When incentives work against investors

The other day, I came across a snippet from a podcast with Elon Musk where he was talking about homelessness in California. His observation was simple: the problem could never be solved as long as the NGOs tasked with solving it were paid per homeless person. The more homeless people there were, the more money these organisations made. Solving homelessness would put them out of business.

Homelessness in California is not my brief. But the underlying principle applies strongly to personal finance in India. If you want to understand why a problem persists, ask who profits from it rather than who suffers from it.

Look at the derivatives market. SEBI's studies showed that roughly nine out of ten individual traders in futures and options lose money. That is the structural outcome of a system where brokers earn fees on every transaction, exchanges earn from volumes, and institutional players with superior technology systematically extract value from retail participants.

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Consider a retail trader who buys Nifty futures worth Rs 10 lakh on Monday using leverage. The broker earns Rs 2,000 in brokerage regardless of whether the trade makes or loses money. The trader exits Thursday at a Rs 50,000 loss. The broker has made Rs 4,000 on the round-trip. Repeat this fifty times a year across thousands of traders, and the trader's Rs 25 lakh annual loss is the broker's Rs 2 lakh annual revenue stream. The more people trade, the more money the ecosystem makes. The fact that those people are losing money is not a bug. It is a feature.

The pattern repeats everywhere. When NSE proposed extending derivatives trading hours into the evening, the official justification was investor convenience. The actual incentive? Exchanges earn revenue from transaction volumes. More trading hours mean more transactions mean more revenue. If retail traders can lose money only between 9:15 AM and 3:30 PM, why not give them another four hours to lose in?

Take insurance. An agent selling a Rs 1 crore term insurance policy earns roughly Rs 4,500 in first-year commission. The same agent selling a ULIP with a Rs 1 lakh annual premium earns Rs 15,000 to Rs 25,000 in first-year commission. The customer needs term insurance. The agent needs to sell a ULIP. Guess who wins that conversation.

Some years ago, I wrote about Charlie Munger's views on incentives. He told a sad story about a broker who churned his own blind father-in-law's account until the old man was broke. Munger's observation was unforgettable: 'They just think if you need it enough, it's OK to do.' That single sentence captures the moral universe of commission-driven financial selling better than any regulatory white paper ever could.

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Now here is the uncomfortable part. Whenever these problems surface, the industry's favourite response is to call for more financial education and investor awareness. This sounds noble and responsible. It is also useless.

Let me be precise. Independent financial education can be valuable. Value Research exists because that kind of education matters. But industry-led financial education, where the educator profits from the problem continuing, is theater.

Think about it through the lens of incentives. Who conducts most financial education in India? The industry itself. Brokers, distributors, insurance companies, platforms that profit from investor activity. Asking them to educate investors about the dangers of their own products is like asking the casino to run a programme on the futility of gambling. They will happily conduct seminars, distribute pamphlets, and sponsor awareness campaigns, because none of it changes the incentive structure that drives their revenue.

The proof that incentive reform works sits right in front of us. After years of tinkering, SEBI evolved a commission structure for mutual funds that eliminated upfront payments and removed the incentive for churning. The result was exactly what you would expect. The worst abuses in mutual fund distribution declined sharply. Not because distributors suddenly became more ethical or investors became more educated, but because the economic reward for bad behaviour was taken away. Change the incentive and you change the behaviour. It really is that simple.

This is the lesson that matters. Whenever you encounter a persistent problem in personal finance, whether derivatives losses, insurance mis-selling, or unsuitable advice, do not ask why investors are not better informed. Ask instead: who is making money from this problem continuing to exist? The answer will tell you why it persists, and what it would actually take to fix it.

For you as an investor, the application is direct. The next time someone recommends a financial product, ask a simple question: how does this person get paid? If the answer is higher commission for product A than product B, you know whose interests are being served. It is rarely yours.

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