15 September 2017

How human is the world of risk and return?


When you think of human nature and the market, two opposing theories come to mind. The first concerns the perfectly rational homo economicus who sits at the heart of much economic theory. In a world of scarce resources, he navigates supply and demand in whatever way maximises his utility. The second features what Keynes dubbed animal spirits: the irrational forces of optimism, fear and greed that can drive decisions and move markets.

These two conceptions have helped economists understand why prices change in the way they do. But neither really offers anything close to an accurate account of how human nature works. And why should they? When market participants – and in particular those involved in today’s highly complex financial markets – consider humanity, they do so only to help their bottom line.

Humanity and finance would seem, therefore, to be worlds apart. Surely there is nothing more impersonal than the rows of graph-and-chart-filled screens that furnish 21st-century trading floors?

Not according to Mihir Desai, a professor of finance at Harvard Business School and the author of The Wisdom of Finance: Discovering Humanity in the World of Risk and Return. “Many distrust markets, particularly financial markets, because they are thought to be hostile to humanity,” writes Desai. “But perhaps that has things completely upside down. Perhaps finance is deeply connected to our humanity.”

To make that connection, Desai casts a wide net. The result is a lively book full of surprising references. The Wire’s Stringer Bell and Pride and Prejudice’s Lizzy Bennett are your guides to mitigating risk. The accidental success of Springtime for Hitler in The Producers explains the principle-agent problem. An episode of The Simpsons demonstrates how insurance can create moral hazard.

But it is when Desai uses finance as a window on life – rather than the inverse – that he writes with the most insight.

Insurance, he argues, is about so much more than the superficially dreary work of actuaries. Channelling the philosopher Charles Sanders Pierce, who said in 1869 that “each of us is an insurance company”, Desai writes: “Risk is everywhere, it is undeniable, and it shouldn’t be ignored or surrendered to – it should be managed. And insurance is the primary way we manage risk in our lives.”

Bankruptcy law prompts a thoughtful consideration of the meaning of failure. By lowering the costs of failure and thereby encouraging people to take risk, US bankruptcy law has helped build a successful economy. Companies who stigmatise failure are less likely to learn from them. The logic, Desai argues, applies as much in our everyday lives as it does in business.

This might make The Wisdom of Finance sound like the sort of pseudo-spiritual guff Alain de Botton writes. “The last thing I wanted to do was write a self-help book,” Desai told me when we met recently in London. “I think they are kind of ridiculous in many ways … There is wisdom in there but it’s not three easy steps to nirvana.”

I asked Desai what he thinks the most common misconception people have about finance. His answer is blunt: “I think they think it is evil.” It’s a worrying thought for those who make their living in the square mile. As for the finance world’s view of itself, too many insiders subscribe to Goldman Sachs CEO Lloyd Blankfein’s view that they are doing “God’s work”, which Desai says is a “knee-jerk defensiveness”.

There is a grain of truth in both exaggerations. Some of finance’s bad reputation is justified; as Desai argues, “there are chunks of finance that are not creating value but extracting value”.

He thinks that Joseph de la Vega, the 17th century Jewish philosopher, captured the contradictions of the world of finance better than anyone else. It is a business, wrote de la Vega in Confusion de Confusiones, “which is at once the fairest and most deceitful in Europe, the noblest and the most infamous in the world, the finest and the most vulgar on earth. It is a quintessence of academic learning and a paragon of fraudulence; it is a touchstone for the intelligent and a tombstone for the audacious, a treasury of usefulness and a source of disaster.”

“That duality is what finance is,” says Desai. “We’ve lost a sense of that duality.” And, if anything, that duality proves the link between humanity and finance.

Re-establishing that connection, as The Wisdom of Finance does, allows the lay reader to understand finance, something they see as remote and abstract, in terms they understand. While for those in finance, that link is a reminder of the moral element of what they do.

Paradoxically, after eight chapters about “how great finance is”, Desai ends The Wisdom of Finance with a chapter on what has gone wrong with it.  “The biggest problem is that people confuse luck with skill,” he tells me, introducing his “asshole theory of finance”. Everyone, no matter what they do, is guilty of attribution error, crediting their own brilliance for successes and blaming failures on forces beyond their control. Finance, because of the precise and instant feedback people get on their performance, simply magnifies this particular human weakness.

Take an investor who outperforms the market eight years in a row. He is likely to put this down to his expertise and skill as a money manager. But the randomness of the market means it is impossible to know how much luck is involved.

“There is no industry where it is easier to dress up luck as skill,” Desai says. “You can’t do that in tennis. There is only a trivial amount of luck in Roger Federer’s game. I can say with absolute certainty that he is incredibly good at what he does. There are skillful people in finance, don’t get me wrong. But my ability to divine who they are is really limited.”

As he makes clear in the book: “It’s not finance that’s bad. It’s not the people who finance attracts who are bad. It’s just that finance fuels ego and ambition in an unusually powerful way.”

It is ironic that it has fallen into this trap, given that the very idea of an efficient market, which finance is rooted in, is a humbling one. Theory says that beating the market year after year is almost impossible. But finance isn’t theoretical. Even today it is, at root, the accumulation of billions of real-world human decisions. And the people making those decisions are no different from the rest of us.

Oliver Wiseman is Deputy Editor of CapX