Circle of Competence

If you haven’t read Freakonomics, the extremely popular book by Dubner and Levitt, run, don’t walk to Amazon.com and pick it up. It’s an interesting read on how “common knowledge” is more “common,” than “knowledge.”

The two write a blog for NY Times, and a column in the NYT Magazine. I read their most recent article over the weekend, in the NYT Magazine’s “Green Issue.”

It is about reducing emissions through correct incentives for drivers, emissions being a negative externality to excessive driving (i.e. Your driving causes me problems through pollution and environmental degradation, and I have no control over it). Their main thesis is that drivers have not been correctly incentivized to reduce their driving mileage. The real social costs of our driving are not being compensated for:

“According to current estimates, carbon emissions from driving impose a societal cost of about $20 billion a year. That sounds like an awful lot until you consider congestion: a Texas Transportation Institute study found that wasted fuel and lost productivity due to congestion cost us $78 billion a year. The damage to people and property from auto accidents, meanwhile, is by far the worst. In a 2006 paper, the economists Aaron Edlin and Pinar Karaca-Mandic argued that accidents impose a true unpaid cost of about $220 billion a year.”

Dubner and Levitt’s solution; pay as you go car insurance. With the developments of modern technology, auto insurers would have the ability to monitor your driven miles, and charge you accordingly. If I know anything about Americans, it’s that we like to save money. Once the costs of your driving start hitting you in the wallet properly, you’ll surely be conscious of it (something we’re beginning to see with $3.50 gas). This struck me as a tremendously powerful concept, one that I think, as time goes by, will be adopted in some shape or form.

The reason this article resonated with me on an investing front is that it exemplifies what Charlie Munger has said time and again: to get the behavior you desire, you must have the correct incentive system. If you allow loopholes that you know can be exploited, well by golly they’ll be exploited. As investors, one of our jobs is to look at incentives in a few ways:

1. How is management incentivized? As long term investors, we are looking for management incentivized to create long-term shareholder value. How often do you really see this? I can name only a few, notably American Express, Amazon, and Berkshire Hathaway. Most of the time earnings per share growth, stock price growth, and sales growth take precedent over free cash flow generation and return on capital; the more important factors in creating shareholder wealth.

2. How is your company’s target market incentivized? Hopefully, the incentives point them towards using your product over and over, but maybe not. For example, American Express customers are incentivized to own and use an American Express card because it is very widely accepted and it makes them feel part of the American Express “club.” If you are well-off, chances are you have one because god damn is it sexy. A black American Express card screams “Rich” like very few things do. It’s part of American culture. That is a powerful concept.

The point is that incentives determine behavior. Look at the incentive structure, and you’ll most likely establish what behaviors are likely to occur. Managers who love their businesses are incentivized to sell to Berkshire Hathaway because they know they will be able to run their company autonomously. Poor incentives caused the massive housing and credit bubble, and it will take a revised incentive structure to prevent it from happening again. The incentive-behavior loop is a powerful model to carry in your mental toolbox.