A few months ago, I wrote a post about how people tend to over-complicate things in all aspects of their lives. The main point I was trying to make in that post was that problem solving in your business/personal life is greatly complicated by the human tendency to make things more complicated than they really are.
The proverbial ‘mountain out of a molehill.‘
Alas, it is often said in budding or troubled relationships that “sex will just make things more complicated,” and there aren’t many times where this is not true. Yet, people do it (no pun intended) anyway and the web of complexities is spun. I find this to be true in many other aspects of life.
This doesn’t affect just a few people, it affects virtually every one every day. In fact, it often goes to the next level.
I routinely come across situations that are made with the malicious intent to deceive people through over-complicating what is essentially a simple situation or simple problem. You are wondering: why are you surprised by this? The fact is that I am not surprised by this myself (usually) but I am surprised how insidious and prevalent this problem is.
Through a brief reflection, I drummed up a few instances where over-complexity might be affecting you.
1. Wording in contracts/agreements, financial statements, warranties, etc.
Here’s a little experiment: go to Bank of America’s website and download their annual report. Read through it for a few minutes and let me know how far you get into the footnotes before you drift off into never-never land. This stuff is nearly impossible for the above average intelligence level person to read, let alone understand. You might wonder why anyone that wasn’t a financial analyst or regulator would want to read this stuff, but that would be missing the point. The point is, that the annual report is supposed to communicate business results and other relevant information to stakeholders (not just shareholders) to make decisions. Decisions are impeded when the information needed to make them is clouded in a secret code of accountant and legal speak.
Take a look at the last legal contract you signed. Maybe it was a lease for an apartment. Maybe it was a contract for work to be done to your home. Either way, I bet that if you compared the length and language to that of 20 years ago, you would be offended at the amount of trees killed and ink spilled in the modern creation. There aren’t many things that really require a lawyer, if you get right down to it. Our society has just created enormous complexities because a select few realize that by creating the complexity they can pull the wool over everyone else’s eyes for their own benefit.
Have you looked at your extended vehicle or iPod warranty lately? If you haven’t, let me save you some time: if anything goes wrong with it, it’s probably your fault and not covered in the warranty. In the rare, cataclysmic event that the thing that went wrong is really the fault of the manufacturer, it is your responsibility to prove it and if you do, you have to wait 8-12 weeks for your situation to be remedied.
You might discern that from reading the indefinite small print that we have all the product liability lawyers out there over the years for coming up with it to justify their billing.
2. Business Compliance with Government Regulators
Those of you that are business owners or managers will definitely know what I mean on this. I know that “we don’t have it as bad in America as other countries” when it comes to Big Brother looking over our shoulder, however, there is a difference between smart regulation (a registered oxymoron) and ribbons of red tape that do nothing but confuse and dillute value. The last time I tried to set up a payroll (before I started outsourcing virtually all administrative tasks for my business), it took me several hours to weed through all of the paperwork necessary to get it started. Once I got it started, it took several more hours each week to keep it up. Then, to top it all off, when I ended it (sold business), it took at least a dozen more hours to shut it off. I contined to get notices of delinquent taxes due from both federal and state regulatory bodies.
The million dollar question here is: why can’t the damn payroll form be ONE PAGE? Instead, it’s got to be maze of “check this box, then go here, check that box, go there, etc.” I don’t here anything being talked about in this enormous waste of taxpayer money (aka the Stimulus Bill) that will go toward making things easier and less complicated for business owners and managers to deal with the government.
If you’ve ever raised outside capital for a business (outside of family and friends), than you have likely come into contact with the securities law. While raising capital for my real estate business several months ago, I became ensnared in the vagaries of how the federal and state governments intertwine, overlap and promulgate the Securities Act of 1933 and the Uniform Securites Act.
Now, don’t get me wrong: I see and understand that we need measures in place to protect the average person from the Charles Ponzi’s and Bernie Madoff’s of the world. However, in the process of this the baby is often thrown out with the bath water. There is enough language in all of these laws to virtually scare anyone but a securities lawyer away from doing anything with securities. In case you didn’t notice, securities lawyers are some of the most expensive ones to hire. Billable rates of the 600+ per hour are routine. It is almost to the point where if you aren’t raising over $10,000,000 at once that it isn’t worth it to raise capital from non-family and friends. Is this really what we need in America to encourage entrepreneurship, creativity and innovation? That no small businesses should raise small amounts of capital from outsiders? What if there was a $500 per person limit? Or, increase the regulations in accordace with the amount of capital raised, etc?
I think that the over-complexities in this area create absolutely zero net economic benefit and, in fact, deduct from the creative capacities of American entrepreneurs. Once again, a few people over-complicate to pull the wool over the eyes of the layman so that they may extract dollars from the layman’s pocket.
3. Dealing with Incentives and Incentive Clauses
Have you ever hired a commission sales person? Have you ever tried to work with an employee or independent contractor who had ‘performance-based’ incentives? If so, this will hit close to home.
Many moons ago, I worked as a sales person at GNC (General Nutrition Center) while in college. It was the perfect job. I got to make money, get a discount on vitamin supplements and read weightlifting and nutrition magazines in between customers. On top of all of this, I was paid minimum wage plus commission. Commissions were paid a set dollar amount for certain products sold. At that time, GNC’s private label brands received higher commissions than the other brands and selling a ‘Gold Card’ (what was then a first Tuesday of the month 20% discount) was a high commission earner ($5 per card sold).
Now, let’s take a breath for a second and look at the incentive here. What would a young guy do that was hungry to make a few bucks? Sell the multi-vitamin that was $5 less to the customer or sell the product that was $5 more but has a $2 commission? You probably guessed right. Sell the GNC brand multi-vitamin I did - boatloads of them. I could have probably saved some of the customers more money, but that wouldn’t have made me any money. The customers, most of them, were none the wiser. They assumed that the suggestions I gave them were the ones that were best for them.
Ok, now, lets take a a look at a very famous and close-to-home example of a similar situation of incentives and the problems they can cause in your every day life: selling your home.
When most people sell their home, they hire a real estate agent. The agent lists the house on the MLS, tells a bunch of people about it, shows it to prospective buyers, and so on. Finally, they get an interested buyer. You are asking $200,000 for your house. The buyer offers $180,000. What to do?
Your first inclination as seller might be to make a counter-offer or to pass and wait for an offer closer to your asking price. But, your agent has other ideas. The agent encourages you to take the offer, they mention that a better one might not come along for a while. Here is what is going on in your agent’s mind:
Selling Price: $180,000
Commission (6%): $10,800
or…
Selling Price: $190,000
Commission (6%): $11,400
Unless the market is RED HOT, the agent is probably not going to want to jeopardize a sure-fire payday of $10,800 for a measly $600 gain. However, the difference to you (the seller) is a $9,400 ($10,000 higher selling price less 6% commission). This is the power of underestimating the complexities that come with incentives. The agent has a strong vested interest in selling at $180,000 - and urges you to do the same. Just like the GNC employee.
When you look at or encounter incentive-based situations in your everyday business or personal life, it would benefit you to slash through all the B.S. and look at the alignment of incentives. If you are running into a problem with an employee, take a look at their incentives. Most employees get paid to show up, do the job, and go home. The business owner gets frustrated when the employee doesn’t go the extra mile, stay late, make the additional customer call. The business owner further thinks that there may be some sort of moral problem or other issue. The business owner spends valuable time thinking about the causes of the employees acting ‘at the margin’ when they need look no further than the incentive.
How about the issue causing the current ‘credit market crunch?’ Is is really a problem of indefinite causes (housing for everyone from the Clinton presidency, bad mortgage brokers, bad underwriters, shady appraisers, shady title companies, crooks, politicians, cheap money, etc.)? I think it is simply a matter of what people were incentivized to do. They were incentivized, at every level, to do exactly what they did. There were no incentives for the behavior that would have led to an orderly market correction. The guys on one side made billions while the guys paid to prevent it made thousands. The Wall St. guy goes home at 10:00 at night. The Fed. regulator goes home at 5:00- do the math.
————–
As I descend from my soapbox. I feel a bit lighter of burden but strongly galvanized in a quest to seek simplicity when situations seem overly complex. It has worked for me many times to strip as much of the B.S. away as I can and focus on the bare bones of the issue. For example, when looking at a recent real estate deal, I found myself getting caught up in the probabilities of certain scenarios playing out; caught up with the variables in play and what would happen if A, B or C. Suddenly, I stopped for a moment, shut off my computer, pulled out some scratch paper and a pencil, remembered some second grade math, came up with my number for the deal and my sanity promptly returned. Like magic.
Give SIMPLE a shot.
Adam,
I have to admit, you are one of my local heros. When I read most people’s thoughts, opinions, and certainly that of most of the media, I am left with an empty, disgusted feeling of “Here’s another jackass who has no clue what he’s talking about.”
It’s especially disheartening when I read a “this guy has no clue what he’s talking about” opinion or editorial from a successful entrepreneur.
I tell you, Michigan would be booming if we had a lot more people who truly understood the issues like you do.
I do agree with your view that we should keep things simple. And, I do like your perspective on always keeping in mind what the prevailing incentives are with whom we are dealing.
On the other hand, at the risk of overcomplicating things, I would like to express that there are layers of nuance to this issue.
As Adam Smith pointed out so long ago in “The Wealth of Nations,” the incentives of self-interest that powers the invisible hand of the marketplace is to all of our benefit, whether we realize it or not.
The problem is when, as I know you know, the government encroaches on the free market and distorts these incentives in a myriad of ways.
For example, if we had a free market in finance, the market would set the price of money — i.e., interest rates. Because the government meddles continuously, we have a much lower interest rate than we would have in a free market.
In a free market, nobody would be lending money below the rate of inflation. This creates (and has created) massive distortions.
All of the craziness we’ve seen in the real estate market in the last decade would never have happened…and along with it, all of the appraisal fraud, the frenzied incentives of mortgage brokers, banks lending to subprime borrowers, etc. — if the Government had just left the market well enough alone.
And when people did blow up, they certainly wouldn’t be getting bailed out. What kind of perverse incentives does that create?
Bottomline here is this: I think we have to be careful when we look at incentives (even in the private sector) and divorce those incentives that are created by a free market (beneficial) as opposed to incentives in the private sphere that have been warped by government policies and interventions.
Let me bring this example to life with a concrete example: last year I could not for the life of me get a refinance on an investment property even though my full doc income was over 250k a year, I had an 800+ FICO score, and low debt. After 3 failed attempts at a refi, the mortgage brokers told me that the only loans sailing thru were FHA backed ones.
So, the perverse incentive here was: let’s not give Dan Ho a loan because if he defaults, the government won’t pick up the tab. But if Joe Blow FHA buyer defaults, our loan to him is backed by the government — i.e., tax dollars.
In a free market, the FHA guy would hardly ever get the loan (shaky credit, low income, little money down) and Dan Ho would be the first to get a loan (high credit, high provable income, low debt).
Let’s take the discussion back to business on a smaller level. Specifically, your GNC example of selling vitamins. There are always layers of choices we can make, and what can result in temporary financial gain may actually be the worst thing for longer term profitability.
For instance, legendary marketer Jay Abraham has a philosophy he calls the strategy of preeminence. Shortly stated, the strategy of preeminence says to love your clients (he doesn’t call them customers) like a dear friend. And, if you do, you will always try to do what’s in their best interest.
From a business perspective, Jay would say, if you are selling a product to a client who was running a business and you were truly convinced that by his buying more of your product, his business would genuinely benefit, you literally have a DUTY to try to sell him more of it, even if at first he might resist.
And, just as importantly, by converse, if you knew that it wouldn’t benefit a client’s business if he bought your product, you would not try to sell it to him at all. Although you would lose temporary business, the long term trust you would build up — the strategy of preeminence — would lead to a great deal more profits in the end.
So the question to ponder here is: what is the real incentive here? To make short term profits…or become more enlightened and make more and longer term profits? Nuance. And the free market will decide the ultimate winners from the losers.
If you owned that GNC store (not sure if it’s a franchise or not) and, as the owner, you were selling some B vitamins, some more expensive, some less, do you always go for the higher profit? Or do you sometimes downsell something because it’s in the customer’s best interest (he doesn’t really need the more expensive product)?
And what are the ramifications of both?
Regarding your comment that we need protection from the Bernie Madoff’s of the world, maybe I am a bit more extreme than you here.
But I don’t think we do. And I don’t suspect you believe that either.
The problem here is manifold.
First, I believe that Government regulation well MORE OFTEN than not causes greater harm than good, which I’m quite certain that you believe as well.
The free market is much better at spotting and ferreting out the scammers than the government regulators ever could.
Which is exactly why the SEC failed so dismally in catching Madoff even after having been tipped off for years.
As another example, I knew many sharp short sellers in the market who shorted the hell out of Fannie Mae and Freddie Mac and the bank stocks when they knew that all of this would end badly.
Shorting is a natural market phenomenon that pushes down the price of a stock and helps bring to light fraud…and these short sellers should be rewarded for the risk they take if they are proven right.
But what does our government do? We temporarily BAN short selling based on the outcry of banking shareholders and Wall Street cronies who are in bed with the powers at the Fed or the Treasury.
Which takes me to the problem of collusion. How much of it and by whom? When the private sector and the government gets together, we end up with cronyism. We end up with private companies getting government contracts because the senator or governor get a free lap dance, 200 thousand in free upgrades on his residence, and some vacations, for awarding a contract.
What a lot of anti-free market people don’t get is that they think us free market proponents are always extolling the high ethics of private business people. We are not. Private businessman will often try to collude with the government to gain an unfair advantage. The salient point here is: if they were not allowed to align with the government, they would have to compete in the marketplace, whether they liked it or not.
What kind of society do we live in when the reckless and incompetent get bailed out and the responsible get shafted?
Examine those incentives closely my friends.
Wow, what a rant this turned into.
We should pen a blog together. It’s not good for my nervous system to bottle up all of this angst.
And, it shows that at least there are still two people — you and I — in the state of Michigan who still actually give a damn.
Respectfully,
Dan
Dan,
As always, thank you for the well thought out and shrewd comment(s). Your seem to grasp the concept and implications of moral hazard better than anyone I know or have recently read.
Incentives can be both creative and perverse - we have to be careful with them but WE HAVE TO USE them when we can to get the right things done (private sector job growth, real innovation, etc.) Incentives are powerful things. If you wanted to stop traffic jams tomorrow, you could simply set up toll booth on every highway on-ramp and charge $500 to use the freeway each time. Result = reduced traffic. While there is a demand elasticity to be dealt with on a practical level (think ’sin’ taxes not materially reducing cigarette consumption) the principal remains that people respond to incentives.
My thoughts on government intervention and regulation are similar to yours, though I don’t think am I quite as laize faire as you (but close). I agree that intervention often causes more problems than it solves in the long term, though I feel it necessary in some cases (tax credits for less pollution of rivers and water tables = incentive to build cleaner technology and benefit to society).
It IS irrational to sacrifice more net long term profit for short term gain (as in the case of the GNC employee) - this is where incentives can come in to play in a huge way. Take a look at mortgages - would mortgage brokers have ‘churned and burned’ as many clients as they did if they got paid not on the front end, but as a residual of the interest of the mortgage paid on time every month? If the client wins, the bank wins, the mortgage broker wins - to me this is a good situation with properly aligned incentives. Otherwise, you have mortgage brokers pushing the products that are best for them and not the borrower (e.g. ARM resets result in tripling of payments and subsequent default which screws everyone). Many market participants sowed the seeds of their own demise (irrationality at its definition).
Short selling is indeed a part of a healthy, free market system. The ban on short selling was as deplorable as all of the other impotent measures of trying to stop a tidal wave with a hair dryer.
I’d definitely like to hear more of your thoughts on these subjects and others. Don’t bottle it up.
Smart thinking + Elbow grease = results!
Super scary. Really. Think about it.
Adam,
No doubt we have to identify and respond to incentives — even if we don’t personally agree with those incentives. I may want the world to bend to my view, but above all, I’m a realist.
We have to recognize what the prevailing incentives are, and figure out their consequences. In this instance, your original post on this thread was spot on.
I may hate the massive stimulus package (bailout). I may think it’s morally bankrupt. But based on the evidence, I conclude it’s going to lead to raging inflation down the road. Whether I detest this or not, I place my bets accordingly to profit from it.
Just a couple of other comments from me. You and I could pat each other on the back all day long how much we agree, but in the end, what good would that do?
Like any normal person, I feel more appreciative and secure in the company of people with whom I feel strong affinities, such as yourself. But the reality is that we’re much better served leaping into the lion’s pit of people who don’t agree with us to get our views across…and, perhaps, just perhaps, we will convert a few lost souls to a more rational world view.
But since you asked to hear a bit more of my thoughts, I’ll expand a tad. In particular, regarding your point about what if we changed the incentives of mortgage brokers from getting paid on the front end to an ongoing residual.
You’re exactly right here, too. But from a narrow perspective. In my opinion, we need to broaden the picture and look at what happened to the industry at large.
We need to ask ourselves what distortions were created in the marketplace that induced all of the banks to follow each other off a cliff, like so many mindless lemmings leaping to their collective deaths.
Here’s my abbreviated answer: the Fed, under the non-maestro Greenspan, dropped interest rates to absurdly low levels, creating a flood of easy money. In addition to this, he bailed out all of the screw-ups (including those Nobel prize winning goons who ran Long Term Capital Management).
This, coupled with ass-backward government policies that mandated loans be made for other reasons than creditworthiness and other such rational factors, spurred a lending boom.
Liar loans came into vogue. People who could not afford the homes they were buying to even live in also snapped up second and third homes just to gamble on ever rising real estate prices. Home equity became a seemingly perpetual ATM machine, to tap whenever needed for vacations, new cars, appliances, college tuitions, that finished basement, you name it. This, of course, spurred GDP even more, though it was all illusory.
Of course, when home prices are rising, everything is just chipper. The monthly payments are being made, the banks appear to have a good thing on their hands, and the shareholders are beside themselves with joy.
Now what INCENTIVE does this create? Well if you’re at Bank A and your quarterly profits are soaring, you want more of this. You’re getting a raise. You’re getting that corner office. The stock holders love you. Hell, even that sexy secretary think you’re hot stuff even though you’re bald, have a pot belly, and you don’t know your head from your ass.
Now, let’s say your Bank B. If you don’t start doing the same thing as Bank A is doing and do it fast, you’re going to get reprimanded by the shareholders and/or management at best, and get canned fast at worst.
So, you join the party too to get your profits ramped up.
Party on Wayne! Party on Garth!
Then, like all manias built on sand, it comes crashing down.
Government to the rescue….(the same fools who created the problem).
In short, the problem was much bigger than the incentives of the mortgage brokers, and even if we had shifted their incentives as you suggested, the problem would still have transpired, albeit in a more muted fashion.
Let’s look at the situation last year. And now I’m talking from real world experience. I couldn’t get a refinance for the life of me, whereas before you barely needed a pulse to get one. Every underwriter under the sun was LOOKING for a reason not to give me one.
I’m serious. They were asking for letters from my mother’s brother’s deceased uncle why I should be granted a loan. High income? High credit? Please.
What was going on? What was the incentive now? Well, the pendulum had swung completely to the other side.
Before, if you didn’t let the loan go through, even to someone who was a terrible credit risk, you would have probably been fired. Then when it all blew up, banks were so scared that if you gave a loan even to an excellent prospect, you probably ALSO would have been canned if the loan went bad because banks were so screwed and scared.
In conclusion, the government can screw off. The banks can screw off. The auto companies can screw off. And if anything good happens to the economy in the next 4 years, it won’t be because of Obama’s stimulus; it will happen IN SPITE of it because entrepreneurs do what they do best: make stuff happen — even when politicians try their best to muck things up.
As for your comment about externalities, such as pollution issues, it’s a compelling one. I would address it here, but I’m pretty pooped out. But I want to say that I certainly don’t have all the answers so you don’t think I’m an arrogant ass.
If I did comment on this matter, it would be less of an outright rebuttal and more of a devil’s advocate/food for thought counter.
Maybe some other day.
Respectfully,
Dan
Dan,
I think entrepreneurs and investors succeeding in the face of government’s best efforts to thwart is a close proxy to modern day patriotism.
How far from Ayn Rand did Greenspan drift over his career? Is she rolling over in her grave?
BTW: Last time I checked, JM and the boys from LTCM were still at it going strong….3rd time is a charm I guess! It’s amazing how much trouble an obscure math formula can cause. When you get a chance, check out Taleb’s books (Fooled by Randomness and The Black Swan) - it would be interesting to hear your feedback on his thoughts and his famously violent aversion to Black/Scholes.
Best,
Adam
Adam,
I like your sentiment on patriotism. That’s kick ass, really. A very unique way to view it.
As far as Greenspan, I think he’s a total scumbag, pardon my French.
What makes him so especially despicable in my eyes is that he knows better. He understands capitalism. He understands fiat money. He knows the role gold plays to keep government honest.
But he sold out his principles long ago when he took the Fed position (and even before that).
So, it was simply a case of power over principle.
Some libertarians believed that when Greenspan took the helm of the Fed, he was doing it to ultimately position himself to advance free market principles, and undermine the corrupt status quo.
What a joke that conjecture turned out to be.
Ayn Rand would definitely be rolling over in her grave, of that there is no question.
Ayn Rand always spoke of thinking in principle. Her heir Leonard Peikoff (who I am not really the biggest fan of) told an interesting story in a forward to one of his books. In that anecdote, Peikoff revealed Ayn Rand chewed him out when he was a young guy and kept concocting various philosophical quandaries after she would answer his last.
Finally, Rand became irate at the endless scenerios and yelled “Can’t you think in principle?”
What’s this got to do with Greenspan? Well, he was recently interviewed somewhere. The interviewer basically asked, “Would Ayn Rand have approved of your role as Fed chairman?”
To which Greenspan responded “We never specifically discussed THAT position.” (I am paraphrasing).
That is total BS. Obviously, Greenspan was equivocating and knew he was. How can you write an essay like Gold and Economic Freedom and then accept a position as the guy who can create as much fiat money he wants at will?
That would be like me saying murder is wrong, afterwhich I murder someone. When confronted, I defend myself by saying “Well, we never discussed murdering THIS particular person as being wrong.”
I shed any last remaining iota of hope and respect for him when I heard Greenspan answer that question.
Worse off, he continues to do damage in his retirement. I wish the man would just shut his mouth. The fact that he has a storied history as a “free market proponent” just gives more ammo to those on the far left (disclaimer for others reading this: I am not a republican. I did not vote for McCain), who want to blame the free market for the woes we currently face.
Such people can always point to crooks like Greenspan and say “See, here’s a reformed free market guru who now says the free market needs to be regulated! What proof more do you need?”
I will definitely check out Tabeb’s book. I had heard of it, of course, but I admit have not read it yet.
Keep making money (and as you guys at the REIA of Macomb always say) and making things happen.
Regards,
Dan
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