Highlights: The Wisdom of Finance, by Mihir Desai
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They need to ensure that their activities are truly value creating. More personally, working in an industry that is perceived negatively can take its toll. With expectations so low, finance professionals have little to aspire to, which creates a downward spiral of low expectations and poor behavior.
Rather than the production and dissemination of specialized knowledge, for a moment we would all return to an antiquated notion of a university that acknowledged that, as John Henry Newman put it more than 150 years ago, “the general principles of any study you may learn by books at home; but the detail, the color, the tone, the air, the life which makes it live in us, you must catch all these from those in whom it lives already.”
For starters, the rejection of markets and finance as a source of wisdom is deeply unhelpful. Many highly educated individuals are deeply engaged in markets and concern themselves with financial matters for most of their time on this earth. By suggesting that finance has no positive values embedded in it, we encourage these individuals to live a professional life without values and to separate their personal, moral selves from their work. That compartmentalization is difficult and often untenable. Can you engage in a life’s work that is bereft of wisdom and values and hope to live a good life? Aside from being highly impractical,
As I struggled with these questions, I recalled that the best description of finance I had ever found came not from a textbook or a CNBC special but from a parable told by a Sephardic Jew writing in Spanish in Amsterdam in 1688. In Confusion de Confusiones, Joseph de la Vega provides a vivid description of the nascent financial markets
When the philosopher explains how little he understands about financial markets, the shareholder responds with my favorite description of finance: “I really must say that you are an ignorant person, friend Greybeard, if you know nothing of this enigmatic business 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, and finally a counterpart of Sisyphus who never rests as also Ixion who is chained to a wheel that turns perpetually.”
To set prices, to measure values, to think up equivalencies, to exchange things—that preoccupied man’s very first thinking to such a degree that in a certain sense it’s what thinking itself is. Here the oldest form of astuteness was bred: . . . the human being describes himself as a being which assesses values, which values and measures, as the ‘inherently calculating animal.’” Released from the
Asset pricing provides a powerful perspective on risk and value—but does so by ignoring much of the messiness of life. Indeed, a founding myth of asset pricing is a story of individuals on islands who own trees that produce fruit and must exchange fruit with each other. Asset pricing focuses only on the relationship between owners and their disembodied assets, thereby shearing the world of complexities like companies, more complex individual motivations, and the uneven diffusion of resources and information. That messiness is what most of us experience every day, and that is the subject of corporate finance.
The next two chapters combine the lessons of risk from asset pricing with the messiness of corporate finance by exploring the idea of debt and what can result from excessive levels of debt—bankruptcy. The artist Jeff Koons and William Shakespeare’s The Merchant of Venice allow us to map the commitments of borrowing to a much more personal setting. And Kazuo Ishiguro’s The Remains of the Day, the fall of the richest man in colonial America, and a case study of the American Airlines bankruptcy teach us about the risks of excessive borrowing and the rewards of conflicting obligations.
Flitcraft had created a life that was a “clean orderly sane responsible affair,” and now a “falling beam had shown him that life was fundamentally none of those things.” We live only because “blind chance” spares us. After the initial shock, he became disturbed by the “discovery that in sensibly ordering his affairs he had got out of step, and not in step, with life.” Immediately after lunch, he resolved that he had to “adjust himself to this new glimpse of life.” He concluded: “Life could be ended for him at random by a falling beam: he would change his life at random by simply going away.” He left immediately by boat for
Spade then concludes with his favorite part of the story: “I don’t think he even knew he had settled back naturally into the same groove he had jumped out of in Tacoma. But that’s the part of it I always liked. He adjusted himself to beams falling, and then no more of them fell, and so he adjusted himself to them not falling.”
“same as it ever was.” Like in any good detective story, Dashiell Hammett’s key clues to the parable are hiding in plain sight. By choosing the names Flitcraft and Charles Pierce, Hammett added layers of meaning and connected this story to finance. For finance is, at its core, a way to understand the role of risk and randomness in our lives and a way to use the dominance of patterns to our advantage. Flitcraft is a name that has now all but disappeared, but, as a Pinkerton investigator who worked for insurance companies, Hammett would have known that Flitcraft published the bible for actuarial analysis in the life insurance business at the time. Flitcraft was a statistical wizard who published volumes that helped the fledgling insurance industry figure out the odds of living and dying for prospective clients.
And by choosing Charles Pierce as the second name, Hammett invoked a legend who has also been all but forgotten. Charles Sanders Peirce (yes, Hammett reversed the vowels) was 1) the founder of the philosophical tradition known as pragmatism, 2) a mathematician and logician whose work is considered a precursor to many significant developments in twentieth-century mathematics, 3) the founder of semiotics (the study of signs), which undergirds much of modern literary theory, and 4) a founder of modern statistics and the inventor of randomized experiments.
you’ve struggled as I have with probabilistic intuitions, take solace. For much of human history, simple probabilistic intuitions were elusive. Scholars of statistics have puzzled over why it took millennia for humanity to arrive at the modern intuition that chance is irreducible and omnipresent but can be understood and analyzed rigorously. This revelation, according to the philosopher of science Ian Hacking, is best embodied by none other than Flitcraft’s alter ego, Charles Peirce. And the foundation of insurance and much of modern finance is to be found precisely in this revelation. Finance, ultimately, is a set of tools for understanding how to address a risky, uncertain world. The
The critical breakthrough for probabilistic thinking was the correspondence between two pioneering mathematicians, Blaise Pascal and Pierre de Fermat, about the aforementioned problem of points. In 1654, they created the tools to understand that problem by examining alternative outcomes to derive the expected values of those bets when the game was interrupted. That correspondence then triggered two and a half centuries of rapid-fire developments in probabilistic thinking.
But the quincunx, like many outcomes that are the product of multiple random processes, actually results in the wonderfully soothing bell-shaped distribution where most balls fall in the center. This regularity was found so often and in so many intriguing places that it gave rise to a conviction that what seemed like chance was illusory and that nature followed ironclad laws.
was characteristic of the ironic confusion: the discoverers of the tools to analyze randomness came to believe in determinism. Laplace began a famous volume on probability by asserting that “all events, even those which on account of their insignificance do not seem to follow the great laws of nature, are a result of it just as necessarily as the revolutions of the sun.” Laws are everywhere, and they rule, not chance. Galton, another
Peirce was able to keep two seemingly contradictory ideas in his head at the same time—chance and randomness were everywhere (the insight from the former type of fatalism, think Flitcraft), and patterns emerged that suggested regularities in the aggregate (the insight from the latter type of fatalism, think Flitcraft as Pierce). The universe was full of chance and fundamentally stochastic (randomly determined)—but patterns could help us navigate the world.
Many of my students flock to finance—but often for the wrong reasons. Their view of finance is that it comprises investors and bankers—they either want to work at investment banks or so-called alternative asset managers such as hedge funds or private equity funds. I am delighted and surprised when a student walks into my office interested in venturing down the path less taken—finance within corporations in the real economy or, even better, insurance.
In turn, the lender would be compensated with a higher interest rate than they would otherwise charge. The risk of losing goods to storms or pirates was now shared and priced. Those better able to bear the risk (would you take out that loan if you knew an unexpected storm could result in your enslavement?)—the financiers—would charge the merchants for assuming that risk.
It gets better. In probably the earliest example of financial engineers bringing havoc to the world, a group of Swiss bankers bought annuities on behalf of groups of Swiss five-year-old girls who were found to come from particularly healthy stock. They then allowed people to invest in portfolios of these annuities, in what is likely the earliest example of securitization. By the time of the French Revolution, these annuities were the dominant source of financing for the government and the majority of annuitants were below the age of fifteen.
That Simpsons plotline provides a great example of how the presence of insurance can create an incentive to alter your behavior, a manifestation of what’s known as moral hazard. The example isn’t perfect, since usually the insured person takes more risk because of the insurance, as opposed to trying to kill people because of insurance—but you get the idea. Insurance and safety nets of all kinds can lead to more risk-taking, and insurers have to think through that behavioral response in pricing insurance. For more on this, just stream that classic film noir Double Indemnity and think about Barbara Stanwyck’s character—that’s serious moral hazard.
against you. Well, of course, that’s the family. You don’t get to choose your family, so that takes care of adverse selection. And families provide the intimacy for making sure behavior isn’t changing to take advantage of the insurance. Indeed, families have been the most important source of insurance for millennia. Various studies have confirmed that insurance of all kinds is provided within a family and extended families, particularly in developing countries. As one clear example of this, consider what happened to the rate of “household formation” after the financial crisis. We saw a collapse in the creation of new households as children moved back in with their parents in the wake of the financial recession. As Robert Frost said, “Home is the place where, when you have to go there, they have to take you
of making sense of the world and seeking out the patterns that can guide your behavior. That leads us to probabilities as
Once you embrace randomness, you are left with the task of making sense of the world and seeking out the patterns that can guide your behavior. That leads us to probabilities as the only way to really understand the world—nothing is entirely certain and we should approach the world probabilistically. If we want to understand how probable things are and how the world works, the only way to figure out these probabilities is through experience, just as with an insurance company. The more experience an insurance company has with a population, the better their understanding of probabilities and the more successful their business. That’s why, in effect, we’re all insurance companies—experience is the
Death makes the number of our risks, of our inferences, finite, and so makes their mean result uncertain. The very idea of probability and of reasoning rests on the assumption that this number is indefinitely great. We are thus landed in the same difficulty as before, and I can see but one solution of it . . . logicality inexorably requires that our interests shall not be limited. They must not stop at our own fate, but must embrace the whole community. This community, again, must not be limited, but must extend to all races of beings with whom we can come into immediate or mediate intellectual relation. It must reach, however vaguely, beyond this geological epoch, beyond all bounds . . . Logic is rooted in the social principle. To be logical, men should not be selfish.
Stevens declined the offer to become the Charles Eliot Norton Professor of Poetry at Harvard and, instead, spent most of his days figuring out how the Hartford Accident and Indemnity Company should settle or litigate insurance claims. Fellow poet John Berryman, in his elegy to Stevens, poked at him by calling him a “funny money man” “among the actuaries.” So, what did Stevens see in insurance? As we’ve seen, insurance tries to make sense of the chaos of human experience by capitalizing on patterns and then creating pooling mechanisms for us to be able to manage that chaos. For Stevens, poetry had the same aim of addressing the chaos of the world. In his preface to the volume Ideas of Order, Stevens labeled the volume as “pure poetry” that aimed to address the “dependence of the individual, confronting the elimination of established ideas, on the general sense of order.” In addition to the dramatic developments of the first third of the twentieth century (World War I and the Great Depression), Stevens was also sensitive to the chaos of nature and our own minds.
Poetry was critical to Stevens because it manifested how imagination could help us make sense of the chaos around us. In his essay “Imagination as Value,” Stevens reacts strongly against Pascal’s ideas that “imagination is that deceitful part in man, that mistress of error and falsity.” Instead, Stevens concludes that “imagination is the only genius” and the “only clue to reality.” Why was imagination so important? For Stevens, “imagination is the power of the mind over the possibilities of things” and is the “power that enables us to perceive the normal in the abnormal, the opposite of chaos in the chaos.” Stevens almost sounds like one of the early discoverers of the normal distribution.
The eligibility created by annual incomes factored critically into the risk management problem that figures so largely in nineteenth-century English literature—the problem faced by young women in the marriage market. Opportunities for financial security had to be weighed against the associated risks of various suitors—navigating that tradeoff is what preoccupies many a heroine and her family in these novels. In what is likely the most cringeworthy marriage proposal ever, Mr. Collins approaches Lizzy Bennet, the heroine of Pride and Prejudice, and delivers a hopelessly narcissistic appeal for her hand. Despite Lizzy’s protests, Mr. Collins doesn’t give up. Rather than praising or wooing Lizzy, Mr. Collins argues that Lizzy must accept his proposal, given the risks she faces.
am not romantic, you know; I never was. I ask only a comfortable home; and considering Mr. Collins’s character, connection, and situation in life, I am convinced that my chance of happiness with him is as fair as most people can boast on entering the marriage state.” In short, from her perspective, this is a good trade given her appetite for financial risk and her expected risks and returns of a marital bond. Faced with the risks of the marriage market, Charlotte chooses comfort over further risk exposure, while Lizzy chooses continued exposure in hopes of a romantic outcome.
These questions implicitly consider risk and return and require you to think about how to allocate your time, energy, and resources given a set of choices in the face of an uncertain future. This allocation problem is precisely the problem at the center of finance.
Fortunately, finance has adapted the logic of insurance to create the two most important risk management tools available to us—options and diversification. These risk management strategies may seem esoteric and unrelated. Fortunately, Violet Effingham of Anthony Trollope’s Phineas Finn, as we’ll see, is a thoughtful guide to the risk management problem of the marriage market because she managed to intuit both of these strategies well before they were formalized by modern finance. These two instruments also happen to have a common intellectual forefather—an obscure French mathematician who never got the respect he deserved for solving the problem laid out by a British botanist.
The conventional history of subsequent intellectual developments goes like this: in his annus mirabilis of 1905, when he produced four remarkable breakthroughs, Albert Einstein provided the first understanding of the mechanisms of so-called Brownian motion. He demonstrated that many processes that seem continuous (like the motion of dust or pollen) are in fact the product of many discrete particles moving about. In other words, the pollen particles were moving around in a continuous way because they were reacting to tiny water molecules that were bumping them at random. This foundational idea transformed physics by demonstrating the presence of atoms and also provided the machinery to mathematically describe all kinds of seemingly random processes, ultimately giving rise to quantum mechanics.
This is a convenient narrative that suits those who are dissatisfied with the rise of finance—but it is shoddy intellectual history. In fact, the person who beat Albert Einstein to the punch by five years was Louis Bachelier, a doctoral student in Paris. Rather than studying the movement of particles, he studied the movement of stocks and derived the mathematics to describe all kinds of motion, including the motion of pollen particles observed by Robert Brown. How did he do it? He realized that he could employ and generalize the magical distribution created by the quincunx into settings where outcomes weren’t the locations of falling balls, but rather processes of motion that were the result of lots of molecules behaving as if they were going through a quincunx. Even better, his data on stock prices fit that mathematical description extremely well. At the time, the use of stock market data was looked down upon, and Bachelier, despite his breakthrough, never received the recognition he deserved. In fact, leading mathematicians falsely claimed he had made mistakes, leaving Bachelier to operate on the margins of French academia and to die in relative obscurity.
Bourse). It is then used to resolve a mid-level mystery in physics (Brownian motion). Finally, it clears up an even deeper mystery in physics (quantum behavior). The implication is plain: Market weirdness explains quantum weirdness, not the other way around. Think of it this way: If Isaac Newton had worked at Goldman Sachs instead of sitting under an apple tree, he would have discovered the Heisenberg uncertainty principle.”
After all, a husband is very much like a house or a horse. You don’t take your house because it’s the best house in the world, but because just then you want a house. You go and see a house, and if it’s very nasty you don’t take it. But if you think it will suit pretty well, and if you are tired of looking about for houses, you do take it. That’s the way one buys one’s horses—and one’s husbands.”
In financial parlance, this is tantamount to creating a portfolio of options and then choosing to invest in one asset at the opportune time. The portfolio of options allows you to wait until you are ready to invest and to see how these assets are evolving—far preferable to committing to one asset prematurely or waiting in the hopes that the “right” asset will come along eventually.
People in finance love options for the freedom and opportunity they represent. And they frame much of their life in analogous terms. By pursuing education, for example, they increase “option value” because more degrees and networks mean that more choices will be available to them. But what exactly are options and how does one use them? The father of Greek philosophy, the Dutch financial markets of the seventeenth century, and the entrepreneur behind Federal Express are excellent guides to understanding that question.
Despite these remarkable accomplishments, Thales still had something left to prove. According to Aristotle, Thales’s poverty led him to be “taunted with the uselessness of philosophy.” Seeking to redress this impression, Thales decided to capitalize on his ability to forecast a good olive harvest. “He raised a small sum of money and paid round deposits for the whole of the olive-presses in Miletus and Chios, which he hired at a low rent as nobody was running him up; and when the season arrived, there was a sudden demand for a number of presses at the same time, and by letting them out on what terms he liked he realized a large sum of money.” Aristotle’s lesson from this story reflects the smug sentiments of philosophers and academics everywhere—Thales demonstrated that “it is easy for philosophers to be rich if they choose, but this is not what they care
The “deposit” that Thales first paid secured the right, but not the obligation, to rent the presses. This transaction is the essence of an options transaction—relatively small premia are paid to secure the rights to enter into transactions rather than obligating someone to do something, thereby enabling them to access resources they might need but don’t know if they will need. A stock option, for example, allows you the right to buy a share at a predetermined price at some point in the future for a relatively small price today.
In part, people in finance love options because of the nature of this 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?
“optative mood” is the Greek grammatical form, now lost, for expressing wishes. Purchasing options allows us to wish for outcomes and allows us to imagine what is possible and what might come true. This link between options and the desire to explore what is possible is precisely why Ralph Waldo Emerson called America “optative”—options are for people who want to imagine the outcomes that they desire.
By implication, if you hold an option, you will be encouraged to undertake riskier adventures. So, the real payoff from having options is the risk-taking that it enables. This is particularly evident when you come to realize suddenly that you hold an option. A story from the beginnings of Federal Express, the global logistics company, manifests this relationship between options and risk-taking. In the company’s very early days, the CEO, Fred Smith, was struggling mightily to convince suppliers, investors, and customers of the virtue of expedited delivery. On one Friday, things got so bad that fuel suppliers were threatening to shut off supplies, thereby ending the young company, because of an unpaid $24,000 bill. Smith only had $5,000 in the bank. How did he respond? As
victory. That sounds a lot like an option—an asymmetric payoff with little to lose and much to gain. So, how do you behave if you own an option? Well, you seek out volatility and risk. And where can you find that? FedEx still survives today because Smith went to Las Vegas and converted the $5,000 into $32,000 at the blackjack table. When confronted with the riskiness of the decision, Smith simply said, “What difference does it make? Without the funds for the fuel companies, we couldn’t have flown anyway.” As the owner of an option, Smith did what came naturally—he took on a great risk; if he won, he would win big, and if he lost, it was no difference to him. Owners of companies only have these incentives when they come close
Acquiring options can help you assess a set of outcomes beyond your current capabilities, allow you to take more risks than you would otherwise, and simultaneously protect you when you stumble.
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.
Implicitly, the act of marriage is characterized as the loss of something—future choices—rather than the beginning of something. As a result, a focus on the creation and preservation of choices can ironically lead to an inability to make choices. Alternatively, individuals most unable to make decisions become obsessed with the idea of optionality and frame their inability in terms of preserving optionality.
But the interpretation I think is most resonant is that, by not saying either yes or no, Bartleby was preferring the prospect of potential outcomes over real ones. We’ve all done this at different times—sometimes, the prospect of multiple outcomes is so tantalizing that we resist actually making a decision, preferring to live in a world of possibilities. This is what Bartleby does—preferring potentiality over reality, preferring optionality over real decisions.
Practical judgment was in abeyance. He had worn himself out, and the decision was no decision. How had this happened? . . . It was because Wilhelm himself was ripe for the mistake. His marriage, too, had been like that. Through such decisions somehow his life had taken form.” Tommy concludes that “ten such decisions made up the history of his life.” He comes to see his shambolic life as having “taken form” as the result of decisions that were not decisions at all—just stumbles that resulted from his inability to make choices and his overthinking of decisions.
Bartleby and Tommy Wilhelm are shattered individuals—passive actors who are seemingly unable to make choices. But they are also different. Melville provides a fable of inaction and the inability to make choices. Bellow provides a more realistic portrait of what happens when we don’t make choices—the world makes decisions for us and we find ourselves caught in currents without any ability to navigate them. This latter version is a result of the temptation that I see many of my students confronting—they choose majors and graduate schools and employers by appealing excessively to a logic of optionality. Soon, these students, like many of us, find themselves undertaking choices unconsciously that they had no idea they were setting themselves up
This logic of diversification is the cornerstone of portfolio theory and represents the only true “free lunch” in finance. It’s also a logic with a long history as a risk management strategy. The earliest examples, like those of insurance, date back to early shipping where cargo would be divided among ships and routes to mitigate the risks of a loss. In medieval England, the critical risk for farmers was that they were overly exposed to the output of a single plot of land. The remarkable “open field” agricultural system of medieval England was a response to this risk management problem. Serfs tilled narrow strips of land that were spread far and wide across a lord’s manor rather than one large piece of land.
This logic is especially true for your most precious resource—your time and experience. Stephen Curry is arguably the greatest basketball player active today; did he get there by specializing in one sport and devoting all his energy toward that sport? Contrary to popular sports parenting wisdom, specialization in one sport is not recommended for amateurs or promising high-performance athletes. And it’s not the path Curry took. Rather
The insight from finance is not only that diversification can help with risks but that there is actually a built-in bonus from diversifying your assets. This is actually a difficult logic as evidenced by the fact that various thinkers have not understood it—even John Maynard Keynes concluded, prior to the advent of modern portfolio theory, that “the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” But the logic of diversification has been intuitive to many for millennia; the advice in Ecclesiastes is to “invest in seven ventures, yes, in eight; you do not know what disaster may come.” And in the Talmud, R. Isaac recommends “one should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.”
In fact, the best kinds of assets are those that behave very differently from the assets you already own—such assets, when included in your portfolio, reduce risk and can preserve returns. And assets that perform much like what we already
That lesson on the virtues of diversification also extends to our personal lives. A dear friend framed his portfolio problem to me in this way: “I know that the most important thing I can do with my time is to spend it with my children—but if I spend all my time with them, I’ll screw them up terribly and probably go crazy myself. Why is that?” The finance take on this is that diversifying our experiences and relationships is precisely what we should be doing—relationships don’t crowd each other out but they enrich each other. Being a good friend and colleague doesn’t diminish your efforts as a parent but may well benefit those efforts.
same world that we inhabit is not nearly as powerful. Just as Keynes found it hard to intuit diversification, the logic of a diversified portfolio of relationships runs counter to many of our instincts. Homophily, or the desire to surround ourselves with like-minded people, is a common social instinct—and one that finance warns against. Yes, it’s easier to be around like-minded types, but finance recommends the hard work of exposing yourself to differences, not shielding yourself from them.
fluctuate very much along with your portfolio are “high-beta” assets that are not highly valued because of their limited diversification value. In fact, they make your exposure to the market even more pronounced—when the market goes down, these stocks go down a lot. The low values of these high-beta assets are the result of the high returns you expect from those assets—since they don’t provide much diversification value, they’d better be associated with high returns. And here’s the most elusive part of that finance logic—if you need high returns from assets, that can only be accomplished by giving them lower prices today. Lower prices for a given stream of cash flows create the higher returns you need to compensate you for the risk presented by these high-beta stocks.
“Low-beta” assets, in contrast, move with your portfolio but just not as much, so they don’t need to generate as high returns and, therefore, have higher prices. As you may already surmise, betas are simply shorthand for the correlation of an asset with your portfolio. At the other extreme, “negative-beta” assets move in the opposite direction of your portfolio—when your whole portfolio does well, these negative-beta assets do poorly, and when your whole portfolio tanks, these stocks do very well. And for that reason these assets are very valuable.
The high-beta assets in your life are likely your LinkedIn network or professional acquaintances. These relationships are largely instrumental; in other words, these individuals are likely to show up when you do well and disappear when things go poorly. Accordingly, they should be given low values—it’s not that they can’t be a source of great benefits; it’s just that they compound the risks you face and don’t provide much insurance. When you’re down on your knees, these assets provide no relief. Low-beta assets are considerably more valuable—they are the steady friends who are there for you no matter what happens to you. In fact, this classification of friendships closely mirrors the taxonomy of friendships provided by Aristotle in Nicomachean Ethics.
The high-beta assets in your life are likely your LinkedIn network or professional acquaintances. These relationships are largely instrumental; in other words, these individuals are likely to show up when you do well and disappear when things go poorly. Accordingly, they should be given low values—it’s not that they can’t be a source of great benefits; it’s just that they compound the risks you face and don’t provide much insurance. When you’re down on your knees, these assets provide no relief. Low-beta
But Aristotle reserves his highest praise for the love that is unconditional—the negative-beta assets in your life. When you stumble the hardest, these people are there for you the most—and when you fly too high, they manage to pull you back down to earth. Noting that “most people seem . . . to wish to be loved rather than love,” Aristotle contrasts that typical sentiment with mothers who “take delight in loving” and “they themselves love their children even if these owing to their ignorance give them nothing of a mother’s due.” That sounds just like the negative returns we are willing to live with for negative-beta assets. When we love our negative-beta assets unconditionally—we give and give and give and expect nothing in return—that’s negative expected returns.
For me, this parallel prompted several questions: Am I providing insurance to my loved ones and friends? Am I there when they need me the most? Am I dedicating too much time to the high-beta assets in my portfolio rather than realizing that they are relatively low-value relationships? And am I valuing the negative-beta assets in my life appropriately?
Her visit to Darcy’s estate is a critical turning point as she learns of his generous character and steadfast nature from his staff—he is not the arrogant, opportunistic high-beta asset she was wary of. With risks investigated and returns well established, Lizzy gets a second bite at the apple as Darcy presents the option yet again, and now Lizzy doesn’t hesitate. Instead of thinking of how much the loss of optionality would cost her, she “hits the bid.” She seems to have understood that risk management is not a goal in and of itself—but rather a set of strategies to ensure that one can take the big bets one needs to take to truly create value.
When we think about our talents and how we should use them, we don’t consider our financial wealth itself as a talent. Our talents are more personal than a simple calculation of net worth. They are the gifts that make us special and the abilities that we develop over time. If there is a link between money and talents for our modern sensibilities, it is that money and fortune may accrue from the exercise of our
God is not pleased. “You ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest.” As punishment, God takes the talent away from the poor servant and gives it instead to the servant who has ten talents, explaining, “For to everyone who has will more be given, and he will have an abundance. But from the one who has not, even what he has will be taken away.” Then, God delivers the ultimate punishment: “And cast the worthless servant into the outer darkness. In that place there will be weeping and gnashing of teeth.” The poorest servant is deprived of his talent and banished from the kingdom of God. Yikes.
clear—everyone has been endowed with talents and gifts; they are distributed unequally; they are incredibly valuable; and, most importantly, they should be exercised to their fullest extent. We are the stewards of those gifts and must make the most of them. At some point, we’ll all be held accountable for what we do with our gifts, and living in fear and depriving yourself and the world of your gifts is sinful. There also seems to be a close connection to our earlier discussion of risk: one can try to insure against and manage risk to some extent, but, ultimately, life entails risks.
how should we measure value? In particular, when we think of companies whose value goes up over time, it
The big questions in finance are: how is value created, and how should we measure value? In particular, when we think of companies whose value goes up over time, it is because they are presumed to be creating value.
Their expected returns are your cost of capital. You are a steward of their capital, and the sine qua non of value creation is that you have to exceed their expectations and your cost of capital if you want to create value.
The logic becomes even more brutal. If you generate a return with your investors’ capital that is below their expectations, you’ve actually destroyed value. In essence, it would have been better if you didn’t take their capital at all. You might think that you are doing well if you generate an 8 percent return. In fact, if they expected 10 percent, you destroyed value. You should have stayed in bed.
If you just exceed investors’ expectations for one or two years, it’s not that exciting. True value creation arises if you are a steward of their capital for multiple years and you beat their expectations every year. In a similar vein, if you can grow and continue to reinvest their earnings at a high rate of return, that’s even better than simply returning profits to your capital providers—precisely because you’re good at beating their expectations.
In short, finance has a simple recipe for value creation—1) surpass the expected returns of your capital providers; 2) surpass those expectations for as long as you can; and 3) grow, so you can keep generating returns that are higher than your cost of capital. That’s all that really matters for creating value.
That logic of stewardship and obligation is central to finance—we are overseeing the capital that others have entrusted
That logic of stewardship and obligation is central to finance—we are overseeing the capital that others have entrusted to us, just as the servants must take care of God’s talents.
That logic of stewardship and obligation is central to finance—we are overseeing the capital that others have entrusted to
That logic of stewardship and obligation is central to finance—we are overseeing the capital that others have entrusted to
Second, that role of steward comes with high expectations, is risky, and can be characterized by great outcomes (high returns/salvation) or terrible outcomes (value destruction/damnation). There is a harsh and challenging logic to both: make the most of what you are given, be aware of how much you’ve been given and how much is expected of you, and make every effort to exceed those expectations.
Finally, “grow, so you can keep generating returns that are higher than your cost of capital” is just another way of saying that you should never stop investing in yourself and continue to grow. Postpone harvesting as long as you can—because the returns to investing in your efforts can be enormous.
Finally, “grow, so you can keep generating returns that are higher than your cost of capital” is just another way of saying that you should never stop investing in yourself and continue to grow. Postpone harvesting as long as you can—because the returns to investing in your efforts can be enormous.
He explicitly linked the parable to finance in a sermon titled “The Use of Money.” The latter two parts of the sermon are summarized as “Do not throw the precious talent into the sea” and “Having, First, gained all you can, and, Secondly saved all you can, Then give all you can.” This quote is in fact the origin of the more popular framing of Wesley’s logic: “Do all the good you can. By all the means you can. In all the ways you can. In all the places you can. At all the times you can. To all the people you can. As long as ever you can.” It is difficult to summarize the financial logic of value creation any better.
Finance and accounting are often seen as basically the same and fundamentally interchangeable. Nothing could be further from the truth. Finance is a direct reaction against accounting and its limitations. Accounting uses balance sheets to tally the value of assets owned and obligations undertaken;
For people in finance, accounting’s approach to value is deeply troubling. Representations on balance sheets deliberately leave out a company’s most valuable assets because of the idea of “conservatism”: accountants give zero value to assets that they can’t value precisely. In fact, the most valuable assets of companies like Coca-Cola, Apple, and Facebook (their brands, intellectual property, and user community) never show up on balance sheets. It gets worse. Because of the principle of historic cost accounting—that assets should be represented at their acquisition price—some assets are listed at values that are completely distinct from current values. You’ll see balance sheets with large amounts of “goodwill” (the amount paid to acquire a company in excess of its book value) that may now have little value at all. As such, accounting and balance sheets are static and backward-looking by their nature. They are incomplete snapshots divorced from real value.
Given that accounting is so problematic, finance adopts a different approach to measuring value. Finance’s starting point in valuation is that previous accomplishments and what you have today bear little relationship to real value. Finance is completely and ruthlessly forward-looking. The only source of value today is the future. The first step of valuation is to look forward and project what a company or investment will produce in the future.
Ignore the past and present. Look forward to the future and project economic returns. Translate those back to today’s value using a “weighted average cost of capital”—a blend of the returns expected by your debt and equity financing. That translation gives you what something is worth today—and if it’s more than what you have to pay for the asset, you have a good deal.
This brief description of valuation allows a taste of the finance approach and how it might refract onto our lives. First, ruthlessly look forward and ignore the past and present in deciding what value is and what actions to undertake. Your previous accomplishments and missed opportunities mean nothing when looking at yourself today. Second, this emphasis on the future means that all estimates of value and decision making are acts of imagination and fundamentally conjectural. Imagining alternative futures is critical for making good decisions, just as it is for valuing investments. Finally, most value arises from terminal values (reflecting returns into perpetuity) and not returns in the short run. We are in a long game, and most enduring value arises from what we leave behind—our legacies—and not what we enjoy while we’re here.
father often telling me something that I now tell my daughters (my terminal values)—“the world belongs to the young.”
No matter how much he accomplished, Samuel Johnson feared damnation for not using his talents fully. “He that neglects the culture of ground naturally fertile is more shamefully culpable than he whose field would scarcely recompense his husbandry.” Johnson’s sentiment is precisely the burden many gifted, privileged people feel. Rather than congratulating himself on being the beneficiary of the unequal distribution of abilities, he framed it as a task to live up to.
Milton was obsessed with his incalculable debts to his earthly father, who had invested so much in his education, and to his heavenly father, whom he saw as the source of his poetic talent. Milton repeatedly worried that he wouldn’t be able to settle these debts and used the parable to voice his concern. He, like many of us, bumbled around for years looking for what at the time was called “credible employment.” This concern reached a climax in Milton’s forties when he discovered he was going blind. While he had already accomplished much as a pamphleteer for free speech and republicanism during the English Civil War of the 1640s, he had yet to use fully the talents he knew he had for poetry—and the progression of his blindness made him worry that he never would.
In other words, there is more to the world than the harsh logic of the parable of the talents, and one cannot live by its lessons alone. There is kindness, generosity, and forgiveness—and the parable of the talents ignores all that, says Milton. The generosity of spirit that Milton gleaned from that second parable may well have allowed him to complete Paradise Lost, Paradise Regained, and Samson Agonistes, all after he went completely blind.
Many people in finance, particularly investors, frame their efforts as “alpha generation” and deride those who get “paid for beta.” What in the world does this mean? As we saw, beta is a measure of how a stock moves with the market. And that co-movement with the market is the risk that investors can’t diversify away and must bear, and therefore demand compensation for. So money managers who get paid for providing returns that are just associated with bearing that risk are doing nothing of value. According to the logic of valuation, they are not creating value. Yet, they are still being compensated handsomely—they are being paid for beta. Returning to our previous example, they are just meeting expectations, yet they think they’re creating value.
The mistake people in finance make all too often is reflected in their appreciation of the more challenging parts of the parable of the talents. They attribute much of their success and returns simply to alpha generation and they pride themselves on it. In reality, finance teaches us that it is very difficult to know the extent to which our efforts are responsible for generating alpha. As a consequence, much of what we label as alpha generation is anything
The lesson from this experiment is that it is very difficult to disentangle skill from luck in finance. First, there is the nature of randomness that will make any measure of success unreliable. Second, there is the inability to identify cleanly which risks have been undertaken, creating ambiguity over what expected returns should have been. Finally, there is now plenty of evidence that indicates that few money managers consistently beat the market, after consideration of their fees.
So, the machismo that heralds market outcomes as clear indicators of effort and ability should be tempered. And the heroism associated with the supposedly meritocratic nature of finance is unjustified. If anything, there is no endeavor where it is easier to recharacterize luck as skill and bad performance as exceptional performance than within the field of finance.
The massive growth of the alternative assets industry over the last three decades is an underappreciated development in our capital markets. That development is predicated on the idea that some investors—such as hedge funds, private equity funds, and venture capital funds—are truly skilled and can generate alpha.
Of course, the reality is not quite so benign. These investors have been shown to not outperform reasonable benchmarks on average, and the evidence of skill for most of them is fleeting—except for, perhaps, funds in the top decile of those funds. And their compensation is predicated on benchmarks that don’t usually reflect the risks they undertake. Similarly, executive compensation contracts that naively use stock performance to judge how managers are doing are deeply misguided. Separating skill from luck over shorter horizons (less than ten years) is nearly impossible in financial markets. Large chunks of compensation arrangements throughout the economy don’t reflect this reality—and have actually contributed handily to growing income inequality.
settlement,” as in the settling of a debt with a final payment. The first known use of “finance” is from the medieval story “Tale of Beryn,” which is sometimes included in Chaucer’s Canterbury Tales. In it, one of the characters considers his life and states, “To make from your wrongs to your rights, finance.” In short, living up to and settling one’s obligations is the road to salvation. When the Day of Judgment arrives, have you financed?
We’ve looked so far at matters of risk and return and why investors choose to invest, but there’s also the matter of how and why investors get their money back. This might seem like a trivial matter because, obviously, they own their share in a company or a production and are therefore due their share of the profits. But The Producers captures an essential truth of finance—investors have few rights and usually have little knowledge of what actually is going on. So then the puzzle becomes, as economists Andrei
Positive reactions to unexpected CEO deaths, in addition to being vaguely ghoulish, are a manifestation of the basic problem that arises when owners delegate authority to managers—those managers don’t always do what they’re supposed to, and shareholders struggle to control these managers. This is the problem of corporate governance and a manifestation of the principal-agent problem. It’s also the fundamental problem of modern capitalism.
Why was the CEO resistant to their pleas? Well, part of the reason might have been that the CEO knew that selling the company would deprive him of his job—a job that came with $8 million in compensation, including $1.2 million that the company spent annually on a private plane to take him from his home in Massachusetts to Chicago every week. And those numbers are very large when you consider that the company only had $500 million in annual sales. Tim Cook gets paid millions of dollars, but his company’s revenues are $150 billion—three hundred times that of Tootsie
The most significant way we’ve tried to solve the agency problem is with stock-based compensation for managers. If managers have skin in the game, they will internalize the interests of shareholders, and the alignment problem will be solved. But that grand experiment over the last forty years has yielded mixed results, to say the least. Yes, perhaps managers are more attuned to their owners’ perspective, but now we have a new set of problems. Who decides how much stock managers should get? In theory, a company’s board of directors decides, but in practice it can feel like the managers decide how much stock to give themselves, and everyone goes along with it because it’s not “real” money, i.e., cash. More dangerously, as managers prepare to sell their stock, they have strange incentives to alter firm performance to their advantage. In short, they can have an incentive to burnish their current performance by sacrificing the future well-being of the company.
And those evil short sellers may be, in fact, seekers of truth as they try to unmask those managers who are perpetrating frauds. And these short sellers have succeeded, with Enron, for-profit colleges, and others. Many people regard these players as leeches extracting value from productive enterprises—but the other view is that they are solving a deep problem.
They provide another solution to the agency problem by replacing the diffuse ownership of public capital markets with concentrated ownership so that they can watch managers carefully. Venture capitalists, who fund early stage companies, are particularly preoccupied with this problem and, as a result, stage their investments in bite-size portions with curious instruments like “convertible preferred stock.” The peculiarities of these financial practices are designed to facilitate the monitoring of entrepreneurs and to make sure they are pursuing an agenda that is coincident with their investors’
Activist investors and short sellers are paid in ways, including contracts that allow them to reap gains over short horizons, that can lead them to place short-term gains over long-term value. Private equity might seem better, but these investors are also paid with similar contracts that provide incentives to harvest investments at particular horizons. And private equity investors often ultimately take their companies public, leading to a set of games they can play because of their informational advantages prior to a public offering.
In many ways, the biggest debates today on what is wrong with capitalism are actually debates about finance and agency theory. For some, the big problem is that the proponents of agency theory have been too successful: managers now only care about their owners! They should be looking out for workers, customers, and the environment, too. If only managers would be more capacious in their thinking and not just pursue profits, the world would be a better place.
In the name of advancing her interests, were we actually just advancing our interests? Were we truly serving her as her dutiful agents, or were we making her into an agent of our own agenda to improve our own lives? At the same time, it was unclear whether she was even being a good agent for her own interests, since her resistance may have just reflected the costs of change rather than the benefits of the new arrangement in the future. Finally, above it all, it was unclear what my father would have wanted us to do for her. In many ways, he was a hidden principal that I was trying to please. Without us realizing it, the situation had become a muddle—with principals pretending to be agents and
They’re much more likely to follow our professions and enjoy the things that we like, relative to some random draw from the general population. In fact, for many of us, the chief responsibility of parenting is the act of imprinting a set of values on our children—if that’s the case, who’s the agent and who’s the principal in parenting?
“My dear, I am worried about you. It seems to me that you are in a muddle . . . Take an old man’s word; there’s nothing worse than a muddle in all the world. It is easy to face Death and Fate, and the things that sound so dreadful. It is on my muddles that I look back with horror—on the things
In this final version of the principal-agent problem, our childhood experiences end up serving as the hidden principals whom we end up serving whether we know it or not.
read Freud in college and found his ideas incredibly alluring. But then I read the ultimate takedown of Freud by the literary critic Frederick Crews, who demonstrated how nonscientific the whole endeavor is. Still, I come across these ideas and they sound right.
These children grow up to be exemplary agents, engines of achievement as they seek to be admired. But they can’t figure out how to be principals when they are adults. Never having had to formulate their own agenda, they find themselves deeply unsatisfied and frustrated as they only know how to fulfill the needs and dreams of others. They are trapped in the role of agents who don’t know how to become principals. And then they repeat that cycle with their children.
Without diminishing the art of acting too much, this vignette seems to hit on an essential truth. Yes, it is hard to play a role authored by someone else and be the agent of a screenwriter. But it is harder still to be a principal, where you are called upon to author and produce that story from whole cloth. Sidney Sheldon, the seventh best-selling fiction author ever (he knew how to confront a blank piece of paper!), may have been channeling Mel Brooks (or Freud) when he said, “A blank piece of paper is God’s way of telling us how hard it is to be God.” The act of creating ourselves is a miracle—and, fortunately, we have more than seven days to become principals rather than agents.
Mike Nichols’s 1988 film Working Girl vividly captures most of the best and worst of Wall Street—the sexism, the snobbery, the self-indulgence are all there, but so is the emphasis on talent, the competition, and the joy of solving problems. Besides, you get younger versions of Melanie Griffith, Harrison Ford, Sigourney Weaver, and Alec Baldwin—all with clothes and hairstyles that only made sense in the 1980s.
The importance of marriages and dowries gave rise, along with other circumstances, to the Dowry Fund. The Dowry Fund—an early feat of financial engineering—solved three seemingly unrelated problems. First, parents of daughters were faced with a marriage market where young women significantly outnumbered eligible older men, in part due to the plague. As one reflection of this, dowries were escalating in price rapidly, creating more risk for fathers and their daughters. Without a sufficient dowry, either the nunnery or a life of prostitution awaited a daughter. As one example, Francesca shows me dowry records featuring the payment of 833 florins to one Paolo upon marriage to Magdalena, and the payment of 50 florins to a nunnery upon the entry of Margherita to that nunnery. Failure to match in the marriage market was costly in many ways.
The confluence of uncertain dowry prices, groom anxiety over dowry transfers upon consummation of marriages, and unstable government finance gave rise to the Dowry Fund.
state for fixed interest rates at the time of their daughter’s fifth birthday, and these accounts would mature ten years later, along with their daughters (giving new meaning to the idea of “yield to maturity”).
Talk about financial innovation. As Francesca shows me yet more letters concerned with marriages and dowries, I am comforted by the fact that we only have to think about 529 plans for our daughters instead of dowry funds.
The Dowry Fund then exploded in popularity and became a dominant form of the financing of Florence in the fifteenth century. In a city with a population of fifty thousand, nearly twenty thousand accounts were established over one hundred years. Art historians have speculated that The Arnolfini Portrait by Jan van Eyck that opens this chapter, one of the most famous paintings of a wedding, actually reflects the payment of a Monte-linked dowry.
The dowry fund encouraged what is known as “assortative mating,” where individuals mate with people like themselves rather than at random. As a result, elites could stay in power by creating strategic alliances between elite families. Marriages were, in effect, mergers between powerful families, and the Monte was the financing mechanism that allowed them to keep pursuing those mergers.
When Hannah Mayer chose to marry outside of the family in 1839 (almost straight out of the plotline of a nineteenth-century romantic novel), the family reacted violently, to ensure that the message was clear. James, one of the Rothschild leaders at the time, wrote to his brother: “I and the rest of the family have . . . always brought our offspring up from their early childhood with the sense that their love is to be confined to members of the family, that their attachment for one another would prevent them from getting any ideas of marrying anyone other than one of the family so that the fortune would stay inside the family. Who will give me any assurance that my own children will do what I tell them if they see that there is no punishment forthcoming?” Indeed, inmarriage did stave off the Buddenbrooks-like decline that most family firms experience, as the Rothschilds ended up flourishing for several generations to come. If you think marriages as mergers of
1. Due diligence is critical: Time Warner never did appropriate due diligence—the thorough investigation and vetting of a target company’s financials and operations—and subsequently found fairly significant accounting fraud.
2. Filling a hole in your organization is not a merger strategy: Levin had struggled with adapting to a digital media
another—also known affectionately as “bolt-on acquisitions”—are easy because the dominant organization can simply force changes and savings. But they also don’t occasion that much value creation. Mergers of equals are incredibly hard, given the joint decision making they imply—but they are the only occasions when the logic of 1 + 1 = 3 is even feasible. AOL and Time Warner had the worst of all worlds—AOL went in thinking that they were dominant, and Time Warner became dominant as soon as the deal was consummated and the tech bubble burst.
So when should you do which and why? The story of General Motors and Fisher Body in the 1910s and 1920s is, for economists, Anna Karenina, Middlemarch, and Jane Eyre all rolled in one—the classic story that explains the nature of flirtation, commitment, marriage, and love.
This merger happened when their dependence on each other grew so much that it was important to curtail distinct one-sided incentives and to create one entity. For Fisher to take the next leap to a completely relationship-specific investment (a new, dedicated factory for auto bodies right next to GM’s Flint operation) required a level of certainty and commitment that was beyond the scope of a necessarily incomplete contract between two separate parties. That leap, and all the attendant investments it would generate, would create a much larger joint surplus for both parties. But that leap of faith required
merger. The merger was highly successful, with the Fisher brothers continuing to work with GM for two decades. GM CEO Alfred P. Sloan considered the merger “decisive” in their ongoing competition with Ford. GM flourished for the next several decades, becoming the largest automobile company in the world. Indeed, until the early 1980s, GM cars continued to feature a stamp of “Body by Fisher.” This version of the merger, and the one I prefer, is not a marriage of convenience but a marriage of love. AND THEY LIVED HAPPILY EVER AFTER.
This unusual gentleman was Jeremy Bentham, an Enlightenment philosopher who had the foresight to advocate for universal suffrage and the decriminalization of homosexuality in the early nineteenth century.
founder of utilitarianism, he established the idea that social policy should be evaluated by the improvement in human welfare aggregated across all individuals. The simple maxim that “the greatest happiness of the greatest number is the foundation of morals and legislation,” a phrase Bentham attributed to Joseph Priestley, was remarkably radical for its time and still serves as the foundation of much economic and philosophical analysis.
The Wealth of Nations, Smith had argued that interest rates on loans should be capped at 5 percent. His logic manifested the deep historical bias against borrowers.
In a series of letters to Smith that were published, provocatively, as a “Defence of Usury,” Bentham decimated Smith’s arguments for limits on interest rates. Bentham pointed out that Smith had overlooked how lenders would have an incentive to select and monitor borrowers to protect their capital. Bentham noted that “there are, in this case, two wits set to sift the merits of the project . . . and of these two there is one, whose prejudices are certainly not most likely to be on the favourable side” of wasteful projects. More broadly, Smith’s arguments were inconsistent with the liberty that Smith himself had championed. Bentham reminded Smith, using Smith’s own words, that “it is the highest impertinence and presumption . . . in kings and ministers, to pretend to watch over the economy of private people [Bentham’s emphasis].”
By limiting access to only the best credits, Smith was privileging the position of “old-fashioned” borrowers with traditional needs and impeding the innovators and upstarts with well-grounded but risky projects. Smith had applied a “stamp of indiscriminate reprobation” upon “all such persons as, in the pursuit of wealth, strike out into any new channel, and particularly, into any new channel of invention” in favor of those “whose trade runs in the old channels, and to the best security which such channels can afford.” Outlawing high interest rates and demeaning borrowing prevented innovation and growth, was inconsistent with liberty, and was unnecessary since lenders could take care of themselves.
Auden saw a play superficially about debt but more deeply about bonds between people. He notes that “there are few plays in which the word love is used more frequently.” Contrasting it with a feudal order, Auden concludes that “in The Merchant of Venice, you are free to form the relationships you choose, but your obligations are then enormous.” Debt, it turns out, is about much more than money—it is about the ties that bind.
And of course, there’s that other thing about borrowing—it’s a very meaningful commitment. To protect themselves, lenders have rights that allow them to limit what you do with their money—so-called covenants—and if you violate them, they can extract a penalty or even seize your assets. For example, you usually can’t take on additional indebtedness without getting their approval. These mechanisms allow lenders to make sure you don’t do something crazy with their money. Most seriously, lenders have rights and claims on you and your assets if you fail to make ongoing payments. For homeowners, this can mean losing your home. For companies, this can mean declaring bankruptcy if they don’t provide periodic interest payments.
The simplest finance answer for firms is that they trade off two contrary impulses—the tax advantages of using debt versus the risk that debt imposes on organizations. Because interest payments are tax deductible for firms and individuals, it can be advantageous to use debt. In short, by taking on debt to finance equipment purchases or a home for an individual, you are allowed by the government to pay less in taxes and to shift value from the government to yourself.
kinds of firms are candidates for such transactions? The best candidates are firms that have lots of profits, so that the tax motivations are operative, and have very stable business models, so that the likelihood of financial distress is mitigated. Think tobacco or, better yet, casinos—lots of profits, little technological innovation (so disruption risks are low), and addicted customers. Casinos are promising candidates for leverage—as long as you don’t get greedy with too much debt and you know how to run those businesses. Otherwise, you might go bankrupt—several times over.
The central question facing borrowers—how do I access opportunities beyond my current resources?—is analogous to a question that inspires many of us: How do I live the fullest life? Much of what life has to offer requires the help of others. Being married, starting a family, engaging in meaningful friendships, working in organizations, starting a business are all value-generating activities that one simply can’t do alone. Getting that help creates a set of commitments—and those commitments come with constraints. In short, how you are able to embed yourself in broader networks and relationships through commitments will determine your ultimate trajectory—much as debt shapes the trajectories of firms by providing resources in return for commitments.
artists—George Orwell and Jeff Koons. Orwell’s journey to completing 1984 demonstrates the costs of interdependency and the virtue of a low-leverage life. It’s the story of just how important solitude and independence are to achieving great things—and how important it can be to insulate yourself from the world. As World War II ended, Orwell was struggling
In the early 1980s, Koons was facing escalating costs for the Hoover vacuum cleaners and other found objects that he was transforming into art. To finance the art he was working on at night, he began working as a cotton futures trader in the day. Unsurprisingly, the lessons of leverage from Wall Street were not lost on Koons. Building on a sales experience that began as a nine-year-old when he sold wrapping paper and chocolates door to door, Koons became an expert salesman. In this case, he was selling futures contracts. Futures contracts commit you to selling goods in the future at a set price, regardless of whether you own those goods now. With the exception of the set price, this is what Koons went on to do with his art. Koons describes himself as “the idea person. I’m not physically involved in the production. I don’t have the necessary abilities, so I go to the top people, whether I’m working with my foundry—Tallix—or in physics.” His large installations require him, as Schjeldahl describes, “to constantly escalate deluxe materials and expert fabrication in his work, with a pattern of selling works in advance in order to secure the cash to execute them, usually in small editions. (Collectors have waited years for their purchases.) The more money he makes, the more he spends, maintaining a Chelsea workshop that employs a staff of a hundred and twenty-five.” Koons characterized the leverage of his production process as “a system to control every gesture as if I did
Salmon notes that “the Koons model is a little bit like the patronage model, where a wealthy patron will pay an artist’s expenses in return for his artistic output. But Koons flipped that model: he had the collectors working for him, more than the other way around. They weren’t calling the shots: he was.” While some ridicule Koons, I think Salmon gets it right: “Koons does something very interesting, which very few other artists do. He turns money into art, rather than just turning art into money.” Koons’s factory and
And their distinct choices represent the kinds of choices we face in creating our lives. Orwell’s path of solitude can be deeply enriching—one has complete autonomy and the pleasure of knowing that the resulting efforts are singularly one’s own. Koons, in contrast, operates on a completely different scale by embedding himself in rich networks, accepting the tradeoffs that this implies, and operating an organization in the service of his art. Seen in financial terms, Orwell is the all-equity financed firm exempting himself from any constraints and commitments in order to flourish, whereas Koons is the leveraged buyout, piling up commitments and constraints in order to attempt larger and larger things, with associated risks and rewards.
Choosing to have children is the most obvious example of levering up your life. You make an unimaginable set of emotional and financial commitments to them, and they open up a world that is beyond imagination.
great places, but embedding yourself in an organization can amplify your potential impact on the world. At the same time, these organizations will require you to surrender autonomy and accept compromises. Successful entrepreneurs are Orwells who must become more like a Koons. Ideas may germinate in your head, but creating a business out of them will certainly require innumerable interdependencies with other people.
bankruptcy. But what mistake do people make on average? One of the central facts about corporations and their financing decisions maps particularly well to our lives. By most measures, firms are dramatically underlevered. They don’t appear to take the full advantages that the tradeoff theory implies and, as a result, remain underlevered. Many individuals may well do the same thing—they retreat from commitments and obligations, and in the process, they limit what they can do. Studies of regret show that regret mostly arises from commitments avoided—untaken educational opportunities, missed love connections, and inattention to children.
So, it turns into a bad investment for the homeowner. The real curiosity is that the lender would be better off if the owner did the extension, but lenders often hesitate to make the compromises required to make the owner have the right incentives. The shadow of that preexisting commitment prevents the owner from doing the things he needs to do. This idea of debt overhang, in part, is why the housing crisis was so scary—with nearly one in five owners underwater in 2009, we might have seen many more neighborhoods with highly levered homes just continue to deteriorate because of these crazy incentives. What’s the answer? Well, the
Finally, Miss Kenton begins seeing someone else but wants to provide one last chance to Mr. Stevens. She tells him of this budding romance and baits him with this: “It occurs to me you must be a well-contented man, Mr. Stevens. Here you are, after all, at the top of your profession, every aspect of your domain well under control. I really cannot imagine what more you might wish for in life.” Having been served up this easy pitch, Mr. Stevens whiffs. His commitment to Darlington and his profession prevents him from pursuing the opportunity in front of him. “As far as I’m concerned, Miss Kenton, my vocation will not be fulfilled until I have done all I can to see his lordship through the great tasks he has set himself. The day his lordship’s work is complete, the day he is able to rest on his laurels, content in the knowledge that he has done all anyone could ever reasonably ask of him, only on that day, Miss Kenton, will I be able to call myself, as you put it, a well-contented man.” The commitment to professionalism and Darlington were paramount.
On two of the most important nights of his life, Mr. Stevens’s professional obligations crowd out his personal needs as he fails to attend to his father on his deathbed and fails to follow through on the final opportunity presented by Miss Kenton. Curiously, those two nights end up filling him with a “sense of triumph” for the professionalism he is exhibiting. This absolute dedication borders on martyrdom—or maybe masochism.
we see that Miss Kenton left Darlington Hall for a marriage that turned out to be an unhappy one. Darlington turns out to be a misguided amateur diplomat who dies mired in shame because he is known as the architect of Neville Chamberlain’s appeasement policy toward Adolf Hitler. And what of Mr. Stevens?
After seeing Miss Kenton again and realizing what he did not pursue, Mr. Stevens concludes: “I gave [Darlington] the very best I had to give, and now—well—I find I do not have a great deal more left to give . . . I’ve given what I had to give. I gave it all to Lord Darlington . . . I trusted in his lordship’s wisdom. All those years I served him, I trusted I was doing something worthwhile . . . Really—one has to ask oneself—what dignity is there in that?”
Negotiating our existing commitments to allow us to take on new ones is the critical life skill that finance highlights. Debt overhang is the manifestation of not being able to renegotiate those commitments to take on new opportunities—and the resulting loss for everyone involved. And Mr. Stevens is the manifestation of the fear that taking on new commitments is inconsistent with preexisting commitments—a belief that leads him to a life of emotional poverty. Fortunately, even if lenders are sometimes too silly to change their expectations, we can renegotiate our commitments—to loved ones, to jobs, to society—when we need to so that we can invest anew. Sometimes, as with Mr. Stevens, fear is the only thing that is stopping us from trying to do so.
And I see this with our girls. When and how should we introduce the idea of commitments and obligations to them? How do you structure chores and responsibilities so that they become accustomed to them but they don’t crowd out the joy of childhood? We constantly walk the line between introducing them to leverage and shielding them from
late. As a consequence, we were free of commitments through our twenties and were both able to invest heavily in our human capital and our careers, the benefits of which we now are reaping. The tradeoff seems clear, at least in retrospect—we now have young children at an age that may not be optimal for bringing up children and we will have them at home until I’m close to retirement. But we were able to invest in ourselves and careers in very advantageous ways. Had we levered up earlier with family commitments, I don’t think either one of us would be where we are professionally.
The reluctance of managers to use leverage reflected their desire to be free of obligations in order to pursue other activities that might not serve their shareholders. A natural corollary to that was that leverage could be used to limit managers’ ability to do things that served themselves and not shareholders. In effect, leverage ties the hands of managers and enforces a discipline on them to serve their masters best. In Jensen’s words, “the threat caused by failure to make debt service payments serves as an effective motivating force to make such organizations more efficient.”
Companies continued to invest in exploration, and in unrelated companies, well beyond the point they should have instead of returning cash to shareholders—in part, because there were so many profits sloshing around and no commitments to anyone. Tying their hands with mandatory debt payments would have prevented them from destroying lots of value. That’s the leverage bonus.
Indeed, the problem of self-control is fundamental for many of us, and the best solution to it, as much research has documented, is to make meaningful commitments to others to ensure that we do the right thing. These commitments might be expensive bets with friends, costly memberships in health clubs, or forced savings plans. Such commitments effectively do the same thing that debt does in the modern corporation—they restrict choice to increase the odds that you’ll do the right thing.
In offering advice to young people, Thomas Watson, the founder of IBM, said, “Don’t make friends who are comfortable to be with. Make friends who will force you to lever yourself up.” Commitments to smart and demanding people keep us from doing stupid things—we gain from those commitments. Leverage is not a zero-sum game.
relationships. “It is social aptitude,” he writes, “not intellectual brilliance or parental social class, that leads to successful aging.” Warm connections are necessary—and if not found in a mother or father, they can come from siblings, uncles, friends, mentors. The men’s relationships at age 47, he found, predicted late-life adjustment better than any other variable, except defenses [mechanisms for reacting to adversity]. Good sibling relationships seem especially
Vaillant’s response: “That the only thing that really matters in life are your relationships to other people.”
Perhaps the most valuable lever imaginable is the esteem your colleagues, friends, and community regard you with. It enables you to mobilize resources, and you are provided remarkable latitude because of how individuals understand you and regard you. Indeed, Thomas Jefferson’s observations on the value of reputation bring us back to Archimedes and the power of leverage. In a letter to José Corrêa da Serra in December 1814, Jefferson wrote: “I have ever deemed it more honorable, & more profitable too, to set a good example than to follow a bad one. The good opinion of mankind, like the lever of Archimedes, with the given fulcrum, moves the world.”
But don’t be afraid to use leverage—it’s a powerful force to accomplish much more that you’re otherwise able to. Most of all, leverage may actually make us better people by holding us accountable as we commit ourselves to others with high standards. It also just might enable us to live longer and richer lives than we can imagine—and to move the world in the process.
art. The spinach is the art. Art can change your life. It can expand your parameters. It can give this vastness to life.” A better description of leverage is hard to find. Who knew spinach, art, and leverage were all connected?
But those roles were not the roles that led Washington to call him the “financier of the revolution.” Morris literally underwrote the Revolutionary War by using his own credit to secure munitions at crucial moments, including using personal IOUs to enable Washington to turn the tide at the critical Battle of Yorktown in 1781. Why were his IOUs as powerful as other currencies? At the time, Morris’s commercial success was such that, according to legal scholar Bruce Mann, “the American economy did not see his likes again until J. P. Morgan and John D. Rockefeller, Sr., a century later . . . he was the most modern economic figure of the early republic.”
Anxious to focus his attention on rebuilding the fortune that had been depleted during the Revolutionary War, Morris recommended Hamilton in his stead. Already you might be slapping your forehead and asking yourself, “What was he thinking?” But this dramatic tale of choosing money over service gets even better.
His North America Land Company was the largest land trust ever in American history (and arguably the first Real Estate Investment Trust) with more than six million acres of land (as a point of comparison,
Morris’s main legacy is that he triggered, because of the height from which he fell, a thorough reexamination of how the young country should think about failure and financial distress. That reexamination resulted in the modern notion of bankruptcy, which proves to be a remarkably good guide to understanding failure generally. And the complexities of bankruptcies, as manifest in a case study of American Airlines, illuminate the conflicting commitments that are essential to our lives.
As a consequence, imprisonment was common for debtors. In fact, punishments through history have ranged from forfeiture of property to being pilloried to imprisonment to dismemberment, and even to death. Puritan sermons were filled with the logic that no fate could be worse than debt, and that debts must be fulfilled no matter the circumstance. That Morris could fall to such depths led to a change in the way bankruptcies were treated, and it created, Mann indicates, “a milestone in the law of failure.”
Failure would be redefined away from a moral failing or a sin and toward a more natural consequence of risk-taking with the 1800 act. If failure was a consequence of risk-taking, then the law needed to be reformed to not be so creditor-centric. Punishing debtors for their sins was neither constructive nor terribly humane. Indeed, the new republic desperately needed risk takers, and punishing them so severely froze commerce in the late 1790s. If the young country was to flourish, failure had to be redefined, and the moral stigma associated with it had to be lessened.
colleague Amy Edmondson has studied attitudes toward failure in settings ranging from the Challenger shuttle disaster at NASA to medical errors in hospitals. Her conclusion is that one has to acknowledge “the inevitability of failure in today’s complex work organizations. Those that catch, correct, and learn from failure before others do will succeed. Those that wallow in the blame game will not.”
The natural corollary of defining failure away from morality is to understand that bankruptcy should provide for an opportunity for rebirth rather than signaling a death. Allowing for the discharge of debts is just one example of how bankruptcy law became centered on allowing for rebirth and away from declaring death. For bankruptcy to be oriented toward rebirth, the most important change had to be around the process immediately following the declaration of failure. Insolvencies
problem in bankruptcy proceedings is often not about protecting the creditors from those unscrupulous, immoral debtors—but more about protecting debtors from unreasonable creditors whose impatience lessens the value of the overall assets.
Coming in the aftermath of government-assisted sales and bailouts through 2008, the Lehman Brothers bankruptcy was unprecedented in scale and extremely disorganized because everyone was surprised by the sudden failure. The papers for the bankruptcy that governed $600 billion in assets were drafted and filed in one day without any advance preparation. Unsurprisingly, an estimated $75 billion of value was lost to the claimants because of the chaotic weeks that followed the unplanned bankruptcy. So, what
First, the declaration of a bankruptcy is accompanied by an “automatic stay”—a period during which creditors are prevented from filing claims against debtors, to ensure that chaos doesn’t ensue and that the debtor can outline an orderly process. Second, the process of bankruptcy is overseen by impartial observers who serve as referees—indeed, the judges and trustees who oversaw bankruptcies were called referees until the twentieth century. These referees are meant to ensure that competing concerns are all balanced.
That external help and advice are viewed as so important that advisors’ fees become the senior-most claim on the company’s assets. Finally, debtors are provided with a stay so that they can put forward a plan—and this plan is the lynchpin for any company seeking to emerge from a bankruptcy. The plan should address how, in a forward-looking manner, the company can generate the greatest overall value, rather than concentrating on how to carve up the carcass amongst claimants.
Rather than taking failures as occasions for self-flagellation, see them as opportunities for rebirth. Create some breathing room (an automatic stay), get help (from family, friends, and professionals), and start looking toward the future instead of backward (author a plan for your recovery).
That conversation has always stayed with me. He didn’t question me about my background; he didn’t try to assess my suitability for the program; he wasn’t impatient with me. He simply shrugged and said, “These things happen.” He didn’t try to induce guilt or breed doubt—nor did he reassure me. His great kindness was in implicitly telling me to put it behind me. Because of his kindness and wisdom, that exam debacle marked a fresh start for me and not a lasting disappointment.
As CEO during the 2000s he was tested again. All his major competitors had declared bankruptcy so that they could renegotiate (some would say renege on) expensive pensions and labor contracts with unionized labor. American was alone in not using bankruptcy to gain bargaining power with the unions. For Arpey, it was a moral question: “Call me old-fashioned. But I think companies ought to pay people back. And I think companies ought to make good on commitments to employees and communities.”
those who fail and to prioritize a fresh start for them. But isn’t it wrong to just give up on your commitments? Shouldn’t people be held responsible for those commitments? If we allow people to go bankrupt or fail in other ways without any stigma or punishment, won’t they take advantage of that option even when they shouldn’t? Then bankruptcy isn’t about failure anymore—it becomes a strategic renegotiation tool. In fact, bankruptcies like American’s are called strategic bankruptcies. It all sounds positively Trumpian.
Harvard Business School has a very strict attendance policy, so signing up for a class entails a considerable commitment to attend it. That commitment is amplified because productive discussion of a case study requires effort and participation from everyone. HBS also has a forced grading curve, where the bottom 10 percent must receive a failing grade, and missing class can be a critical factor in moving you into that bottom 10 percent. As a consequence, I am inevitably in the position of administering academic justice at the micro level. Sometimes, it’s simple: Should a student be excused for an absence because of a death in the family?
extra time to finish it—can I have an excused absence?” These are minor examples of what we all face in our professional lives—people who ask for forgiveness when they renege on a commitment they’ve already made to a joint endeavor.
Ultimately, that’s why bankruptcy decisions are so fraught—and so interesting. Bankruptcies are evocative because they are about our attitudes toward our commitments and how conflicting obligations should be navigated. Categorical moral codes like “you should always stand by your commitments” or facile answers like “go ahead, don’t worry about those commitments—do what’s right for you” are insufficient. The hardest moments in life are about competing duties and obligations and how to navigate them—just as the essence of the bankruptcy decision is how to navigate the competing, and seemingly unsustainable, set of commitments that a company or an individual has made.
In her book The Fragility of Goodness, philosopher Martha Nussbaum considers precisely this difficulty of conflicting duties, taking to task Immanuel Kant, among others, for his absolutist ideas on duty. Nussbaum is very tough on Kant, but her basic point is right: a literal reading of Kant suggests that there are no such things as conflicts of duty. If you’re experiencing a conflict, it’s just because you haven’t thought through the correct prioritization of your duties—think it through, and there will be no conflict. For Kant, being moral is about fulfilling your duty, and those imperatives are clear and categorical. Kant would have liked Arpey.
struggles as a working mother. Rather than fall back on facile recipes of “leaning in” or “trying to have it all,”
struggles as a working mother. Rather than fall back on facile
She views that struggle as a reflection of how full and rich a life she is leading. To feel the confusion of competing obligations deeply is, to Nussbaum, the essence of the good life. In Fragility, she writes, “the richer my scheme of value, the more I open myself to such a possibility [of conflicting obligations]; and yet a life designed to
which she staked her moral life. And so what this play says that is so disturbing, is that the condition of being good is such that it should always be possible for you to be morally destroyed by something that you couldn’t prevent. To be a good human being is to have a kind of openness to the world, an ability to trust uncertain things beyond your own control that can lead you to be shattered in very extreme circumstances, in circumstances for which you are not yourself to blame. And I think that says something very important about the condition of the ethical life. That it is based on a trust in the uncertain, a willingness to be exposed. It’s based on being more like a plant than like a jewel, something rather fragile, but whose very particular beauty is inseparable from that fragility.
be a manifestation of having tried to live the good life: “I must constantly choose among competing and apparently incommensurable goods and those circumstances may force me into a position in which I cannot help being false to something or doing something wrong . . . all these I take to be not just the material of tragedy but everyday facts of lived practical reason.” In that same way, bankruptcy is a process that can’t be approached with a simple moral frame or set of decision rules. Instead, it is a process of navigating deeply felt competing obligations—much as a good life
In a letter to his daughter in 1935, the Irish author James Joyce recommended a particular story as “the greatest story that the literature of the world knows.” Joyce, no literary slouch himself, was recommending a story that is steeped in finance and many of the ideas that we’ve been discussing. And it’s a story that illustrates why everyone hates finance. The tale begins with a peasant, Pakhom,
While all begins well, he quickly becomes enamored of all the fertile land he sees. He exhausts himself under the hot sun and, as the sunlight fades, runs back to the starting point. Dehydrated, breathless, and frightened, he pushes himself past his limit, reaching the starting point just as the sun is setting. And then, he drops dead. The last line of the tale, written by Leo Tolstoy, answers the question that is posed by its title, “How Much Land Does a Man Need?”
Tolstoy reveals more detail earlier in the story than I did. The Devil, who visited Pakhom in his dreams, was behind it all. Early in the story, Pakhom had told his wife, “If I had plenty of land, I shouldn’t fear the Devil himself!” Hearing this, the Devil responds, “I’ll give you land enough; and by means of that land, I will get you into my power.” The Devil plants the seeds of envy and greed in Pakhom during these early successful transactions and watches them bring Pakhom under his sway.
takes some form of “if only we had $X more, we could do Y.” It also comes in the form of discussions of “the number”—a common discussion amongst people in finance about how much they need to accumulate so that they can pursue their true dreams.
My favorite novel centered on finance is Theodore Dreiser’s The Financier, published in 1912. A former journalist, Dreiser modeled his main character, Frank Algernon Cowperwood (Cowperwood’s middle name is a reference to sunny, naïve Horatio Alger stories), on robber barons and got all the finance details right.
A lobster is slowly eating a squid as the squid struggles to live. The squid finally dies, and, to Cowperwood, this scene captures everything—“The incident made a great impression on him. It answered in a rough way that riddle which had been annoying him so much in the past: ‘How is life organized?’ Things lived on each other—that was
and made $30 in one day with leverage, he’s hooked. Cowperwood’s bets become larger and larger, and he wins and loses fortunes several times over, some of them illegally. He gets caught in a “short squeeze,” misuses public funds, goes to jail, and then makes it all back again. Stories of his insatiable appetite for money are interwoven with stories of his sexual appetites, tales of adultery, and his acquisitiveness for art. Dreiser completed the Cowperwood story in three novels, christened, in case there was any confusion, as The Trilogy of Desire.
For Dreiser, post–Civil War finance reminded him of the fall of Rome. Dreiser considered Cowperwood’s story, and finance more broadly, as evocative of “the strange, forceful ruthlessness of the human mind when it has freed itself from old faiths and illusions, and has not accepted any new ones. There you get mental action spurred by desire, ambition, vanity, without any of the moderating influences which we are prone to admire—sympathy, tenderness and fair play.” This characterization sounds very much like the way many view finance today.
Given how pervasive the theme of insatiable desire is in modern-day depictions of finance, it begs the question: Does this theme of insatiable desire reflect an idea grounded in finance? It is tempting to conclude that in fact finance is all about the individual pursuit of more. After all, when Gordon Gekko of Wall Street says “greed is good,” isn’t he actually framing a key insight of economics—that the pursuit of self-interest in some settings can lead to good outcomes?
As we’ve seen, finance is primarily the story of risk and its omnipresence. Insurance and risk management (options and diversification) are activities we undertake to deal with risk. Costs of capital and expected returns reflect how we charge for the risks we are asked to bear. Underneath it all, however, is the notion that risk is not something that we like to bear. That’s why we undertake risk management and charge people when we bear risk. If we were indifferent to risk, much of finance would collapse. Insurance and risk management would be unnecessary and we would not charge for risk at
But what does that risk aversion suggest about our underlying preferences? What does it say about us that it is more costly to lose $1,000 than it is valuable to gain $1,000? We are trading off losing dollars when we’re poorer against winning dollars when we’re richer—and risk aversion reflects the fact that those dollars are not worth the same amount to us. Losing a dollar when we’re poorer is more painful than gaining a dollar when we’re richer. Said another way, every incremental dollar of wealth we get is worth less and less to us. More formally, that’s called the “diminishing marginal utility of wealth.”
example, distinctive responses to losses. But underneath all of finance is this underlying idea: the pursuit of more will yield less and less. And any expectation other than that is not consistent with the ideas of finance.
But underneath all of finance is this underlying idea: the pursuit of more will yield less and less. And any expectation other than that is not consistent with the ideas of finance. The game of accumulation is one that will leave one less and less satisfied as one gains more and more. To search for ever-greater satisfaction through accumulation is folly. That is the bedrock idea in finance. And it runs completely counter to how individuals in finance often act and how they are perceived.
One overly simple answer is that everyone gets finance wrong. It is actually a noble profession where people are behaving by worthy ideals but being slandered nonetheless. The slander reflects an age-old bias—dating back to Socrates’s characterization of money as barren—against activities that don’t produce tangible goods. The demonization of finance has been with us forever and reflects this ignorant bias. Another overly simple answer is that finance
One overly simple answer is that everyone gets finance wrong. It is actually a noble profession where people are behaving by worthy ideals but being slandered nonetheless. The slander reflects an age-old bias—dating back to Socrates’s characterization of money as barren—against activities that don’t produce tangible goods. The demonization of finance has been with us forever and reflects this ignorant bias. Another overly simple answer is that finance
One overly simple answer is that everyone gets finance wrong. It is actually a noble profession where people are behaving by worthy ideals but being slandered nonetheless. The slander reflects an age-old bias—dating back to Socrates’s characterization of money as barren—against activities that don’t produce tangible goods. The demonization of finance has been with us forever and reflects this ignorant bias.
simple answer is that finance attracts people who are one-dimensional and who have deep, insatiable desires. The practice of finance is not bad. It just attracts a disproportionate share of bad eggs.
breed insatiable desire in people who venture into it. I think the experiences of Pakhom and Cowperwood are ones that we are all susceptible to. Outsized successes fueled by leverage create enormous wealth at all-too-early ages—just as with Pakhom and Cowperwood. The problem then becomes how to make sense of that success. The human tendency, as well documented by psychologists, is to attribute it to oneself as opposed to the situation. People will most naturally view their successes as related to their abilities as opposed to luck. So-called attribution errors occur everywhere in
is nowhere greater than in the world of finance. People in finance are continuously fed feedback by the markets on their decisions. And those decisions result in both significantly good and significantly bad outcomes. Bad outcomes are rationalized quickly as being the result of situational factors, while good outcomes are understood to be the result of one’s own actions. And it’s entirely feasible to continue in this pattern of self-deception for years. Indeed, one needs to continue in this mode to stay confident and succeed in finance. Otherwise, it is simply too humbling. My most successful friends in finance never seem to talk much about their losing investments.
People in finance are continuously fed feedback by the markets on their decisions. And those decisions result in both significantly good and significantly bad outcomes. Bad outcomes are rationalized quickly as being the result of situational factors, while good outcomes are understood to be the result of one’s own actions. And it’s entirely feasible to continue in this pattern of self-deception for years. Indeed, one needs to continue in this mode to stay confident and succeed in finance. Otherwise, it is simply too humbling. My most successful friends in finance never seem to talk much about their losing investments. The frequency and magnitude of attribution errors differentiate finance from virtually all other endeavors.
The frequency and magnitude of attribution errors differentiate finance from virtually all other endeavors. In business, law, teaching, and medicine (with the exception of surgery), we are confronted only after months and years with measures of our success or failure. In finance, particularly for investors, these attributions can happen every day, in perfectly quantifiable ways, and with amounts that are far larger than any individual would usually command. Moreover, the “discipline of the market” shrouds all of finance in a meritocratic haze. Investors come to see their outcomes as reflecting their ability, given the chaotic, competitive market they work in, rather than acknowledging the dominant role of chance. Ultimately, all those attribution errors result in successful people who are susceptible to developing massively outsized egos and appetites.
Consider the Silicon Valley entrepreneur who comes to believe the hype of ever-escalating valuations. Financial markets, with their patina of quantitative accuracy, let loose our desire to link our outcomes with our character.
the asshole theory of finance. 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.
resources. Alexandra Bergson is our ultimate finance hero. She is a master risk taker who knows how to assess risks through experience and imagination and how to use leverage to change the lives of the people she loves. She values diversification and sees option value, but doesn’t hesitate to make the big decision. She knows how value is created and she knows that she is ultimately only a steward for the capital she is entrusted with. She is filled with forgiveness for those around her who fail, and she knows her success is difficult to attribute to her skill. She is not addicted to risk-taking and does not develop insatiable desires. She remains invested in her deepest relationships with close friends and family. She is everything that Cowperwood, Bateman, Packer, and Shkreli are not.
But Snow is best remembered for a short essay that came out of a lecture he delivered in 1959. In “Two Cultures,” Snow railed against the division of intellectuals into two warring camps—literary intellectuals and scientists, a division that his own life disavowed. Scientists had come to feel that “the whole literature of the traditional culture doesn’t seem relevant to their interests. They are, of course, dead wrong. As a result, their imaginative understanding is less than it could be. They are self-impoverished.” And literary intellectuals were willfully ignorant of the natural sciences, viewing them as pedestrian disciplines lacking any real unifying vision. For Snow, a scientist’s ignorance of Shakespeare was no less a crime than a literary intellectual’s ignorance of the second law of thermodynamics.