The Power of Incentives

I just finished to read a new book called "Freakonomics" by Steven Levitt & Stephen Dubner. Levitt is not the typical economist, he looks at the world in a different way; he uses economics to explain human behavior. The book was written based on few fundamental ideas, I would mentioned two:

a) Incentives are the cornerstone of modern life

b) The conventional wisdom is often wrong (But not always!)

He goes to mention that understanding incentives is the key to understanding about any riddle.

In chapter one, he examines an example of late pick ups from a daycare center. According to Levitt there are three types of incentives: social, moral & economics. The moral pressure to pick up children by the scheduled time was proving inadequate, and late pickups were becoming a business problem for the daycare center. To encourage better promptness, the administrator introduced a small fine for tardy pick ups. If parents were 10 min late they would pay $3USD per child for each incident. The fee would be added to the parents monthly fee.

After the fee was enacted the number of late pick ups went up! double the original number. According to Levitt, this incentive substituted an economic incentive ($3 penalty charge) for a moral incentive, the guilt that parents were supposed to feel when they came late. For a few dollars each day , parents could buy off their guilt... Furthermore, the small fine send a signal to the parents that weren't such a big a problem.

After couple weeks the daycare administration decided to take away the penalty fee, but the number of late pick ups did not went down. Now they could arrive late, pay no fine and feel no guilt.

By now you may have already guess that the solution was a larger penalty fine... large enough that parents really wanted to avoid the payment of the fee.

In October 2003, Charlie Munger gave a speech to the undergraduate students of University of California, Santa Barbara, he posed a problem to the students where a tire store chain in the Northwest has succeeded over fifty years (Les Schwab tire store chain)... Les Schwab started competing first with Goodyear, then competition was with the great discounter's such as Costco and Sam's Club... and Schwab still remains. (Note, the owner has no education at all)

Charlie answered on how Les Shwab accomplished it's success by mentioning that they must have done a lot's of things right, but among the best things was that the company harnessed what Mankiw calls the "superpower of incentives". He must have a very clever incentives structure driving his people.

Just give it a second thought on this concept... and you will find that everything that we do in life is based on some sort of incentive. That's the way that we learned since we were children... if you get A's you get a prize, if you disobey your parents you get grounded.

Isn't it possible then that what Levitt saids about incentives "understanding incentives is the key to understanding about any riddle." can helped us to understand the world that we live?

The Eighth Wonder of the World

Albert Einstein is alleged to have called compound interest one of the most powerful forces in the universe. Charlie Munger considered compound interest as one of the key models in our tool kit.

I found an interesting blog from Michael Moe, posted in May 2005 (ThinkEquity Blog) about compound interest. Below is a portion of his post...

"...we can benefit from the magic of compounding identifying companies that will grow their earnings at a high rate for a long time and hold on for the ride.

An important concept to appreciate as a growth investor is the power of compounding growth. While when it comes to growth companies, where the bulk of their future earnings lie ahead of them, the perception of valuation risk crowds out investor interest in future earnings potential. This said, a few simple math examples may help to underscore the power of growth.

The Power of Long-term Compounding

In 1626, Dutchman Peter Minuit purchased the entire island of Manhattan for $24 from the Wappinger Indians. In other words, for what it would cost to order a bagel and cafe latte at a midtown hotel today, Monsieur Minuit owned the entire Big Apple.

While there are many outside of Gotham that would look at neither as a bargain, our point is to demonstrate the power of compound interest over time. Compound interest has been called the "eighth wonder of the world" and, with the help of the "ninth wonder of the world," the HP 12C, we can calculate whether Peter Minuit got a good deal or not.

Obviously, the key variable to determine the answer is interest rate that we apply to the $24. Or what we could have earned in an alternative investment.

The difference between a 5% return and a 10% return isn't a simple doubling but a compounding that becomes staggering over time. If the $24 was invested at 5% interest over the past 377 years it would have grown to $2.3 billion today, implying a good price given Rockefeller Center sold for $1.9 billion in 2000.

At a 10% return however, the $24 doesn't just double the 5% return, or to $4.2 billion, but magnifies it to $97 quadrillion!

At the foundation of our investment philosophy is that over time, share prices are nearly 100% correlated with earnings. Hence, our objective is to identify companies that can grow their earnings at a high and sustainable rate and hold on for the ride.

In the world of investing, few stocks have accomplished the returns of Peter Minuit, yet, consider that Microsoft went from a $500 million market cap company at the time of its IPO to nearly $400 billion today by growing its earnings at approximately a 40% compound annual growth rate over the past 17 years.

The trick, of course, is that it is almost impossible to grow at a rate that high, for that long of a period, as the laws of compounding cause growth to diminish with size. Bearing this out is the fact that there are fewer than 30 companies that managed to grow their earnings in excess of 20% annually during the past 10 years out of a universe of more than 12,000 companies!

1¢ Doubling Every Day or $10,000 per Week

To illustrate the power of the doubling effect, suppose you were offered a job as a consultant for a month and you had your choice of being paid $10,000 per week or a penny the first day, and having it double every day for the remainder of the month. Easy choice right?

At $10,000 per week, you would make $40,000 for the month. On the other hand, making a penny the first day, two cents the second, four cents the third, eight cents the fourth, and so on, you actually end up making over $10 million by the 31st day."

He also give us a model to use called the "rule of 72"; where if you divide 72 by the interest rate you will find the number of years that your investment will take to double. i.e. If your interest rate is 15% it will take you 5 years to double your investment.

Now our challenge is to get this model in our head and try to applied it to the real world. Remember what Julian Huxley (biologist) said "Life is just one relatedness after another".

Last Best Chance - NTI

Last Annual Shareholders Meeting at Berkshire Hathaway, CEO Warren Buffett did mentioned about him being worry of Nuclear and Bio threat. He also mentioned that he's been working diligently to reduce the exposure in all Berkshire Insurance subsidiaries.

During the meeting he did recommended a video produced by the Nuclear Threat Initiative (NTI). Warren called it "a fictional but not fanciful" scenario. I got interested and ordered it.

Last Best Chance mentioned that " Nuclear terror is the most potentially devastating threat facing the world. The most effective way to prevent it is to lock down nuclear weapons and materials at the source, in every country and facility that has them"

Based on the latter, the NTI believes that the only way to stop terrorist groups to get a nuclear weapon is through the security of materials; such as uranium. NTI believes that is easy for terrorist groups to build a nuclear weapon than to get the raw material. Thus, they urge government's to take actions to secure them and lock them down.

I suggest you go to www.lastbestchance.org and get a free copy of the video.

What is Worldly Wisdom? (Charlie Munger thoughts)

For those who are not familiar with Charlie Munger's Worldly Wisdom, I attached below link to a speech given by him at the USC Business School (1994)...

http://www.paladinvest.com/pifiles/MungersWorldlyWisdom.htm

Just a final quote from Charlie T. Munger: " Acquire Worldly Wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with you peer group... then to hell with them."

Charlie Munger's "Independence"

Today was the day that I finally understood Charlie Munger's words about why he wanted to get rich. His answer was "independence"!.

At age 22, I got the opportunity of an explosive growth career... My career growth was not due to high IQ or because "my uncle" helped me to escalate the corporate ladder. Neither it was because of a stike of luck or any fortune teller wisdom. Today, I finally understood why. The reason: I was not afraid. Not afraid of making mistakes, not afraid that I may step in someone's powerful toes. I was "independent".

Long time ago, I read Charlie's words... I read them, they clicked in my head but never in my heart; until today.

Today, I realized that I was not independent anymore... Yes, I know we all think we are independent, but how can we be independent if we are still depending on our employees salary?. I also noticed that my career has not been growing at the same rhythm as before... The reason: Now I take more conservative steps, I'm not as aggressive as before, now I care about what my bosses think... In short, I'm afraid.

Nevertheless, today is a different day... Today is the day that I finally understood Charlie Munger.