Finance has developed a bad reputation since the Global Financial Crisis of 2008, with even many insiders decrying the very questionable practices within the industry. But can finance be principled and noble? Mihir Desai certainly thinks so. Drawing on a wealth of knowledge of finance, classic novels and popular culture, he shows how finance addresses the key issues that individuals and societies have faced over the centuries. Whether that be how to finance a very costly war, to guarding against living too long, or the marriage choices of an 18th century woman.
The Wisdom of Finance is a must-read book for anyone who is interested in business, regardless if you are a finance practitioner.
Finance has developed a bad reputation since the Global Financial Crisis of 2008, with even many insiders decrying the very questionable practices within the industry. But can finance be principled and noble? Mihir Desai certainly thinks so. Drawing on a wealth of knowledge of finance, classic novels and popular culture, he shows how finance addresses the key issues that individuals and societies have faced over the centuries. Whether that be how to finance a very costly war, to guarding against living too long, or the marriage choices of an 18th century woman.
The Wisdom of Finance is a must-read book for anyone who is interested in business, regardless if you are a finance practitioner.
You are listening to the Book Judge, a podcast about books that you should read if you are interested in business. I am your host, Conrad Chua. I will review books that cover the usual business school disciplines like strategy, marketing, innovation but also some professional development books and even fiction.
For today’s episode, I will be introducing a book first published in 2017 by Mihir Desai. This book should be required reading for anyone who is taking an MBA and starting to learn about finance. Heck, this should be required reading even for people who have had decades of experience in finance. The full title of this book is The Wisdom of Finance, how the humanities can illuminate and improve finance. And that explains what this book is getting at. That behind the complex equations, the power suits and the algorithmic rocket scientists, there is a very human core to finance. Finance addresses many fundamental problems that individuals and societies have faced for centuries, and one should occasionally step outside the equations and think about the purpose of finance. To do this, Desai draws on several centuries of stories, some from history, others from mythology, classic novels and more than a few popular movies and musicals.
Desai starts with that most unglamorous area of finance. Risk Management. He explains how risk management is the bedrock of finance and, in many ways, of human interactions. To illustrate this, Desai uses an extract from the Maltese Falcon. No not the movie starring Humphrey Bogart but the book on which that film noir classic was based on.
The director John Huston chose to omit what some people call the central moment of the novel. This is where hard nosed detective Sam Spade relates the story of a successful real estate executive who narrowly escapes death from a falling steel beam one day walking to work. The executive realizes that he had spent his entire life organizing his career and family life into neat buckets when life is full of chance. He decides to embrace blind chance and just walks off to start life anew under a new identity. The twist is that while the executive embraces chance to try something new, within a few years his life had gone back to the same neatly ordered existence that he had left behind. Spade says “he adjusted himself to beams falling, and then no more fell, and so he adjusted himself to not falling.”
Desai goes from this story to talk about risk management. There are some lessons that everyone learns in introductory finance or statistics courses. That while chance is impossible to predict at the individual level, when aggregated into large populations, there are sound mathematical formulae and distributions to model such probabilities. And these patterns, think the normal distribution, can help free us from being blindsided by blind chance through that wonderful invention, insurance.
Before you think that insurance and risk management are the most boring parts of finance and you want to skip to the exciting chapters, Desai issues a warning about how not getting risk management right has brought down people from Lehman brothers to the French monarchy. The French were financing their expensive wars through issuing annuities. These are financial instruments that pay a certain amount to an individual up to their death. But they gravely mispriced their annuities and ran into serious financial difficulties that created so much public anger that it sparked the French revolution. So if it can happen to the French kings, it can happen to you.
But Desai does not just stay in the lofty macro view. The beauty of his book is how he can move through the layers of life and bring these principles of finance down to you as an individual. So to further illustrate risk management, he examines the marriage choices that Elizabeth Bennet made in Jane Austen’s Pride and Prejudice. How these choices reflect Ms Bennet’s risk profile versus her more risk averse friend Charlotte Lucas. Those were the days when the most important financial decision a woman could make was who she married. Fortunately, we have moved on since then.
I loved how Desai uses examples to illustrate financial principles. For example, he uses the movie the Producers, to illustrate the principal-agent problem. This is where you have investors, or what finance calls the principals, who are unable to fully control the managers of their money, or the agents. And much of finance is wrapped around this tussle for control and accountability. This challenge has been multiplied many fold in the modern world. Similarly in your personal life, you have to rely on others for whom you have very little control over. A good example is your plumber or building contractor. You will never know more than them and you can never be sure they aren’t pulling a fast one on you. Innovations like share-linked compensation help to give you more control over your agent but control will never be complete.
Another story is the case of Fred Smith, the founder of FedEx who was down to his last Five thousand dollars and was at risk of losing his company that weekend to creditors. He recognized that in that dire situation, there was a chance to save the company. And he took the company’s last cash money and gambled it all in the casino. He won enough money to pay back the creditors and FedEx turned things around. Fred Smith recognized that he had limited downside risk when he entered the casino. He would lose his company even if he didn’t gamble the money, /pause/ but the upside if he could win enough money was unlimited because Fed Ex would survive. Now there are all sorts of ethical questions here since his creditors would have stopped Smith at the casino door if they knew what he was going to do.
This is the part of the podcast where I place the spotlight on one part of the book that you can use immediately in your business, or in an interview, or just to impress your business school friends. I call this the Did You Know section.
That example of Fred smith the CEO of FedEx illustrated the power of options. Options are one of the first things you learn in finance. They are financial instruments that give you the option to buy or sell a financial asset at a pre-determined price, sometime in the future. Options are used in all areas of finance to hedge risk. And as you heard in the story of Fred Smith, they can be very powerful but they can be abused.
Desai talks about how financiers love options because, if correctly constructed, they can give you unlimited upside while protecting your downside risk. But what he does brilliantly is to turn the idea of options round to examine your own life choices.
Higher education for example is an option. Your downside risk is capped at tuition fees and living expenses but your upside could be unlimited if you could capitalize on your degree to swing a high paying job.
What I thought was most interesting is how Desai uses options to look at people’s career choices. He talks about his students at Harvard Business School who see a consulting career as an option to try out different industries before choosing the right sector for themselves. But some of them never leave consulting because they never make that choice of what is the right sector.
And herein lies a danger in options that I had never thought about. That one could get so addicted to options that one never makes a choice.
I see this too in some of my MBA students. They start the year thinking, I am going to immerse myself and try out everything and decide later what I want to do. But they never move out of that first stage and before they know it, their time in Cambridge is up and they have little to show for it.
This is not to say that options are a bad thing. Definitely not. But in life, one needs to remember that options protect your downside and give you choices, but if you keep hiding behind an option instead of making choices, then you are not going to get very far in life.
There are other parallels that Desai draws from finance that resonate in my professional life in a business school. He shares my dread when considering whether to grant exemptions for students to miss classes because of an employer interview or business case competition. On the one hand, that employer interview could mean the difference between the student getting a job and being a happy alum; or a student whose job search continues to hang over the rest of his or her school year. What many students in that situation don’t consider is that by going for the employer interview, they are forsaking a commitment they made to their study group or seminar stream to participate actively in the classroom. Now some of my students do think about the impact on their classmates but there are others who cast it aside without much thought.
How does this relate to finance? Desai points out that bankruptcy is essentially a process where a company reneges on previous commitments to its creditors, its shareholders and its employees in the hope that things can turn around. Disentangling these commitments is always messy and principals have to make painful choices about which commitment to prioritise. Desai looked at the example of the bankruptcy of American Airlines, which rewarded bond and equity holders who stayed the course while punishing labour. The previous CEO had rejected the idea of bankruptcy because he felt it was morally unjust to walk away from one’s commitments, but Desai proposes a less dogmatic view. The web of commitments in any company or in anyone’s life is complex. We need to understand our manifold obligations and embrace them. There will be times when we have to go through the difficult and, to some, distasteful process of re-prioritising our commitments to others. But we should welcome and not shun that process.
It is unfortunate that Desai wrote the Wisdom of Finance before the Trump Presidency got into full swing. I can only guess at the parallels he would have drawn between Trump in the cavalier way he used bankruptcy and divorce to cast off his commitments to others. We might be well-served to think about how potential leaders have handled their personal and professional commitments in the past before we cast our votes for them. It would also make for more productive debates that bring people closer together if we try to recognise the web of commitments behind each side.
For every book I introduce, I have this segment called the author question. One question that I could ask the author. And my question to Mihir Desai is what is the role of government in preventing bad behaviour in finance .
I am going to tweet this question to Mihir and hopefully he replies and I can share his answer.
That’s all for this episode of the Book Judge.
If you have comments, you can tweet me @ConradChua16, or DM me on Instagram. I am <> there.
Till next time this is your Book Judge, Conrad Chua