Good Investors Make Money. Great Investors Create Value.

Professor of Finance and Law, Harvard Business School

People have a bad impression of finance, and that's mostly worrying because its often justified, says Harvard Business School professor Mihir Desai. The sector is in dire need of rehabilitation, and there are several ways it can be done. The first is to realize that turning money into more money is a shortsighted investment. To play the long game, the system needs to focus on and reward value creation, which drives innovation and the economy. The second is to demystify finance (which is what Desai's new book The Wisdom of Finance is all about). Desai explains that finance got into its current state because it's more complicated than it needs to be, which makes it harder to control, given the general lack of understanding among the public. To remedy that, Desai taps into the brain's own strengths: humans process stories much better than they process logic, so narratives from history, literature and philosophy can be used to teach and demystify finance. As an example, the The Parable of the Talents from the Bible teaches value creation as well as a finance textbook can. The philosophy of Charles Sanders Peirce can teach risk management and insurance. Mel Brooks can teach fiduciary responsibility. Finance has become demonized, but it's not a system that we can live without. It's becoming more pressing than ever to make reforms that increase value in society, rather than wealth. Mihir Desai's most recent book is The Wisdom of Finance: Discovering Humanity in the World of Risk and Return.

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TRANSCRIPT

Mihir Desai: So I’ve been concerned because finance has become demonized in the last several years and decade or two. And in part it’s for good reason, which is the practice of finance in many ways is broken. We see a lot of activity that is value extracting as opposed to value creating, and that is really disturbing. And, you know, that’s not just the financial crisis, but we see it in various parts of finance: in asset management to some degree, in banking, and so it is really worrisome that A: people have such a terrible impression of finance, and B: that we sometimes live up to it. But the truth is that we can’t live without finance and we need to rehabilitate finance. And the reason we can’t is because it is so central to the modern economy.

So I think even people who are really upset about finance have to acknowledge that it’s really central, and we have to make it better. It is the fundamental mechanism by which companies grow, we save, we allow ourselves to potentially borrow to go to college, we save for our retirement. And innovation in general has to be funded. So finance is really central. What we have to try to figure out is how and why it's become so extractive as opposed to creating value.
How do you know whether you’re creating value, and what is the recipe for creating value? So that sounds very finance-y. In fact I use The Parable of the Talents, which is a very odd parable from the bible, a very harsh parable in the bible, which effectively captures the logic of value creation straight out of a finance textbook.

By that I mean it tells the story of these three servants, two of whom actually use what they’re given well and one of whom buries his talents. People don’t often know that the word talent is actually historically money. It is now—the modern notion is what we now think of as an ability.
But the neat thing about that story is it maps to the basic recipe for value creation and finance which is, just to be a little technical, you know, you beat your cost to capital. You surpass people’s expectations. You do it for a very long period of time and you continue to grow. So that’s how companies create value. That little recipe for value creation, I show is exactly what is in The Parable of the Talents. And, in fact, John Wesley Mitchell, who is the founder of Methodism, in his essay on The Parable of the Talents, basically says almost the exact recipe for value creation that kind of comes out of a textbook which is, you know, beat your cost to capital, which is a way of saying: give back more than you take as long as you can to as many people as you can, and so on and so forth. So it’s actually kind of neat in the sense that The Parable of the Talents, that recipe for value creation, actually maps to the recipe for a reasonably good life. So that’s one example, but there’s like the book is littered with kind of basically examples like that.

So one of the mechanisms by which finance has kind of gone wrong is they’ve made it more complex than it needs to be. And so what I try to do in the book is tell these stories from literature and philosophy and history that actually make the ideas really quite intuitive.
So ideally you take a look at the book and you kind of get a host of ideas, the core ideas of finance but just by reading stories. And I think that’s a much more powerful way for people to understand finance. And in that process of demystification what I hope will happen is people will feel empowered, you know. They’ll understand what finance is. They’ll understand what finance is doing and so they’ll A: be more appreciative of the underlying functions even if it is broken today. But also feel more empowered to talk about it and think about it and confront people when they’re faced with it.

There are a bunch of different ideas that are kind of core to finance. The most important one is risk and insurance which is just to really try to understand the omnipresence of risk and then to think about how all the kinds of things that pay off in life, really the way they’re priced are a function of those risks that they address and how they are associated with those risks. So that’s a really big idea in finance that underlies the way we think about securities and how they’re priced. The way we think about chunks of corporate finance. And that’s a really core idea.

So, for example, to think about risk and insurance and to think about the omnipresence of risk I use these two folks who are really fun: this philosopher Charles Sanders Peirce and this poet Wallace Stevens. So by using people like that, people who actually really deeply appreciated risk and insurance but people who you would never expect to be in a finance book, I think you can actually explore the idea of risk and insurance in a different kind of way.

There are various misconceptions. So the first about risk is somehow that it is complete randomness. Actually risk is something that can be understood. There are patterns and it can be managed. So, in fact, that is what finance is. Finance is all about those patterns, about those regularities and then figuring out how to manage in that world. So risk is not really randomness. Risk is: you don’t know what a particular outcome is going to be, but there can be all these patterns in life that can actually help us navigate what seems like chaos.
And in fact, that is exactly what insurance companies do, and that’s what a lot of people in finance do is try to make sense of the chaos of the world by exploring those regularities. And, in fact, that’s exactly why Charles Sanders Peirce, who is this philosopher I mentioned, actually said near the end of his life, he just kept walking around everywhere saying, “We are all insurance companies.” Because we are all insurance companies. We are all trying to make sense of the chaos, and he was the founder of pragmatism. And so his recipe for figuring out the chaos was: you sample, you try, you try everything—which is a pragmatic approach to life. It’s also the approach that insurance companies take.

Once you kind of come to terms with the omnipresence of risk then you have to kind of think about risk management and, in particular, hedging. And one of the counterintuitive pieces of this is there are these things that help you manage risks. Things like diversification, things like options. People get a little confused about that because they think they’re an end in and of itself. Like you’re just trying to prevent risks from affecting you.

You know in reality those are instruments which allow you to take bigger risks. So you can take, you can buy a little insurance and then that allows you to take the bigger bets in life. So, for example, in options people think options—as in financial options—are gambles. You know they can be. But in reality the way we typically think about using options in finance is as insurance and as protection. And that protection allows you to take bigger kind of idiosyncratic bets because you have these options that allow you some protection. So risk management is actually a huge chunk of finance because it allows you to think about taking even bigger risks than you might otherwise.

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Big Think Edge helps organizations get smarter, faster by catalyzing conversation around the topics most critical to 21st century business success. Led by the world’s foremost experts, our dynamic learning programs are short-form, mobile, and immediately actionable.