To start off simple, take a baseball player that is taking steroids to enhance his performance in an attempt to break the standing home-run record. The benefit (or as traders say "upside") of taking steroids is that he has a better chance of attaining a new home-run record, achieving great fame, and living the non libation related high life.
If the punishment (or as traders say "downside") of getting caught doing illicit drugs is a $50 fine, the the baseball player will most likely brush it off as a cost of doing business and achieving fame, in other words let the juice flow! However, if the penalty is getting kicked out of the National Baseball League - yes this blog is based in the United States - the player may think twice about juicing. So, if the NBA really wants to put their foot down on steroid use, they would increase the penalties to create an incentive system geared towards discouraging steroid usage.
This logic can be extended to businesses as well. Take the example of a business CEO (Chief Executive Officer) who is granted a bonus that gives him an extra $50,000 for every .1% that he increases net income over the year. If he increases sales by a full percentage point he gets an extra $500,000 - not a bad bonus.
The problem with this incentive system is that it is rather short-term. There are any number of ways the CEO can juice net income in the short-term to help his bonus. He can sell inferior products and lower costs, this may work for a year but over the long-term will cause customers to purchase from other businesses. He could also create deep discounts and encourage customers to buy lots of product and stock up before the end of year. This will increase net income but will significantly drop sales because the customers will purchase less the following year.
This is a poor incentive system because it only focuses on the short-term needs for the business. Many businesses have tried to get around this by granting stock as bonuses and finally stock options that CEO's could not cash in on for a certain amount of years (say five) in order that they keep the stock price up for at least that long.
We can also look at the financial crisis. In the past when a bank loaned money to someone to purchase a house they then held that mortgage on their books as an asset (yes an asset - for banks loans are assets because they are entitled to a future cash flow). When securitization became popular banks could sell those mortgages in a package to a firm that pooled them and then issued bonds to individual investors that purchased a share in that cash flow.
This skewed incentives for the bank making the loans. In the past a bank that would only make loans if they knew they were to be paid on those loans, after securitization became popular they had "no skin in the game" because if they made a bad loan they got fees for it but did not have to suffer consequences if the mortgage holder didn't pay their mortgages. This was a main contributor to the housing crises as people with poor credit quality and an inability to pay their mortgage were extended loans. Now regulators are trying to make banks retain a portion of those mortgages to expose them to the "downside" risk, not just the "upside" benefits.
Or take politics....I don't need to get to the incentives lobbyist provide to individual politicians in Washington D.C. but you get my drift. A lack of understanding of the incentives we establish within society is what creates most of our problems. We can all help this issue by just thinking about the "upside" and "downside" to any decision we make. As far as your investing, are you purchasing shares in companies that align their executives incentives with what is best for the company long-term - if not you may want to start!
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