Aligning Incentives

During value investor Charlie Munger’s speech to Harvard students in 1995, Munger underscored his belief in the power of incentives:

“Well, 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 but I get some surprise that pushes my limit a little farther.”

Twenty years later, at the 2015 Daily Journal (Nasdaq: DJCO) annual shareholder meeting, Munger elaborated on the importance of designing incentive systems that reward proper behavior. When that decision goes wrong, the system is unlikely to produce favorable results.

“If the incentives are wrong, the behavior will be wrong. I guarantee it. Not by everybody, but by enough of a percentage that you won’t like the system.”

If you have ever been a part of the traditional car-buying experience, you can probably relate to being subjected to a suboptimal system. Steered toward vehicle models you are less interested in, passed off to financing experts, and waiting as salespeople speak with managers in back offices, the traditional automotive retail experience can be frustrating.

Part of the reason for the unpleasant experience is the perverse sales incentives inherent in traditional auto retailing. Traditional salespersons are trained to push models that capture higher gross profit, often at the expense of an enjoyable car buying experience.