The Problem of Incentives

The Problem of Incentives

Expertise does not remove a conflict of interest. A financial advisor, for example, may earn more by recommending one product than another, regardless of which better fits a client’s needs. Access to low-cost index funds does not by itself settle how an advisor is paid or which incentives influence the recommendation.

In cases like financial advisory, we’re not on solid ground until we know, in some detail, the compensation arrangement our advisor is under.

The same goes for buying furniture, buying a house, or buying a washing machine at a retail store. What does the knowledgeable advisor stand to gain from our purchase?

It goes beyond sales, of course. Whenever we are getting advice, it is from a person whose set of incentives is not the same as ours. It is not being cynical to know that this is the case, and to then act accordingly.

Consider taking a car to a mechanic. The mechanic usually knows more about cars and has inspected the particular problem. That information gap makes the recommendation harder for the customer to assess. Charging for repairs can create an incentive to recommend more work, while reputation and repeat business can favor honest advice. Ask for an explanation of the diagnosis and proposed work.

For major nonurgent work, a written estimate, some focused research, or an independent second opinion can help. Online research may improve the questions you ask, but it does not reproduce an inspection or establish that a repair is unnecessary.

When Queen Elizabeth I of England ascended to the throne, her reign was by no means assured. The tumultuous years under her father, brother, and sister had contributed to a political situation that was precarious at best. England was in a religious crisis that was threatening the stability of the kingdom, and was essentially broke.

Elizabeth knew there were aspects of leading the country that were outside her circle of competence. She had an excellent education and had spent most of her life just trying to survive. Perhaps that is why she was able to identify and admit to what she didn’t know.

In her first speech as Queen, Elizabeth announced, “I mean to direct all my actions by good advice and counsel.”[9] After outlining her intent upon becoming Queen, she proceeded to build her Privy Council—effectively the royal advisory board. She didn’t copy her immediate predecessors, filling her council with yes men or wealthy incompetents who happen to have the same religious values. She blended the old and the new to develop stability and achieve continuity. She kept the group small so that real discussions could happen. She wanted a variety of opinions that could be challenged and debated.[10]

The account presents Elizabeth’s council as an example of seeking advice beyond one’s expertise and allowing disagreement. It connects this practice to the stability and influence of her reign, though the story alone cannot establish how much the council explains those larger outcomes.

When you need expertise you do not have, look for relevant experience and ask what may shape the advice. Understanding your limits helps you choose whom to consult; understanding incentives helps you assess what they say.

“Ignorance more often begets confidence than knowledge.” — Charles Darwin[11]