Saturday, April 10, 2010

Freakonomics: Chapter 2

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

Even if incentives exist for a particular action, information assymmetries can cause destructive outcomes. Levitt discusses various corporate scandals, and how they were caused by certain groups possessing information that other groups did not have: research analysts Henry Blodget and Jack Grubman wrote positive research reports about stocks they knew to be junk; Frank Quattrone covered up investigations into his company, Credit Suisse; Sam Waksal and Martha Stewart dumped shares of ImClone on inside information; managements have fabricated billions of dollars in revenues.

All of these situations exist because one group has information that other groups don't have. They seek to profit not by normal means, but by exploiting this information differential. They do this by either promoting false information, or hiding true information.

Most types of crimes leave visible victims, such that even if the perpetrators aren't caught, it is known that a crime has been committed. Such is not the case with respect to crimes of information, which can go completely undetected.

You are more likely to listen to the advice of an expert. But because of information assymmetries, the expert may be acting in his own interest. The weapon of choice for such experts is often fear. "If you don't agree to this surgery", or "without this safer car", or "by not accepting this offer for your house", "the consequences may be dire".

The internet is a useful tool in reducing information assymmetries, but they will always exist to some extent. Readers may wish to follow the advice of Charlie Munger: "Fear advice that, if implemented, is good for the advisor. Learn the basic elements of your advisor's trade, and double-check/disbelieve much of what you're told."

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