The Psychology of Entrepreneurial Misjudgment, part 1: Biases 1-6

Saturday, March 29th, 2008

If I weren’t already a fan of Charles Munger, then Marc Andreessen’s recent post on The Psychology of Entrepreneurial Misjudgment might make a fan out of me.

“The Psychology of Entrepreneurial Misjudgment” is the name of Munger’s magnum opus speech, included in Poor Charlie’s Almanack, a book inspired by Ben Franklin’s Poor Richard’s Almanack and assembled by a group of Mr. Munger’s friends from his most interesting thoughts and speeches.

In part one of his planned series of posts, Andreessen examines the first six of the 25 “key forms of human behavior that lead to misjudgment and error” that Munger has discovered in his 60 years in business.

Munger feels strongly about the first bias, Reward and Punishment Superresponse Tendency:

I place this tendency first in my discussion because almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.

…We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard’s Almanack: “If you would persuade, appeal to interest and not to reason.” This maxim is a wise guide to a great and simple precaution in life: Never, ever, think about something else when you should be thinking about the power of incentives…

One of the most important consequences of incentive superpower is what I call “incentive caused bias.” A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior [like a salesman who harms her customers by selling them the wrong product because she gets paid more for selling it, versus the right product -- see, e.g., the mutual fund industry].

…Another generalized consequence of incentive caused bias is that man tends to “game” all human systems, often displaying great ingenuity in wrongly serving himself at the expense of others. Antigaming features, therefore, constitute a huge and necessary part of almost all system design.

…Military and naval organizations have very often been extreme in using punishment [the inverse of reward] to change behavior, probably because they needed to cause extreme behavior. Around the time of Caesar, there was a European tribe that, when the assembly horn blew, always killed the last warrior to reach his assigned place, and no one enjoyed fighting this tribe.

Andreessen agrees and believes that stock options make excellent sense for startups:

There is a wrong-headed and dangerous theory afoot that restricted stock (grants of fully in-the-money shares of stock) is a more appropriate motivator of employees of tech companies than stock options. [...] From an incentive standpoint the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating value. And new hires will by definition be people who are conservative and change-averse, as the people who want to swing for the fences and get rewarded for creating something new will go somewhere else, where they will receive stock options — in typically greater volume than anyone will ever grant restricted stock — and have greater upside.

And sure enough, in the wake of shifting towards restricted stock and away from stock options, Microsoft’s stock has been flat as a pancake. The incentive works.

I think it’s a bit facile to attribute Microsoft’s flat stock performance to the move from stock options to restricted stock.

More importantly, employees with restricted stock are not incented to preserve value instead of creating value; they’re incented to both preserve and create value. It’s the employees with stock options who have an incentive to create value without much incentive to preserve value. Options are an incentive to swing for the fences — to go big or go home.

This can make sense, if we think employees are systematically biased against risk, but it’s not the obvious answer.

And let’s not forget that restricted stock in a startup that isn’t worth anything yet is no different from a stock option with a strike price of zero.

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