Breaking the ice
In January 1908, just outside of Paris, a child fell into the river Seine. The front page of the February 2nd edition of The New York Times reported that the child was playing by the banks of the river but had come too close to the edge and fallen in, condemned to almost certain death at the bottom of the freezing river. By a stroke of sheer luck, a large Newfoundland dog – a breed unsurpassed in both its instincts and abilities to rescue people from water – heard the cries of the child, and sprinted to the rescue, pulling them to safety onto shore. Needless to say, the reaction was overwhelming: everyone hailed the heroic pooch and the child’s father ordered a large, succulent steak for the dog as a reward.
Having made such a miraculous rescue, one might have thought that the dog would enjoy a well-earned rest. This it did, until just two days later when another child fell into the river nearby. Yet again, the dog was quickly on hand, and, yet again, made a heroic rescue. Cue more cheering and of course another juicy steak. People started to get worried, however, when a third child fell into the river the following day, and had to again be rescued by the giant dog. Thus began a harrowing saga: on a nearly daily basis, children playing on the riverbanks began falling, inexplicably, into the river, and the rugged Newfie was continually called upon to rescue them from a watery grave. Eventually, the local townspeople became so terrified that there was a mysterious child murderer on the loose that they set up a special, round-the-clock watch to get to the bottom of the strange events.
The next day, all was revealed. The watchman on guard at the time bore witness to what was happening: a child had been playing innocently by the banks of the river when he saw someone creep up and suddenly push the child in. That someone was none other than the giant Newfoundland dog.
The dog had followed his unsuspecting victims to the edge of the water before rushing up behind them and giving them a not-so-gentle shove into the freezing Seine. As soon as they fell in and began to yell for help, he would dive in and rescue them in a gallant display of heroism that would then land him his ultimate prize: a juicy steak.
The locals surmised that, having made one genuine rescue and earned a steak for his efforts, the Newfie had figured out that he could simply engineer for himself an everlasting supply – all he needed was a steady stream of children to rescue. If he couldn’t find them, well then he’d just create the circumstances on his own and get what he wanted. Whilst the dog’s owner was mortified, parents were pleased at least that there was no maniacal would-be child-killer on the loose. The solution was simple: having observed the Newfie make his final, now-discredited rescue, he was denied a steak as a reward – and the manufactured rescues stopped.
Put your money where your mouth is
The story of the opportunist Newfoundland illustrates a critical lesson for the discerning investor: incentives matter. In the words of the late great Charlie Munger: “Show me the incentive, and I’ll show you the outcome[1]”
For the Newfie, the incentive was a nice steak for each child rescued, and so the outcome was a series of manufactured rescues. When it comes to making investments, the same rules apply, and it is incumbent upon all investors to carefully consider all of the incentives that may drive outcomes.
On the front lines of equity investing, the incentives we focus on are how management and the Board get paid and what ownership stakes they have in the company: their ‘skin in the game’. Take, for example, Sandisk, a semiconductor company in which we recently invested[2]. The Chairman and CEO, Dave Goeckeler, personally owns over 500,000 shares, currently valued at around $75m[3]: in our view, that is quite a statement of his belief in the value of the company and its future prospects, from someone who probably knows better than anyone. Often, it is easy to dismiss management’s vocal enthusiasm for the businesses they lead: that is, after all, their job. However, it is much harder to ignore the signal of belief that comes with such a massive investment of personal wealth on the part of the company’s leaders.
Investors need to carefully consider all the incentives that may drive outcomes.
After an outright ownership stake, the most important incentive on which investors need to focus is on compensation. Whilst it is easy for managers to wax lyrical about maximising shareholder value, investors can simply look at company financials and observe what a management team is actually being paid to deliver – and whether or not they are simply being thrown steaks whenever they hit arbitrary targets poorly aligned with long-term positive outcomes.
A good example of the latter is when compensation outcomes are tied to numbers that can be meaningless for, or even detrimental to, shareholder value. For instance, many Boards expect that a growing revenue base leads to increased shareholder value over time, which as a general rule is an excellent starting point. However, a simplistic focus on revenue growth alone can, in fact, deliver poor outcomes for shareholders, if not checked and balanced with other performance metrics. For example, if a CEO is paid mostly on the absolute rate of sales growth of their company, they may well be much more likely to do large acquisitions, which can aggressively expand sales at the expense of profitability, or utilise a huge chunk of shareholders’ money that could have been more profitably employed elsewhere – or even given back to them as a capital return. These actions may serve to lower the value of the company on a per-share basis – a value which every management team should ideally be striving to sustainably increase – but might help a CEO hit their growth targets and get paid.
We focus on how management and the board get paid and what stakes they have.
The ecosystem of incentives
As well as with individual companies – very much our arena – we would urge investors to consider, too, the incentive and alignment structure of their investment managers. A simple question can often do the trick: does a manager have their own money heavily invested in the fund? Do the analysts? It may not be quite Dave Goeckeler’s $75m [4], but if the investment team doing the day-to-day work have their own money riding alongside yours, the chances are that – unless they are inveterate gamblers – they are going to be investing your money with maximum care. By contrast, if an analyst doesn’t even know the process by which they can invest in their own funds (a reality that we have encountered in the industry), let alone have any portion of their net worth invested alongside you, it is a poor signal of their belief in the efficacy of their investment approach.
At the same time, it is important to understand the broader set of incentives that surround the investment industry, and how institutional allocators might be incentivised, implicitly, to push money into strategies that offer them something other than excellent returns. Our favourite hobbyhorse on this topic is private markets. Is it truly the case that private equity and credit strategies outperform their public equivalents over time, and is that what drives increasing institutional allocations? Or is it simply the fact that private markets, no one is going to switch on the news and see the market value of their investment fluctuate wildly over the course of the day, subject to the public pronouncements of politicians, the price of oil, or other equally volatile factors?
Consider the position of the employee who needs to choose whether to allocate $1bn of pension fund capital into a public equity strategy – such as ours – or a private one. Fundamentally, the companies operate in the same countries – with similar customers and macro-economic forces at work – and usually those in the public markets have similar or better balance sheets than those privately held. But, if you choose a public strategy, where holdings are published daily and you can have your money back anytime, you know that you will constantly face probing questions – both from your own nagging doubts, and from your Investment Committee or Board of Trustees – as the value of the public companies your pensioners own tumbles about day to day, quarter to quarter, and year to year. By contrast, if you give the money to a private manager (who is going to charge you more for the privilege), you will receive quarterly pieces of paper with some valuations on it, derived from estimates of the value of your private holdings from three months ago. All else equal, the institutional allocator seems likely to mimic the electron – and take the path of least resistance.
Misaligned incentives play a substantial part in the extreme concentration in global equity markets today.
Not that this means the public markets are immune from allocator incentive problems. We believe that misaligned incentives play a substantial part in the extreme concentration we are witnessing in global equity markets today, with the top ten companies now comprising nearly 27% of the MSCI World Index; NVIDIA alone is currently 5.5% of the global equity index [5]. Even as these companies climb ever higher, who continues to buy them? Well, again, we would encourage a closer look at the incentives of the money managers piling dollar after dollar into these companies.
Active portfolio managers are principally measured – and thus paid – by performance relative to a benchmark, with a nervously hovering central management that wants their mutual funds to avoid looking too different from the index. Many portfolio managers are therefore strongly incentivised to buy these technology behemoths, unable to shoulder the tracking error and relative underperformance that comes with calmly ignoring them and sticking to their usual knitting.
The need to keep up with surging benchmarks – even as valuations become stretched – also influences allocators at the top of the food chain. Judged by their investment committees against the benchmark of beta (the pure return of the market which they could earn by owning a cheap tracker fund), allocators funnel money into funds that look a great deal like the index – lowering their risk of relative underperformance – often with a higher exposure to the largest growth companies, again insulating them in all directions from looking too different. What this incentivises, then, is similarity over absolute returns: better to go down with the ship, the thinking goes, than to be alone in a lifeboat when there’s a party on deck.
Many portfolio managers are strongly incentivised to buy these technology behemoths.
Understanding sheep
In the years leading up to the 2008 financial crises, misaligned incentives created clear capital flows of carnage: banks lending money to people who couldn’t pay it back, selling those poor exposures immediately and earning quick fees for doing so. This was, in hindsight, an obvious factor that added substantial risk to the financial system, and we would argue that misaligned incentives – wherever they are found – remain a key source of potential pitfalls for investors today.
Having started with a tale of animal incentives, it seems fitting to end with one too [6].
Charlie Munger relayed the tale of a teacher in Texas, who was introducing her primary school children to basic addition and subtraction. She picked on little Johnny with an example [7]:
Teacher: “Johnny, if there are ten sheep in a pen, and one jumped out, how many sheep will I have left in the pen?”
Johnny: “None, miss”
Teacher: “Clearly you don’t understand mathematics”
Johnny: “No, miss – you don’t understand sheep”
Whether in the field of Newfoundland dogs, sheep farming, or investments, the universal truth applies: incentives matter. Understanding incentives – and the behaviours they create – is a prerequisite for success and an antidote to failure.
Sources:
[1] Munger, Charles T., and Peter D. Kaufman. ‘Poor Charlie’s Almanack: The Essential Wit and Wisdom of Charles T. Munger’. Fourth abridged edition 2023, Stripe Press, 2023
[2] Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.
[3] Bloomberg, October 2025
[4] Although this analyst would be happy to test the hypothesis that a $75m personal investment would improve his performance; kind sponsors should feel free to get in touch directly
[5] Bloomberg, MSCI, 21 October 2025
[6] No, I don’t get paid on a per-story basis, although given the nature of the article, that is the right question to be asking
[7] Munger, Charles T., and Peter D. Kaufman. Poor Charlie’s Almanack: The Essential Wit and Wisdom of Charles T. Munger. Fourth abridged edition 2023, Stripe Press, 2023
Key Information
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to the future. The prices of investments and income from them may fall as well as rise and investors may not get back the full amount invested. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.
