Too often has finance been portrayed as the villain, often enough the lead, but seldom in the supporting role it plays best. This, if I have understood him correctly, is the germ of Mihir Desai’s message in The Wisdom of Finance. Activities in this sector of business and the economy are absolutely necessary for flourishing in society, although only as a lesser, not the supreme, unqualified good many take them to be. Finance is at its finest in support of other activities choiceworthy in themselves.
How can wisdom in finance be brought to light? Desai seems to propose a two-step process. First, we’ll have to bridge the gap between finance and the humanistic disciplines, such as literature, history, philosophy, music, religion, art, and so forth. This division of knowledge into airtight compartments has contributed to the separation of work in general, and finance in particular, from our personal and moral lives, making them lose meaning. Finance and the economy have followed the scientific model of physics too slavishly, forgetting that they are, at the core, social, and therefore, humane sciences. Rigor and precision are fine, but not at the cost of losing relevance to people’s lives. Mathematical equations describing physical forces cannot capture what is important in human interactions. They cannot explain the things individuals, families, and firms do and why. We need stories for that. So if finance is to become a valuable practice, and a work life dedicated to finance a worthy profession, we may have to look beyond the maths and physics to other sources of meaning. It may not be “God’s work,” but neither should it be something to be ashamed of. For this purpose Desai turns his attention to biology, specifically molecular biology, an extended metaphor for asset pricing, the building block of finance, and sociobiology, for him analogous to corporate finance, the web of relationships between investors, managers, and assets. Instead of a turf war between the hard and the soft sciences, Desai propounds that both consider overlapping boundaries as virgin territory to be jointly reconnoitered and exploited for shared benefit.
The second step in reconciling finance with the humanities consists of framing financial activities as intelligent and creative responses to universal human problems. Here Desai shows himself to be master of his craft, deftly pulling up tropes from the humanities to illustrate the significance of financial transactions. In chapter 1, “The Wheel of Fortune,” insurance is presented as a way of coping with the random yet unavoidable evils that haunt earthly existence, such as serious, incapacitating illness, death (either too early or too late), and natural disasters. Despite the unpredictability of these risks, in the aggregate they all follow the bell-shaped curve of normal distribution, making their harmful effects easier to manage. First, we have to pool risks, however. We have to face dangers and assume possible losses in solidarity with each other; the more people, the better. Protection lies in our willingness to conceive insurance as a common good in which everyone participates, albeit in diverse manners. Inclusion is a social good. The question then becomes: How much is each individual supposed to contribute to the common safety net? It would be hard to persuade the old, the well-off, and those without family obligations to part with their money for this common fund (adverse selection), for example. And similarly, would we not be creating an incentive for the young and fairly healthy to engage in all sorts of reckless adventures, knowing the collective would eventually foot the bill (moral hazard)? The best institution so far in communizing risks and dealing with freeloaders to effectively provide protection to all members is the family. On the one hand, membership, especially for the children, is normally adventitious, and on the other, parents have a very strong incentive indeed to closely monitor each one’s behavior, lest they take more chances than what prudence dictates. Family formation, then, reflects the ebb and flow of the economy. Interestingly, during the Great Recession, there was a collapse in the formation of new households, as vulnerable individuals retreated to the safe cocoons of their families of origin.
Insurance takes care of capricious risks we wish to avoid, but how about the strokes of good fortune we desire? What can we do for luck to be on our side when choosing marriage partners or careers, for instance? In these circumstances chapter 2, “Risky Business,” comes in handy, instructing how best to allocate limited time, energy, and resources for favorable future outcomes. The key, Desai says, lies in ensuring the right options and in diversifying risks. We create options by acquiring the right, but not the obligation, to use certain assets. Think, for instance, of the guarantees that come with appliances and electronics. Within a given period and under specified conditions, we may return, exchange, or get our money back if dissatisfied with the purchase. Returning to the marriage market, it is often said that women bear most of the risks, as they are the ones who get pregnant. They have to be very careful in creating a portfolio of options, such that each reflects the values they truly admire in a partner. But they have to exercise even greater caution in choosing whom they marry, for “marriage is the death of optionality” (46). In other words, options are fine, yet they are valuable only when exercised. Diversification is the opposite of pooling. It manages risks by spreading them over time and space through different, preferably unrelated assets. For this reason, in getting an education, it makes no sense to specialize too much or too soon. The knowledge and skills most valuable in the market today may be replaced by AI and robotics tomorrow. Individuals who invested heavily in them suddenly lose opportunities to make a decent living.
In this same chapter Desai also explains why investment assets should not be priced in isolation, but relative to the portfolio. As a result we distinguish among high-beta, low-beta, and negative-beta assets. High-beta assets have low values, as they fluctuate largely in synch with the portfolio. Low-beta assets, on the contrary, have high values, as they don’t fluctuate as much in tune with the portfolio. However, negative-beta assets, which run opposite to the direction of the portfolio, are good as gold. They are the most valuable elements because they can save us when all the other chips are down. Time and energy dedicated to people should follow this same logic. High-beta individuals are our LinkedIn connections or Facebook acquaintances; they’re the tailwind in fair weather sailing. Low-beta friends are of greater value, the ones who help in times of difficulty. Yet even more valuable are our negative-beta family members and friends. They’d throw us a line and keep us afloat when we’re about to drown or become lost in a storm. They stand by us unconditionally.
In the third chapter, “On Value,” Desai muses on the lessons from the “parable of the talents” and the “parable of the vine-dressers.” The first teaches that everyone is given “talents”—gifts of incredible value—although these are distributed unequally. Nevertheless, we’re expected to develop them fully, and we will be held to account if we fail. We’re just stewards, taking care of capital for and on behalf of others, who are the real owners. Hence, we should always strive to grow our business, surpassing expected returns as long as we can, to exceed the cost of capital entrusted to us. Insofar as financial valuation is forward looking, projecting what assets will produce, it’s the opposite of historic cost accounting, which starts with the acquisition price of assets and is backward looking. “Most value arises from terminal values (reflecting returns into perpetuity), and not returns in the short run” (67). However, the apparently contradictory lessons from the “parable of the vine-dressers” should also be considered. Despite significant differences in the time spent and the hardships borne at work, all journeymen were paid the same. Upon hearing their complaints at this “injustice,” the vineyard owner retorted, “Had they all not been paid the agreed wages? Why protest at this gesture of kindness and generosity?” Desai draws much from this response for issues regarding executive compensation. Unfortunately, too many senior managers see themselves as rainmakers, deserving of outsized pay when skill cannot really be separated from luck in financial performance, especially for periods shorter than a decade.
Beginning chapter 4, “Being a Producer,” Desai leaves topics related with asset pricing for those concerned with corporate finance, particularly corporate governance. No doubt the biggest challenge, given information asymmetries and agency problems (adverse selection and moral hazard), is how to ensure investors fair returns. Why should managers not only care about themselves (supposedly the default option) but also consider the welfare of shareholders, workers, customers, the environment, and so forth? Desai sheds light by referring to the conflicts between the familial roles which we, in turns, inhabit: those of parents and children. Together with his siblings, he once tried to convince his elderly, widowed mother to relocate to a place closer to where they lived. As a dutiful son, he saw himself as the “agent” of his mother or “principal’s” best interests. But their opinions did not coincide, and soon enough, he had to give in to his mother’s wish to remain in her home, where everything reminded her of her late husband. We fall into similar traps when trying to decide on what is best for our children. Understandably, while they’re young, we’re commissioned to act as agents, deciding on whatever we think is best for them. Consider helicopter parents, and particularly “tiger moms.” But sooner or later, parents will have to learn to fade out, allowing children to be agents of their own lives. Children cannot forever be mere agents of their parents’ desires. Growing up means being able to decide and act by one’s own lights.
Chapter 5, “No Romance Without Finance,” speaks of marriages and mergers, while chapter 6, “Living the Dream,” focuses on building up family estates and leverages. The parallels between marriages and mergers, and how to make them work, are commonplace. When does it make sense for firms to have just a casual relationship, when to step up to a strategic alliance, and when to eliminate all boundaries and merge? On a smaller scale, when should we content ourselves with Uber services, when ought we get a lease, and when are we better off buying a car straight out? In more personal terms, when is it enough to Tinder, engaging in spot market transactions, so to speak, when to live together, reaping benefits of stability and volume, and when to tie the knot and marry? The reasoning in all three cases would be very similar, from the economic perspective. Desai also gives curious insights based on dowries and the marriage market (favorable to grooms) and how all that saved the finances of fifteenth-century Florence.
Growing families need increasing resources, and this introduces the concept of leverage. There is a similarity between the life cycles of firms and families, shaped like an inverted U. Both firms and families need some leverage when they’re young and starting out; however, they should be careful since this can compromise growth. The best time for leveraging is when they’re at the peak of earning power. And again, firms and families may require leverage when mature and on the verge of decline, knowing that too much can hasten their demise. But as a family or a business, why leverage when you’re at the top? For the same reasons that firms may benefit from (the threats of) leveraged buy-outs (LBOs). Heads of families and managers may sometimes get lazy or complacent, favoring meager but secure earnings over opportunities for growth. Of course debt, like all obligations and commitments, entails loss of control. But that may be a small price for faster growth and greater welfare, notwithstanding the duty to work harder and better. By taking on more obligations and commitments (debt, leverage), we’re actually promising others we’ll push ourselves to the hilt in doing the right things. Not all ambition is fueled by greed; desire for excellence is not necessarily selfish. “Leverage may actually make us better people by holding us accountable as we commit ourselves to others with high standards. It also might enable us to live longer and richer lives than we can imagine —and to move the world in the process” (140).
Chapter 7, “Failing Forward,” describes what may happen when we overshoot the mark and leverage in excess: bankruptcy. Desai is strongly biased against considering bankruptcy, the inability to service debt, a “moral failure.” For him it is only a technical one. He thus argues vigorously against “punishing risk-taking” and “stigmatizing failure,” narrating his own experience of academic failures (his own and others) and how much people benefit from second chances. As is the case of the US, bankruptcy laws ought to be “opportunities for rebirth,” laying down measures to “protect debtors from unreasonable creditors” by establishing an orderly process through which businesses might be saved (148). When faced with the possibility of using bankruptcy —inappropriately, some would say— as a “renegotiation tool,” he turns to how luck and fortune trump our best intentions and how fragile goodness can be. Readers are somehow kept guessing why Desai doesn’t liken bankruptcy to divorce. Both seek an orderly distribution of assets and settlement of claims after acknowledging failure, often with a view to “second chances” or remarriage. They also often leave a lot of collateral damage, mostly innocent workers and children, in their wake.
Chapter 8, “Why Everyone Hates Finance,” is largely self-explanatory. Besides reasons previously rehearsed, Desai adds the insatiability of desire running up against the decreasing marginal utility of wealth. Behavioral economics has explained this phenomenon quite convincingly. But ironically, this hasn’t prevented us from falling into the same trap time and again.
The volume ends with an afterword in which Desai restates his objective of greater dialogue between finance and the humanities in search of wisdom.
For a book that carries “wisdom” in the title, little is said in the text about it and how it could be applied to finance. Desai does a marvelous job reconnecting financial transactions and activities with human aspirations and desires, giving them context and meaning. His choice of examples and allegories from the humanities is superb and ingenious. Yet he seems to take for granted that people understand what wisdom is, when events surrounding the financial crisis which provoked the Great Recession clearly indicate otherwise.
Perhaps Desai should have turned to philosophy, “love of wisdom,” for something more than just a source of illustrations for financial concepts. Reading Aristotle’s Metaphysics he would have learned that wisdom is the knowledge of the first principles and final ends of things; an understanding of what (essence) and why (causes) things are ultimately. So it’s not just the best explanation or model so far of how things work. We are told —and rightly so— that finance deals with risks and uncertainty, that it arises from a desire for growth and development, that it springs from ambition and a yearning for excellence. We gather from this that financial knowledge and skills are instrumental or a means to achieve flourishing, the best life for human beings in society. Wisdom consists of observing this order of means (finance) and ends (flourishing); loss of wisdom results from subverting it.
Towards the beginning of the book, Desai shares his disappointment when the majority of students at the Harvard Business School interested in finance opt for a career in investment banking, rather than insurance or corporate finance, which are more humdrum. They wish to be at the cutting edge of financial engineering and be handsomely rewarded for their efforts. Of course this is understandable. But perhaps, from a different perspective, it only goes to show that despite Desai’s best efforts, something has gone amiss. Where is the wisdom in all this, for the most part self-serving, financial sophistication?
