The Wisdom of Finance book summary

The Wisdom of Finance

In The Wisdom of Finance, a thought-provoking look at money and human endeavour, Professor Desai illustrates the concepts of finance and applies them to everyday situations, drawing on literary and historical examples as well as his own experiences. Though some of the parallels that Desai draws between finance and life may seem a bit laboured, you will find yourself nodding in agreement with most of his perceptive observations.

He invites readers to open their minds for new insights from the wisdom of finance. He explains how people can use financial tenets to improve their lives, and he illuminates the field overall, making this a worthwhile addition to your library for understanding economics in personal terms and in its broader context.  

Finance as the Villain

Professor Desai points out that, in spite of all the ways in which people apply the basic principles of finance to their daily lives, the subject of finance draws consistently negative reactions. Stories in literature and the arts about short-sighted, stubborn and grasping characters in the financial world.

For instance, Desai relates Leo Tolstoy’s tale about Pakhom the peasant’s effective use of financing to secure real estate and enrich himself to show how greed – goaded by the Devil – made Pakhom’s desire for even more land the cause of his death. The infamous banker Gordon Gekko in the film Wall Street is also cast as a modern-day villain, extolling the virtues of avarice. 

But Desai notes that, rather than being evil, finance is, in fact, rooted in human nature and that it facilitates life for individuals and society. Finance provides a way for people to deal with a risk-filled environment, especially when they face choices requiring trade-offs between enjoyment today and gains in the future. The Wisdom of Finance believes that the modern topics of asset pricing, risk management, options, diversification, mergers, leverage and bankruptcy all find their expression in people’s daily decision-making.

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The Wisdom of Finance Started with Insurance

The Wisdom of Finance begins with a return to ancient times when human beings attributed outcomes to supernatural forces. Over time, the spread of commerce and rational thought provided incentives for individuals to understand risk so they could reap high returns. Eventually, mathematicians discerned that all sorts of natural events occurred following a normal, or bell-shaped, curve. This distributional pattern led to the development of complex insurance instruments and to the birth of modern finance. 

Insurance originally catered to the needs of businesspeople whose merchandise sailed the high seas. Desai depicts merchants who typically financed these voyages with borrowed money, but couldn’t pay back their loans if their goods didn’t make it to their destinations. Thus, a contract of bottomry emerged when lenders, for higher interest rates, would forgive the loans in case of shipwreck or piracy. Eventually, insurance developed into a mechanism for the pooling of risks to spread perils over a broad base and minimize their effect on individuals.

The Wisdom of Finance Make the Most of Limited Resources

The Wisdom of Finance illuminates the concept of finance as focused on how to make the best choices, given your limited time and resources. Financial instruments, such as options help you manage risks and can also bring about good outcomes in your personal life. A financial option gives you the right to buy an asset. However, you are not obliged to buy it. This means you get to participate in any potential price increases without having to take any losses if prices fall. Options create an asymmetrical payoff that encourages risk-taking. 

Desai finds English literature of the 1800s rife with examples of the use of options. Fictional female characters considered the prospects of the financial returns their suitors promised versus the risks they might represent. Jane Austen’s Pride and Prejudice offers one such tale in Lizzy Bennett’s weighing of Mr Collins’s marriage proposal. In the Anthony Trollope book, Phineas Finn, Violet Effingham manoeuvres the matrimonial market through options, choosing from a portfolio of suitors she has assembled.  

Many decisions in today’s world involve making trade-offs between risk and return. For instance, in deciding to opt for higher education, people typically consider if the yield they will get is worth the debt they’ll take on and whether it is worthwhile to specialize in a particular subject. 

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Diversify Resources Across Your Relationships

Diversification is a form of insurance in which you spread your options to mitigate risk. The Wisdom of Finance points to finance’s capital asset pricing model (CAPM), which formalizes “the logic of diversification”: It calls for investing in a portfolio of opportunities whose outcomes fluctuate and differ from another.

For example, owning equities in different industries often means that if the value of one stock drops, the others are likely to keep or increase their value. A portfolio may include some “high beta” assets with prices that move with the market, along with “low beta” assets that don’t move in lockstep with overall costs. “Negative beta” assets tend to follow a direction opposite to that of the market.

The Wisdom of Finance relates this to an instance of diversification in your personal life compared to the idea of getting a liberal arts education, which could expose you to a variety of ideas and life alternatives. Diversification also refers to the people you know. Your personal portfolio could include professionals with whom you transact business. They are high beta assets because they might be prominent in your life when you’re successful and less so when you’re not doing so well. Your low beta relationships are those friends you can count on in good times and bad. The negative betas are the people, such as your parents, who provide real, unconditional love, even when you are down, and your returns are negative.

The Wisdom of Finance on Estimating Value

The Wisdom of Finance asserts that people create value when they give the world something greater than their personal skills, and when they do so on an extended basis, while continually growing by investing in themselves. 

The financial approach to valuation is to estimate a business’s future output and then apply a cost of capital – the price of waiting to realize those benefits in the future – to discount this output to its value today. Similarly, it’s possible to estimate the return from an investment in education by calculating the additional income you would make, discounting it back to its current worth and then subtracting the cost of tuition. If this return is positive, then the education is a good investment. 

The Wisdom of Finance advises looking forward when deciding how to proceed with your life and not fixating on past achievements or failures. What you leave behind, in the long run, is what counts, much more than your pleasures in the short term.

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Humility and Luck 

Blind luck can have a significant impact on your life. Some patterns are visible, and making sense of them can help you use them to your benefit. But because chance plays such a big part in human interactions, when you weigh successful outcomes, separating the effect of luck from that of an individual’s actions and skills is not so easy. The Wisdom of Finance believes people should more deeply appreciate the role that good fortune plays in success and learn the lesson of humility.

Capital requires certain returns based on the risk it encounters. Clients see their money managers as creating value when they provide a return that is greater than the cost of the capital, as well as higher than the clients’ return expectations. Considering that money managers cannot diversify away market risk, any returns they get that merely compensate for this risk are nothing more than “beta,” a basic return that investors expect for bearing this risk.

It is only when managers provide “alpha,” a higher level of return, that they are adding value. Although people in finance tend to pride themselves on their alpha generation, the author explains that, in reality, it is difficult to relate their efforts to the returns they produce directly. In fact, The Wisdom of Finance cautions that they may have been just plain lucky. 

The principal-agent-problem

Those who manage risks for others may not always act in your best interests, The Wisdom of Finance warns. “The principal-agent problem,” a disconnect between the managers of a business – its agents – and its owners, who are its principals, is intrinsic to the structure of modern capitalism. Agents may have their own agendas that conflict with what’s best for principals.

The Wisdom of Finance offers the example of corporate managers who enjoy compensation incentives that conflict with shareholder value, as happened during the Enron fiasco and the housing market collapse. While finance has come up with incentives, such as stock payments for executives to align their interests with those of shareholders, managers could cash-out by boosting short-term performance at the expense of long-term company growth.

The Wisdom of Finance extends this parallel to circumstances that often arise in families. Although they are their children’s agents, parents may not always act in the children’s best interests, especially when families push their ambitions and hopes onto their kids. Sometimes people unknowingly allow those childhood experiences to take over their adult lives so that they act as agents for other people’s dreams and never achieve their own. To realize your full potential, Desai writes with empathy, you need to be true to yourself, aligning your life with your goals, not those of other people.  

Leverage Cuts Both Ways 

The Wisdom of Finance highlights the two distinct approaches that affect the use of leverage, or the taking on debt, throughout history. While the 18th-century economist Adam Smith was in favour of capping interest rates at 5% to deter the negative aspects of borrowing, others of the same era, like philosopher Jeremy Bentham, were attuned to the idea of lending to risk-takers to encourage innovation. While leverage allows you to take advantage of opportunities beyond the reach of your resources and provides you with returns, you would not have earned. Otherwise, debt can also hurt you if your ventures don’t succeed. 

The Wisdom of Finance correlates the leverage that companies undertake to the debt that people assume. Businesses follow a blueprint: Younger firms tend to operate with little debt; mature and stable companies increase their leverage to expand and create new value, and those past their heydays cut back on obligations. But he points out – adding a layer of complexity – that the life pattern for individuals differs, in that borrowing is heavier among the young, who have few assets. As they become more financially secure, they pay down debt and accumulate wealth for retirement. In middle age, people usually have the most obligations, including financial, career, family and social. In later years, individuals tend to “delever” from work and material bonds. 

While leverage in commerce centres on money, it also depends on relationships with lenders and investors. The Wisdom of Finance notes that leverage in life comes from making commitments to other people, whether through getting married, raising children or contributing to society in civic organizations. Leverage enables firms to expand and people to live fuller lives. 

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The Wisdom of Finance For Love and Money 

The Wisdom of Finance traces the link between finance and romance from the earliest days of mankind. In 15th-century Florence, monetary exchanges figured prominently when arranging marriages, which led the state to set up a “dowry fund.” Parents of minor daughters could lend money to the state and accrue funds, with interest, in the form of dowry payments that the state would make to grooms when the daughters were ready to wed. This practice also enabled the elite to stay in power through strategic intermarriages that resembled corporate mergers. Even in contemporary times, people engage in “assortative mating,” choosing partners of similar educational and economic standing. 

The Wisdom of Finance draws illustrative comparisons among the factors that make for a successful corporate merger and a happy marriage: He offers that both businesses and individuals should conduct an adequate amount of due diligence on a partner and that they shouldn’t rush into anything because of deadline pressures. Neither should try to fill a hole in life or an organization nor should they expect that the result of a merger or marriage will make them better or more valuable.

Sharing similar cultures and values with an intended partner matters. The Wisdom of Finance explains, “The determinants of successful mergers are…the closest we come to see the emotion and tumult of romantic love and marriage in the commercial world.” And, he says, mergers of equals are potentially the most rewarding, but even then worthwhile alliances take hard work.

Bankruptcy 

The Wisdom of Finance reminds readers that, before 1800, society considered failure to repay your debts as a moral shortcoming. Distressed borrowers faced prison or even death. Attitudes and laws have shifted over time, becoming more tolerant of risk-taking and considering it inhumane to punish debtors for failing.

Today, borrowers’ ability to declare bankruptcy allows them a fresh start. Such an attitude has also helped to develop American businesses, as troubled companies work through their problems and often emerge from bankruptcy as operating concerns. Taking on risk in your personal life could lead to failure, but if it does, the author counsels that you should learn from it and develop a plan for the future. Get help from family and friends, even from outside professionals, if necessary. And see these letdowns as stepping-stones to your future achievements.

Life Counsel

The Wisdom of Finance makes the indisputable claim that life, much like the financial world, is not well ordered. Both come with conflicting demands and commitments. Still, the advice to meet such uncertainty head-on, rather than shying away from the fray, makes this a valuable and worthwhile read, as does his ability to keep his eye on long-term outcomes. As he says, “We are in a long game, and most enduring value arises from what we leave behind – our legacies – and not what we enjoy while we’re here.”

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Author: Muhamad Aarif

A notorious book addict by night and an oil and gas executive by day. As Mark Twain said, "The man who doesn't read good books has no advantage over the man who can't read them." So, read, read, and read some more.

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