The Wisdom of Finance Key Takeaways

wisdom of finance

I first came across Mihir Desai and his ideas when I encountered the transcript of his Harvard commencement speech on optionality. His speech (among others) helped inspire my Optionality Trap blog post. Mihir and I eventually connected via email and I learned that he had written what I now know to be an excellent book, called The Wisdom of Finance.

Finance is something I’ve had more than a passing interest in for the better part of a decade. Back in high school, I was pretty sure I wanted to go into finance. Even the 2008-2009 financial crisis did nothing to shake that belief. What did eventually shake it, however, was an Introduction to Mathematical Finance class, which I found to be so abstract and irrelevant to the “real world” that I eventually dropped both the class and the idea of studying finance altogether.

While reading The Wisdom of Finance, I re-learned why I was interested in finance in the first place Рnamely, its intimate connection to real, human problems.

As a side note: It’s always an awesome experience to read an author with erudition like Mihir Desai. I got something like twenty other book recommendations out of this book, many of them fiction.

Below are my key takeaways and notes from The Wisdom of Finance:

The Wheel of Fortune

Our lives are dictated, to an incredible degree, by chance. While that may not come as a surprise, how we deal with chaos, randomness, and disorder has evolved greatly over the years as humanity developed better tools to deal with probability.

As those of you who’ve read Against the Gods encountered, human intuition is not a great tool for understanding probability. It took a long line of mathematicians, such as Blaise Pascal, Charles Sanders Peirce, and Pierre de Fermat, to develop the tools for analyzing situations probabilistically. The development of these tools in the context of human problems leads one directly to…insurance.

As Desai laments, the topic of insurance doesn’t really strike business students as innovative or interesting. But insurance is how finance intersects with the real world of issues around probability and risk – which is the basis from where everything else in finance stems. Indeed, for Charles Peirce, insurance was a metaphor which explained the chaotic nature of the world – and how to handle it: with experience, pragmatism, and empathy.

Risky Business

There were so many good ideas in this chapter, all related to the ideas of risk and risk management:

Options are a form of insurance

This directly links to the previous chapter’s idea of the world being unpredictable. Because events can’t be predicted, one form of insurance used in finance and life alike are options. From the book:

In part, people in finance love options because of the asymmetric payoff. Losses are contained and gains are unlimited. And experiences that create optionality – educational experiences, for example – are valued precisely because of the asymmetric nature of the payoffs. With well-defined losses and no set ceiling on the upside, who knows what could come of such possibilities?

The concept of Beta Applied to Friendships

Investors use something called beta as a measurement of risk to market fluctuations. In general, an asset that is “high beta” goes up a lot when the market goes up and goes down a lot when the market goes down. And a low beta asset goes up less than the market when it goes up and down less than the market when it goes down.

Desai’s analogy to friendships here is apt – your friends and contacts are “assets” in some sense. High beta friendships are your LinkedIn contacts and most professional acquaintances – they will show up when things are going well and disappear when things are bad. Low beta (or even negative beta) friendships are those friends and family who “tell it like it is” – they will keep you grounded when things are going well and lift you up when you’re in the dumps.

As Desai expands on in the book:

In finance, we are trying to figure out how to invest our assets and manage toward the best risk-return tradeoff. In life, we are trying to figure out how to allocate our time and energies across many people. It also matches because the underlying logic of insurance is present in both settings.

Risk Management Is Not The End Goal

Options are, of course, valuable and have their place in any risk management strategy. But Desai gives a strong warning to those who may overly focus on optionality at the expense of everything else:

People in finance love options so much that they often overlearn the lessons on the value of options. They become obsessed with “optionality” and the creation and preservation of choices…

I am no longer surprised to see students who end up remaining in companies – usually consulting or investment banking firms – that were initially intended as way stations that would create more optionality on the path to their actual entrepreneurial, social, or political goals. They often end up saying to themselves, “Why not stay another year and create more options for down the road?” The tool that was supposed to lead to more risk-taking ends up preventing it.

This is very much related to the the optionality trap concept that I’ve written about in the past. Optionality is an easy trap to fall into – and requires active effort to avoid.

On Value

One of the central goals of finance is figuring out how to value things – both for people and for assets.

Desai uses the parable of talents from the Book of Matthew to demonstrate the concept of “each according to his ability”. In the parable, a master entrusts his property of eight “talents” to three servants -five to one, two to another, and one to the third. When he returns from a journey, he finds that the first two servants have doubled the property from five to ten and two to four. The third servant tells the master that he was fearful and hid the talent in the ground, so he is only able to return the original one talent. The master (interpreted as God) is not pleased and takes the talent away from the third servant and banishes him into “the outer darkness.”

This parable is used to demonstrate multiple ideas – but the most important ones are:

  • Talent is distributed unequally.
  • Talent is incredibly valuable.
  • It is of the utmost importance to exercise our talent to its fullest extent.

Value Compounds

Compounding value is not quite intuitive (at least to me) but the concept is so powerful. This comparison between two scenarios demonstrates the concept. In both scenarios, investors expect a 10% return and you return 20%.

  • Scenario 1: you beat investor expectations (as described above) for 5 years and only reinvest a quarter of their profits while returning the rest as a dividend.
  • Scenario 2: you do the same as Scenario 1 but for 25 years and reinvest all profits for the entire 25 year period.

The difference in results between the two scenarios? Scenario 1: 50% gain. Scenario 2: 900% gain. Pretty clear which one is better…

Finance vs Accounting

Accounting is fundamentally backward-looking: balance sheets and income statements look at what has been done. Balance sheets also give zero value to assets that can’t be valued precisely. This leaves important assets such as brand, intellectual property, and user communities out of the equation. Imagine trying to value Coca-Cola, Disney, Facebook, or Apple without including their brand in that valuation…clearly not a complete picture.

In contrast, finance is ruthlessly forward-looking. Valuation is driven solely by the future. There is a discount given when translating future value into today’s dollars – and that waiting cost is valued by finance by the “weighted average cost of capital”.

Alpha – Value Generation or Luck?

The financial term “alpha” represents the idea of value creation – the returns you generate above and beyond expectations. Too often, especially among investors, success is overly attributed to skill and the role of luck is overlooked. To demonstrate this point, examine the coin-flipping experiment:

This experiment is a provocative way to humble any investors who pride themselves on their success as it directly rebuts the idea that alpha is easily labeled or generated. In a room full of a hundred of your friends, ask everyone to take out a coin, flip it ten times in a row, and record their results. You’ll find that you’re almost guaranteed to have one friend who gets ten heads in a row. Here’s the key insight: that friend is indistinguishable from an investor who says they’ve beaten the market ten years in a row.

Becoming a Producer: The Principal-Agent Problem

The principal-agent problem is one that has been talked about extensively, most notably by Nassim Taleb in his writings on the concept of “skin in the game”.

An easy way to understand the principal-agent problem is the idea of investors and managers. Investors put their money into a company and entrust managers to manage and grow the company. These managers (usually) are paid a salary while investors make their money on company value. These differences in incentives result in decision-making differences and ultimately, conflicts.

To make matters still more confused, modern capitalism is complicated – it often isn’t clear who is the agent and who is the principal. This is true in life as well – roles are blurred and muddled.

No Romance Without Finance: Contracts and Mergers

One of the biggest mergers of all-time, Time Warner and AOL, is now widely regarded as a disaster. But the mistakes that led to this disaster apply equally well to mergers between companies as they do between people – namely relationships and marriages. Here’s Desai’s list:

  1. Due diligence is critical.
  2. Filling a hole in your organization is not a merger strategy
  3. Racing against the clock leads to bad decision making.
  4. Synergies are always overstated.
  5. The costs of integration are always understated.
  6. Asymmetric mergers are easy but of limited value, and mergers of equals are horribly difficult but potentially very rewarding.
  7. Serial acquirers are problematic.
  8. Ultimately, it’s all about culture, “doing the work”, and execution.

Spot markets vs contracts vs ownership

As someone who has spent most of my career building marketplaces, I found the section on spot markets, contracts, and ownership to be extremely insightful.

Spot markets are typical business arrangements – someone needs a piece of machinery and finds a vendor to build it for them. Contracts are things that include terms such as exclusivity, special pricing considerations, minimums, or any other specific deal items. And of course, ownership is when one company decides to buy another for their capability.

The key insight here is given in Desai’s example of the Fisher Body-GM merger. The companies decided to merge when there were relationship-specific investments made which necessitated a requirement for a long-term contractual arrangement (instead of a spot market transaction), to ensure the largest joint surplus. The best way to understand this is knowing that it would essentially be impossible for Fisher Body to justify making an investment in equipment that only serves GM if they have no guarantee that GM will continue working with them in the future.

Living the Dream: Understanding Leverage

Leverage in finance is a fancy way of saying “borrowing money”. The analogy is based on the idea of a lever, which enables you to move items that would otherwise be too heavy to lift. In finance, leverage enables you to buy things you would otherwise be unable to buy and amplifies returns in both directions. If things are go well, you’ll make more money with leverage than without leverage and if things go badly, you’ll lose more money.

Understanding Leverage

A simple example to understand this concept is to imagine you have $100 in capital and are looking to buy a house.

Scenario A: You buy a $100 house.

Scenario B: You buy a $500 house, using your $100 as a down payment and taking on $400 of debt.

As you can see, leverage allowed you to buy a much bigger house than you otherwise could. And this also amplifies returns. If house values rise 10%, in Scenario A, you now have $110 worth of assets and $0 debt, which equals $110 of equity. In Scenario B, you now have $550 worth of assets and still only have $400 of debt, which means your equity is now equal to $150. But this also applies in reverse. If prices decrease 10%, you would have $90 equity in Scenario A but only $50 equity in Scenario B.

The Leverage Bonus

I love the idea of “the leverage bonus” – which basically says that by being leveraged, you are forced to do the right thing to meet your obligations. This is similar to the Death Ground Strategy, described by Robert Greene in 33 Strategies of War. By not giving yourself any options, you lose the ability to waffle on decisions.

The same thing can apply to relationships with others. By making commitments to others (being leveraged), you will take actions that you may never have been able to force yourself to do on your own. Ths accountability hold us to a higher standard and may enable us to live richer (and longer) lives.

Failing Forward

Failure, in many parts of the world, is stigmatized. Perhaps the only place this isn’t true is Silicon Valley – which may be why it is a continuous wellspring of innovation. Risk taking and failure go hand in hand. You literally can’t have one without the other. To paraphrase Desai, failure should not be understood or seen as a moral defect. Inevitably, risk taking will lead to failure, and failure should be viewed as a bad outcome with an abundance of lessons.

Failure in America has undergone quite a transformation since the origins of the country – from debtors’ prisons to modern bankruptcy law. Modern bankruptcies allow companies to walk away from crushing obligations and have a fresh start. This idea understandably makes us nervous. What happens if it’s too easy to walk away from obligations? We stop valuing obligations. But what if some obligations (like interest on debt) makes it impossible to meet other obligations (like paying employees)? Desai says that these trade-offs are intimately connecting to the competing obligations we all feel in the real world:

We are all fragile creatures, all teetering on the edges of bankruptcy, struggling to navigate between competing obligations that arise when we care deeply about things in our lives. The mistake is to reject uncertainty – just as philosopher Charles Sanders Peirce suggested – by not caring deeply enough to feel those competing obligations.

*****

These concepts are only a sampling of the great ones contained in this book. I highly, highly recommend checking out The Wisdom of Finance, no matter what your background is – finance, business, or anything else.

Pick up your copy of The Wisdom of Finance on Amazon or wherever you buy books and let me know what you think in the comments or on Twitter.

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