The Wisdom Of Finance by Mihir Desai

I. Brief Summary

This book offers a thoughtful explanation of how money works which also recognizes how abnormal the industry can be. Desai argues that there is great value in finance. The author romanticizing a domain which is inherently rotten should raise eyebrows. Desai is a pure academician. He is a professor at Harvard Business School. Glorifying the financial industry may not sit well with everyone. Nonetheless, there are several great lessons. Desai employs literature as a device to explain the lessons of money in finance.

II. Big Ideas

• He rejects the idea that finance itself is flawed, but rather it has to do with quick feedback loops on their performance which makes Wall Street greedy. Desai believes through the use of humanities finance can be humanized.
• On Probability:
  • Our lives are dictated by chance, but how we deal with chaos, randomness, and disorder has evolved greatly over the years as humanity developed better tools to deal with probability.
  • Human intuition is not a great tool for understanding probability. But great mathematicians such as Blaise Pascal, Charles Sanders Peirce, and Pierre de Fermat developed the tools for analyzing situations probabilistically.
  • Insurance which is boring, but a great tool to deal with chaos.
  • Insurance is how finance intersects with the real world of issues around probability and risk
• On Risk Management:
  • Events cannot be predicted, one form of insurance used in finance are options.
  • People in finance love options because of the asymmetric payoff. Losses are contained and gains are unlimited.
  • Investors use “beta” as a measurement of risk to market fluctuations. An asset that is high beta goes up a lot when the market goes up and goes down a lot when the market goes down. And, vice-versa with low beta.
  • Desai illustrates this concept using friendships. High beta friendships are your social contacts and acquaintances. Low beta friendships are friends and family.
  • Desai has warning to those who overutilize options—“People in finance love options so much that they often overlearn the lessons on the value of options. They become obsessed with “optionality” and the creation and preservation of choices...I am no longer surprised to see students who end up remaining in companies – usually consulting or investment banking firms – that were initially intended as way stations that would create more optionality on the path to their actual entrepreneurial, social, or political goals. They often end up saying to themselves, “Why not stay another year and create more options for down the road?” The tool that was supposed to lead to more risk-taking ends up preventing it.”
• On Value:
  • Value analysis is a central task for financial professionals
  • Compounding is powerful and great value compounds exponentially. Hence, reinvesting generates greater return than not reinvesting.
  • Talent is distributed unequally. Talent is incredibly valuable. It is of the utmost importance to exercise our talent to its fullest extent.
  • Accounting is fundamentally backward-looking: balance sheets and income statements look at what has been done. Balance sheets also give zero value to assets that can’t be valued precisely. This leaves important assets such as brand, intellectual property, and user communities out of the equation. Imagine trying to value Coca-Cola, Disney, Facebook, or Apple without including their brand in that valuation…clearly not a complete picture. In contrast, finance is ruthlessly forward-looking. Valuation is driven solely by the future. There is a discount given when translating future value into today’s dollars–and that waiting cost is valued by finance by the “weighted average cost of capital”.
  • “Alpha” represents the idea of value creation–the returns you generate above and beyond expectations. Success amongst investors is overly attributed to skill and the role of luck is overlooked. Desai illustrates this illusion to coin-flipping. Attributing coin flipping skill is indistinguishable from an investor who says they’ve beaten the market ten years in a row.
• On Principal Agent:
  • To understand the principal-agent problem is the idea of investors and managers. Investors put their money into a company and entrust managers to manage and grow the company. These managers (usually) are paid a salary while investors make their money on company value. These differences in incentives result in decision-making differences and ultimately, conflicts.
  • It often isn’t clear who is the agent and who is the principal in modern capitalism. This is true in life as well – roles are blurred and muddled.
• On Leverage:
  • Leverage in finance is a fancy way of saying “borrowing money”.
  • The analogy is based on the idea of a lever, which enables you to move items that would otherwise be too heavy to lift. In finance, leverage enables you to buy things you would otherwise be unable to buy and amplifies returns in both directions. If things are go well, you’ll make more money with leverage than without leverage and if things go badly, you’ll lose more money.
  • There are benefits to leverage which Desai calls it “the leverage bonus.” By being leveraged, you are forced to do the right thing to meet your obligations. The same thing can apply to relationships with others. By making commitments to others (being leveraged), you will take actions that you may never have been able to force yourself to do on your own. Ths accountability hold us to a higher standard and may enable us to live richer (and longer) lives.
• On Risk Taking:
  • Failure, in many parts of the world, is stigmatized. Not for Silicon Valley–which may be why it is a continuous wellspring of innovation.
  • Risk taking and failure go hand in hand. You literally can’t have one without the other.
  • Failure should not be understood or seen as a moral defect. Inevitably, risk taking will lead to failure, and failure should be viewed as a bad outcome with an abundance of lessons.
  • Bankruptcy law allows for friendlier risk taking. Modern bankruptcies allow companies to walk away from crushing obligations and have a fresh start. Of course there are trade-offs because it allows for walking away from obligations for less accountable people. But Desai argues such is life.
• On Spot Market vs Contracts vs Ownership:
  • Spot markets are typical business arrangements–someone needs a piece of machinery and finds a vendor to build it for them.
  • Contracts are things that include terms such as exclusivity, special pricing considerations, minimums, or any other specific deal items.
  • Ownership is when one company decides to buy another for their capability.
• Desai's Checklist:
  • Due diligence is critical.
  • Filling a hole in your organization is not a merger strategy
  • Racing against the clock leads to bad decision-making.
  • Synergies are always overstated.
  • The costs of integration are always understated.
  • Asymmetric mergers are easy but of limited value, and mergers of equals are horribly difficult but potentially very rewarding.
  • Serial acquirers are problematic.
  • Ultimately, it’s all about culture, “doing the work”, and execution.

III. Quotes

• Finance has a negative reputation among the general public for being difficult to understand and full of people motivated by greed. However, understanding finance improves the ability to understand challenging situations as they arise in other areas of life.
• Perhaps finance is deeply connected to our humanity.
• Perhaps we can all find our way back to a more noble profession by enlivening the ideas of finance through stories that illuminate our lives and our work.
• Finding narratives that allow us to stay attached to what is meaningful in finance can insulate us from the feedback loops of attribution error — and perhaps help save us from becoming caricatures.
• It has become fashionable to deride the values of finance in intellectual circles and political campaigns.
• 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.
• Commitments to smart and demanding people keep us from doing stupid things. We gain from those commitments. Leverage is not a zero-sum game.
• Failures should not be stigmatized, they are occasions for a fresh start.
• In finance, we are trying to figure out how to invest our assets and manage toward the best risk-return tradeoff. In life, we are trying to figure out how to allocate our time and energies across many people. It also matches because the underlying logic of insurance is present in both settings.
• This experiment is a provocative way to humble any investors who pride themselves on their success as it directly rebuts the idea that alpha is easily labeled or generated. In a room full of a hundred of your friends, ask everyone to take out a coin, flip it ten times in a row, and record their results. You’ll find that you’re almost guaranteed to have one friend who gets ten heads in a row. Here’s the key insight: that friend is indistinguishable from an investor who says they’ve beaten the market ten years in a row.
• We are all fragile creatures, all teetering on the edges of bankruptcy, struggling to navigate between competing obligations that arise when we care deeply about things in our lives. The mistake is to reject uncertainty – just as philosopher Charles Sanders Peirce suggested–by not caring deeply enough to feel those competing obligations.
• Randomness and order coexist in the world. The discovery of normal distribution, as in a bell curve, indicated that what appears to be random is derived from the laws of nature.
• A merger, like a marriage, proceeds most smoothly when both parties are well-informed.
• People recover from failure when they have the space, help, and time to learn from the experience.
• Organizations that stigmatize failure actually tend to repeat failures rather than learn from them.
• In financial and personal matters, people who act as principals appoint other people to act as their agents, but principals often act as agents for other people and agents are sometimes principals as well. This forms a complex web of obligations.
• Creating value requires a firm not only to increase in value, but to exceed the performance of the rest of the market.
• Finance experts calculate value based on how much money investments will produce in the future, the cost of the investment in the present, and how long it will take to receive the benefits.
• A person can reduce risk by investing time, money, or effort into a variety of diverse opportunities.
• One strategy for reducing risk is creating options that allow a person to choose the most advantageous moment to pursue what would otherwise be a risky venture.
• An insurance company improves its ability to deal with randomness by learning from experience and using observations to inform future decisions.
• 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.
• 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.
• We should experience as much as possible—just as insurance companies must—in order to make good decisions and understand the world with the right probabilities.
• Finance, ultimately, is a set of tools for understanding how to address a risky, uncertain world.
• 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.
• 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.
• Pragmatism is the opposite of navel-gazing; in pragmatism, truths are only valuable to the degree they can inform actions, and actions are only valuable if they confirm a truth.
• Perceiving the normal in the abnormal is precisely what insurance is built on and it is what helps us achieve the opposite of chaos amidst the chaos of the world.
• The logic of a liberal arts education is not terribly different—by preventing professional specialization at too early an age, exposure to a broad set of ideas flexes different intellectual muscles and provides alternative perspectives that feed a lifetime of learning.
• 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.