makers benefit from success and suffer from failure, aligning their interests with the principal's. Naval supports equity ownership for employees and sees the future of work involving more independent contractors, whose incentives align with their success.
Acting on the principal-agent problem
Ownership and responsibility. When you have equity, you care more. When you’re accountable, you do better. That's how you solve the principal-agent problem: align incentives by making agents owners. - Naval Ravikant
When I first became aware of the Principal-Agent Problem, I realised that it applied to me too. As an employee in a large corporation, I asked myself, to what extent are my motivations and those of the organisation I worked for aligned? As a consequence, I decided that I needed to think longer term and have more skin in the game so I:
Refocused on projects with a longer term benefits.
Gave more attention to important, rather than purely urgent matters.
Worked on things where I was exposed to the full associated opportunities and risks, e.g. developing apps and writing this weekly blog.
Other resources
Principal-Agent Problem: Act Like an Owner talk by Naval Ravikant
How the Compound Effect Helps Me post by Phil Martin
Pick Ourselves post by Phil Martin
I like Rory Sutherland’s suggestion, You can reduce the principal-agent problem by giving people the space to think for the long term and rewarding them for doing the right thing, not just the measurable thing.
Have fun.
Phil…
