How to protect yourself from the “principal-agent problem.”
- Is your car as old as the Mona Lisa?
- Does it spew more pollution than a petrochemical plant?
- When you turn your windshield wipers on, does it turn your car off?
- Have you ever thought about blasting your car with a tank shell, so you can finally buy another one?
Well, we have a deal for you.
I’m Carl. And here at Best Deals Auto, we’re going out of business, and that means we’re giving every car away, practically for FREEEEE!
We have every used car available; from trucks, to SUVs, to cars big and small, we even have a boat or two, because we know you have needs, and we're here to fulfill those needs.
We have the best deals money can buy.
No money, no problem. Our fully trained staff will offer you an affordable credit option that fits your lifestyle. Why? Because you deserve it!
So come on by, we're not that far away. But hurry, I don't know how long we'll still be in business.
The Principal-Agent Problem.
I bet we've all heard this sales pitch before. And it gives us a warm and fuzzy feeling inside. Or maybe it's a nauseous feeling. I don't know. But this is my fun introduction to the principal-agent problem, let me explain.
"The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal" (Investopedia).
In the example above, the principal is you and the agent is Carl. And “affordable credit option that fits your lifestyle,” is the operative phrase for the principal-agent problem.
My Uncle Carl (name changed to protect the innocent, hehe) is a very likable guy. You can talk to him about anything and he makes you feel good about yourself. After holiday get-togethers, when Uncle Carl leaves, the fun leaves, then everybody else leaves shortly after.
But there’s another side to Uncle Carl, he is a shrewd salesman. He sold cars to people at unaffordable prices and made a good living doing it.
Knowing what he did for a living, I asked him recently if he knew what the “principal-agent problem” is because I was writing about it.
He said, “of course I do, our business model depends on it.”
I didn't expect that kind of honesty, but Uncle Carl is retired now, so maybe he was just coming clean.
Two things you need to know...
He said there's two things you need to know & do in his business:
- Most people already know what they want.
- But they don't have the money to buy it.
- Tell people you have what they want.
- And make sure they have the credit to buy it.
He told me, "Over the years, less people have been paying with cash, because they're paying with credit, and in a credit business, we have more of a fiduciary responsibility to the customer. That principal-agent relationship you're talking about. Because people spend more with credit, than they do with cash.”
However, he explained that he was paid on commissions, just like a stock broker or a real estate agent, and to tell a customer they couldn't afford something, pushed that customer into buying a car from someone else. So, he rarely told them that.
Because people spent other people's money (credit) faster than they spent their own, it made his business very profitable, and him a lot of money, but it did get people into a lot of financial trouble.
“People would sometimes beg me to take the car back,” he lamented. “They would say, why would you give me a loan if you knew that I couldn't afford it?”
One customer told him that they had to make a choice between baby food and the car loan. “The guilt started to wear on me over the years,” he said. “Maybe that's why I'm telling you this now...but I was also an ambitious salesman, and I had a family to feed also.”
Your best interest.
Here are some pointers that may protect you from the principal-agent problem to ensure your best interests are realized.
Do your homework.
- Don't go into the situation blind. Figure out exactly what you need (not want) and whether you can afford it. Do not let the agent talk you into anything.
Learn to say “NO!”
- Warren Buffett said that the most successful people say no to almost everything. Because when an agent suggests something, it’s usually more to their favor, not yours.
Give the decision some time.
- Never impulse buy. You have to do your homework anyway, so just go home and think about what you learned about the product or the person. The more time you give a decision, the more money you will save.
Get a second opinion.
- Some people are more honest and competent than others. Take the time to talk to other people, you may learn something that the first person was hiding or didn’t know.
I hesitated to write this piece because I like Uncle Carl. He is a good man. I was worried that this could put him in a bad light. I thank him for allowing me to use him in this post.
But it was important to me to shed light on a very serious issue. The principal-agent problem is everywhere.
- Legal counsel
- Investment professionals
- Even family and friend advice
It is a conflict within us all. The conflict between our self-interest and our duty to others when we act on their behalf. But maybe somehow, if we are aware of this problem, we can take personal responsibility to mitigate it.
Stay frosty people. Thanks for reading.