The Carrot and the Stick

In college, I took a course called the Economics of the Environment. I wanted to avoid the mathematical grind of econometrics, and I needed an economics elective to complete my finance degree. The class has been invaluable to me, not because I figured out how to solve climate change, but because I learned about incentives. In economics incentives are everything. Incentives drive human behavior. There are two types of incentives. Let’s call them The Carrot and The Stick.

The Carrot is a positive incentive that awards desired behavior. Subsidies, such as grants, low-interest loans, and favorable tax treatment can be used to encourage polluters to reduce emissions. The Stick is a negative incentive that discourages undesired behavior. Fines, fees, and mandates are used to discourage or bar polluters from certain behaviors. Both positive and negative incentives are powerful, but overreliance on one type over the other causes suboptimal outcomes.

I’ve been thinking a lot about incentives as I watch cities and states respond to the delta variant surge in Covid cases. My hometown, New Orleans, is under an indoor mask mandate and requires proof of vaccination or negative test to enter restaurants, gyms, theaters, and sporting venues. Meanwhile, the Governor of Florida threatens to withhold funding to local school districts that require children to wear masks in school. Who is right? Will one locale fare better than the other?

I was pleasantly surprised to see a meaningful uptick in vaccinations in New Orleans one week after the indoor vaccine announcement. My initial fear was that the overuse of The Stick would backfire, with vaccine-hesitant individuals digging in their heals. It appears that at least initially, people were motivated to get the jab.

Which incentive is more powerful – The Carrot or The Stick? Any parent of a three-year-old can tell you that both are necessary. The trick is to find the right balance between the two. Too much Stick and the child loses confidence. Too much Carrot and the child learns to skirt the rules.

We built our firm with the power of incentives in mind. I am not sure if a financial plan is a Carrot or a Stick. Perhaps for some clients, it is a negative incentive that motivates them to spend less and save more. For others, it is a  positive incentive that provides peace of mind that their behavior resulted in a high probability of financial success. Either way, the plan ensures we focus on outcomes in the long run rather than getting distracted by the day-to-day noise of the markets.

The average holding period for a mutual fund is three years. That’s an old statistic, and I wouldn’t be shocked if that time frame is much shorter after the trading frenzy we’ve seen over the past year. But three years is not long enough to enjoy the benefits of compounding returns.

We need our clients to think in decades, not months or even years, so we designed a Carrot incentive to reward their good behavior. After a client has been at our firm for three years, they may become eligible for Milestone Rewards, a loyalty program that results in a reduced management fee for the rest of their lives. I celebrated my three-year anniversary at RWM in June. This means I am now welcoming clients to Milestone Rewards every quarter. This is not the norm for financial advisors – to lower a client’s fee. It’s an extraordinary experience.

Ever since I learned the power of incentives in that economics course, I find it hard not the view the world through an economic lens. The application of incentives is everywhere and all around us. Perhaps after reading this, you will start to see how incentives impact your everyday choices. Armed with this knowledge, we must use it to achieve better, healthier, and wealthier outcomes.





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