How to Use Incentive Theory to Make Better Investments

In the world of business, success often comes at a great cost. Founders and CEOs are nearly always marked by passion and a tireless work ethic. When competition is relentless, and make or break moments happen every day, it takes nothing less than fanatical leaders to steer the ships of industry toward profitable seas.

But passion and zeal can cloud judgement. The will to win can cause people on all rungs of the corporate ladder to cut corners, cross fine lines, and make unethical decisions. If you follow business news, then you’ve heard the tale told time and time again.

From Bernie Madoff’s disastrous downfall to Volkswagen’s emission misrepresentation, these forms of misconduct start small and grow overtime. On a micro scale, scandals can destroy careers. On a macro scale, they can reverberate through markets and devastate large numbers of investors directly and indirectly.

It is important for advisors to understand why these scandals happen in the first place, and to apply this knowledge to every investment they make. FAs need to be able to analyze a company, understand the model, and do everything in their power to safeguard and grow the wealth of their clients.

When FAs are researching different avenues of investment, it is important to understand what is motivating employees at all levels of a particular company. Understanding the reward system that makes an organization tick is crucial when it comes to investing in it successfully.

It all comes down to incentives.

Incentive theory states that behavior is motivated by someone’s desire for reinforcement in the form of reward or avoidance of discomfort.

Always consider this psychological theory when you are looking into the structure of a company. How are people rewarded? If the system is based on merit, and meritorious actions result in profit for the business, that’s very favorable. If rewards are distributed in such a way as to achieve a high frequency of such actions, then the company exists on a solid foundation. It has the makings of a worthwhile investment.

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If you find a company that rewards questionable behavior, then you want to avoid it entirely. Bad behavior is habit forming when incentivized. You don’t have to search heavily through history to find this fact proven over and over. Bad behavior is easily rationalized when it is incentivized.

Amazon revolutionized retail by incentivizing employees to always focus on the customer. Jeff Bezos refers to this focus as “obsessive-compulsive.” That might seem extreme, but it has allowed him to create the kinds of incentives that have turned his company into one of the most successful in the world. Had an advisor identified the quality of Amazon’s incentive structure early on in the company’s history, they could have made a fortune for their clients.

The flip side of incentive theory is the Wells Fargo scandal that made headlines a few years ago. The company had set up a number of initiatives to encourage employees to get customers to buy more Wells Fargo products. This aggressive incentivizing was not aimed at a greater good, it was about more profit without more value. This eventually lead to widespread fraud in the form of employees creating 2 million fake accounts. Customers got hit with overdraft fees on accounts they didn’t even know they had, and eventually 5,300 people were fired by the banking giant.

Understanding both sides of the incentive coin will allow you to make better portfolio choices for your clients. Incentive theory is one of the most powerful elements of business. When you are thinking about making investments for your clients in a certain business or industry, try to gather as much information as possible in regards to how members of the organization are incentivized. Such considerations can empower you to make lucrative decisions for your clients while helping them avoid bad investments.

Written by Sefton Eisenhart

A writer who deeply believes that everyone is in sales.