The Wisdom Of Finance

1. Finance is deeply connected to our humanity and everyday lives

"Money is a kind of poetry." - Wallace Stevens

Finance as human endeavor. Far from being a cold, calculating discipline, finance is deeply intertwined with human nature and our daily experiences. It deals with fundamental aspects of life such as risk, value, and relationships. The ideas of finance provide surprising insights into common aspects of our humanity:

• How insurance helps us confront the disorder of the world
• Understanding risk and return can reveal the nature of unconditional love
• Appreciating value creation can guide us towards living a meaningful life
• Bankruptcy principles can teach us how to react to failure
• Theories of leverage illuminate the value of commitments in our lives

By viewing finance through the prism of humanities - literature, history, philosophy, music, and religion - we can restore humanity to finance and make its core ideas more accessible and meaningful to everyone.

2. Risk and insurance are fundamental to finance and life

"Chance itself pours in at every avenue of sense . . . it is absolute . . . and the most manifest of all intellectual perceptions." - Charles Sanders Peirce

Embracing uncertainty. Risk and uncertainty are omnipresent in both finance and life. Understanding and managing risk is at the heart of finance, and these same principles apply to navigating life's uncertainties:

• Insurance is a powerful tool for managing risks of mortality, longevity, and disasters
• Risk pooling allows us to share and mitigate risks collectively
• Embracing randomness can lead to wisdom and innovation (e.g., randomized trials)
• Experience and empathy are key methods for dealing with the chaos of the world

By acknowledging the role of chance and developing strategies to manage risk, we can approach both financial decisions and life choices with greater confidence and resilience.

3. Options and diversification are powerful risk management tools

"I shall take the first that comes after I have quite made up my mind . . . After all, a husband is very much like a house or a horse." - Violet Effingham in Anthony Trollope's Phineas Finn

Strategic choices. Options and diversification are two critical risk management strategies in finance that have parallels in our personal lives:

Options:

• Provide the right, but not the obligation, to take action in the future
• Allow us to access resources we might need but don't know if we will need
• Create asymmetric payoffs with limited downside and unlimited upside potential

Diversification:

• Spreads risk across multiple investments or life experiences
• Provides a "free lunch" by potentially increasing returns while reducing risk
• Applies to personal relationships, skills, and experiences as well as financial assets

Both strategies enable us to manage risk while maintaining flexibility and potential for growth. However, overemphasis on creating options can lead to an inability to make choices, while diversification must be balanced with focused effort in key areas.

4. Value creation requires exceeding expectations consistently

"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." - Parable of the Talents

Surpassing expectations. The essence of value creation in finance is exceeding the expected returns of capital providers consistently over time. This principle applies to personal and professional life as well:

1. Surpass expectations: Give more than you take, return more to the world than the considerable talents you've been given
2. Do it consistently: Never stop giving more than you take, maintain high standards over time
3. Grow and reinvest: Continue to invest in yourself and grow your capabilities

This approach to value creation emphasizes stewardship, obligation, and continuous improvement. It challenges us to make the most of our talents and opportunities, while recognizing that our success is built on the investments of others in us.

5. Valuation is forward-looking and based on future cash flows

"The land belongs to the future, Carl; that's the way it seems to me." - Alexandra Bergson in Willa Cather's O Pioneers!

Future focus. Finance takes a forward-looking approach to valuation, emphasizing that the only source of value today is the future. This perspective offers valuable insights for life:

• Past accomplishments and current assets have little relation to true value
• Imagine alternative futures to make good decisions
• Most enduring value arises from what we leave behind - our legacies
• We are stewards of resources for future generations

By adopting this forward-looking mindset, we can make better decisions about investments, careers, and personal growth. It encourages us to focus on creating long-term value rather than short-term gains or dwelling on past achievements.

6. Leverage amplifies returns but comes with risks and commitments

"Spinach is the art. Art can change your life. It can expand your parameters. It can give this vastness to life." - Jeff Koons on his Popeye sculpture

Power and responsibility. Leverage in finance allows access to resources beyond current means, amplifying potential returns but also increasing risks. This concept applies to personal and professional life:

• Leverage enables living beyond current resources, but comes with commitments
• High-leverage life (e.g., marriage, children, career) offers greater potential impact
• Low-leverage life (e.g., solitude, independence) provides autonomy and control
• Leverage can make us better by holding us accountable to others

The key is finding the right balance of commitments and independence that aligns with personal goals and risk tolerance. Leverage can be a powerful tool for growth and achievement, but it must be managed carefully to avoid being overwhelmed by obligations.

7. Bankruptcy offers a chance for rebirth and learning from failure

"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 for which you are not yourself to blame." - Martha Nussbaum

Embracing failure. Modern bankruptcy law, inspired by the fall of Robert Morris, redefines failure away from moral failing towards a natural consequence of risk-taking. This shift offers valuable lessons for dealing with personal and professional setbacks:

• Failure should not be stigmatized but seen as an opportunity for learning
• Bankruptcy provides a chance for rebirth rather than signaling death
• An orderly process for dealing with failure is crucial for recovery:
  1. Create breathing room (automatic stay)
  2. Seek help from impartial observers and advisors
  3. Develop a forward-looking plan for recovery

By approaching failure with this mindset, we can build resilience, learn from our mistakes, and emerge stronger from setbacks.

8. The principal-agent problem is central to modern capitalism

"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." - Gerard Arpey, former CEO of American Airlines

Aligning interests. The separation of ownership and management in modern corporations creates the principal-agent problem, where managers (agents) may not always act in the best interests of shareholders (principals). This framework extends to many aspects of life:

• Professional settings: Supervisors delegating tasks to subordinates
• Family dynamics: Parents and children, caring for aging relatives
• Social expectations: Balancing personal desires with societal norms
• Past experiences: Unconsciously serving as agents of childhood experiences

Recognizing these dynamics can help navigate complex relationships and conflicting obligations. It challenges us to be aware of our roles as both principals and agents in various aspects of life, striving to align interests and fulfill our responsibilities ethically.

9. Finance can breed insatiable desire, but its core ideas are noble

"I know, that's all. When you drive over the country you can feel it coming." - Alexandra Bergson on her intuition about land values in O Pioneers!

Wisdom in finance. While finance is often associated with greed and insatiable desire, its core ideas actually question the pursuit of more. The concept of risk aversion and diminishing marginal utility of wealth suggest that accumulation yields less satisfaction over time.

Key noble ideas in finance:

• Stewardship of resources for future generations
• Creating value by exceeding expectations and continuous improvement
• Managing risk to enable productive risk-taking and innovation
• Providing second chances through bankruptcy and failure

To counter the negative aspects of finance:

1. Stay connected to the noble core ideas and their broader implications for life
2. Use works of imagination to maintain perspective and meaning
3. Emulate positive role models like Alexandra Bergson, who embody the wisdom of finance

By understanding and applying the deeper wisdom of finance, we can use its principles to lead more meaningful and balanced lives while creating value for others.

Last updated: August 12, 2024