Want to Predict the Future? Look at Incentives.
“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.”
—Charlie Munger
Background
Most people argue that predicting the future is impossible. In the investing world, we are constantly reminded of this with disclaimers such as, "Past performance is not indicative of future results." This caution is well-founded, as history has shown that even the most successful investors struggle to maintain consistent results over time. However, one could contend that a significant part of an allocator’s or investor’s role—maintaining consistency—does involve a form of future prediction. In the case of an allocator, rather than blindly investing with managers, we dedicate considerable effort to understanding the competitive advantages, people, and culture that define a firm, aiming to maximize the probability of achieving high, risk-adjusted returns.
Psychological Egoism
While I do not believe anyone can systematically predict the future, I do believe that studying incentives can be a close proxy. By incentives, I refer to the structures and systems that, whether deliberately or inadvertently, encourage certain behaviors and actions. To put this into context, let’s consider the philosophical theory of Psychological Egoism:
Psychological Egoism is a long-standing theory in psychology and philosophy that suggests all human actions are motivated by self-interest. According to this view, even seemingly altruistic acts are ultimately done because the person performing the act derives some benefit from it, whether it be a sense of satisfaction, happiness, or avoidance of guilt. In essence, Psychological Egoism posits that people are inherently driven by their own desires and welfare, making self-interest the underlying force behind all human behavior.
Even without understanding or agreeing with the theory of Psychological Egoism, most would agree that people generally choose actions that maximize perceived gain and minimize perceived loss. Of course, what constitutes “gain” and “loss” is situational and varies from person to person—it could be something tangible like money or intangible like social status or happiness. However, the bottom line is that systems and structures can directly influence behaviors, leading to outcomes that are entirely predictable in retrospect.
Incentives in the Context of Investing
The concept of incentives plays a crucial role in investing. In the context of manager selection, it is essential to ensure that the interests of limited partners are properly aligned with the incentives of general partners. Similarly, general partners or fund managers must align the incentives of portfolio company management teams. In turn, the management teams must ensure that the incentives of their employees are aligned with the company's goals. Two specific examples of misaligned incentives that I have observed in my career so far include: 1) a misaligned compensation structure leading to an allocator ignoring venture capital investments and 2) a private equity firm waiting to inform limited partners of a write-down until after the completion of the latest fundraising effort.
Successful outcomes are more likely when incentives are aligned, as they play a role in creating relationships and partnerships that are truly mutually beneficial. Economically, the best financial results are often a byproduct of this alignment between limited partners, general partners, and portfolio company management teams. A notable example of a focus on incentive alignment comes from Warren Buffett, as highlighted in the 1990 Berkshire Hathaway Letter to shareholders, specifically in the section titled "Some Thoughts on Selling Your Business":
In conclusion, while the future remains inherently unpredictable, understanding underlying incentives can serve as a powerful tool for navigating uncertainty. By analyzing the incentives that drive people’s behavior—whether rooted in self-interest or shaped by externalities—we can make more informed decisions that increase our chances of success, whatever that might be. In the context of investing, this means not just reacting to past performance but proactively examining the underlying incentives in place for management teams, general partners, and even allocators or limited partners themselves. Doing so can significantly improve the probability of finding durable, consistent returns. Ignoring these factors risks overlooking significant principal-agent issues and producing lackluster results down the line.
In the Context of Asset Allocation...
The following are a few (basic) examples of questions to ask regarding incentives and alignment for both general partners and allocators:
- Are the general partners incentivized to make investment decisions that are not in the best interest of limited partners?
- Do the incentives reward short-sightedness in decision-making?
- What factors/results are general partner compensation structures tied to?
- Are allocators incentivized to prioritize job stability/compensation to the detriment of objective investment decision-making?
- What factors/results are allocator compensation structures tied to?