In 2020, Richard Dobatse, a Navy medic in San Diego, watched his Robinhood account soar above $1 million – then crash to just $6,956.
Like millions of others, he had been drawn in by the trading app’s simple interface, game-like features, and promise of “commission-free” trading.
What started with $15,000 in credit card advances escalated to two $30,000 home equity loans as he desperately tried to recover his losses through increasingly risky trades.
Dobatse’s story illustrates a fundamental economic principle: the power of incentives.
Because Robinhood’s users traded for free, the company made money by selling their order flow to market makers. This created an incentive for Robinhood to encourage more frequent, riskier trading through behavioral nudges like confetti animations and push notifications.
The strategy worked: Robinhood users traded 40 times more shares per dollar than customers of a traditional brokerage account.
Every day, hidden incentives like these are costing you money.
Whether you’re buying insurance, investing in stocks, or choosing a financial advisor, understanding two key economic principles can help you avoid costly mistakes and make smarter financial decisions:
- The power of incentives – how other people’s motivations affect your wealth
- The principal-agent problem – why delegating financial decisions is riskier than you think
You don’t need an economics degree to benefit from these concepts. It’s about understanding fundamental principles that will help you make better financial decisions in everyday situations.
This article was written by a Financial Horse Contributor.
The Power of Incentives
Charlie Munger could have predicted Dobatse’s story. Warren Buffett’s business partner at Berkshire Hathaway once said: “Show me the incentive and I will show you the outcome.”
In his influential talk on “The Psychology of Human Misjudgement,” Munger ranked incentives as the most powerful force shaping human behavior: almost everyone, even sophisticated investors, consistently underestimate how incentives drives decisions everywhere.
He used FedEx as a case study. The company was struggling with nighttime sorting of packages. It was a critical operation that was constantly delayed, leading to late deliveries and angry customers. Management tried various solutions: supervision, threats, pleading. Nothing helped.
The breakthrough came when they switched from paying hourly wages to paying per shift, with workers free to leave as soon as all packages were sorted. The sorting problem quickly disappeared.
The insurance industry provides another example of potentially misaligned incentives.
Budget Babe wrote about the commissions insurance agents earn. Apart from direct commissions, they also earn additional bonuses when they hit certain sales targets — including overseas trips to destinations like Venice or Iceland. Some agencies offer “persistency bonuses” for retaining clients.
This creates an incentive for agents to recommend products that maximise their sales. While an investment-linked policy (ILP) is not inherently bad, agents may be also pushing them because of the underlying commissions they get.
This also explains why despite term insurance often being more cost-effective for pure protection needs, many advisors still recommend whole life policies. A disillusioned insurance agent wrote:
While a term plan might be more appropriate in some cases, I cannot sell it as I will not receive sufficient commission to cover the cost of prospecting for the client and meeting the client, and worse a term plan is not considered a “life case” so I will be screamed at by my boss (I have seen some bosses throw heavy objects at their agents and I feel concerned for my safety). I was not even given product training on anything except the highest commission products.”
Munger offers three practical antidotes to the incentive-caused bias:
- Especially fear professional advice when it is especially good for the adviser.
- Learn and use the basic elements of your adviser’s trade as you deal with your adviser.
- Double-check, disbelieve, or replace much of what you’re told, to the degree that seems appropriate after objective thought.
As we’ll see next, this understanding of incentives leads directly to another crucial economic concept: the principal-agent problem.
The Principal-Agent Problem
“If you want it done, go. If not, send.” This ancient wisdom, attributed to Julius Caesar, captures what economists call the principal-agent problem — perhaps the most fundamental challenge in finance.
This problem arises when you trust someone else to manage your money or make financial decisions on your behalf.
The concept is simple: When you (the principal) delegate decisions to someone else (the agent), their incentives rarely align perfectly with yours. This misalignment appears in many places.
- Mutual Fund Managers: While you want maximum long-term returns, fund managers are often incentivised to focus on short-term performance to attract new investors. This explains why many actively managed funds underperform their benchmarks after fees.
- Corporate CEOs: When a CEO is parachuted into a large public company where ownership is spread thin among thousands of shareholders, they often prioritise short-term stock prices over long-term value creation. A CEO who isn’t incentivised to create long-term value would naturally do things like ill-advised share buybacks to boost stock performance.
Investors can protect themselves by looking for aligned incentives.
Founder-led companies like Nvidia and Meta succeed because their owners are incentivised to make difficult but necessary long-term decisions, even if it hurts the company’s short-term performance.
This explains why investors like Warren Buffett prefer to buy businesses where owners remain deeply involved.
At Berkshire, Buffet and most subsidiary CEOs have most of their net worth in company stock. When investing in non founder-led companies, examine if management has skin in the game that tie their success to yours as a shareholder.
For example, Elon Musk is not the founder of Tesla, but certainly thinks like one. That’s because he negotiated a pay plan that consisted mostly of stock options. Musk’s compensation package was tied to Tesla hitting incredibly ambitious growth targets. Tesla’s value needed to grow from $60 billion to $650 billion within 10 years.
This kind of growth was impossible to achieve through short-term financial engineering or quarterly earnings manipulation. It required fundamental transformation of the company through long-term bets like scaling production and expanding globally.
Conclusion
For investors, the safest path is to be your own principal.
This is why financial literacy is so important. When you have direct control of your finances, you avoid risk of misaligned incentives.
The principal-agent problem can never be completely solved, but understanding it helps you spot potential conflicts and protect your wealth.
The more you understand incentives, the less you need to rely on trust.