BOOK REVIEW: An engaging look at the world of finance

The Wisdom of Finance: Discovering Humanity in the World of Risk and Return, by Mihir A. Desai

AUTHOR Mihir Desai is a professor of finance at Harvard Business School. His book is aimed at both students and practitioners of finance, but also for readers who are unfamiliar with finance but curious about it.

Most people learn finance (I certainly did) in a mechanistic way, complicated by mind-numbing acronyms, formulae, and spreadsheets that “serve as barriers to understanding the world of finance”, Desai believes. The result is a fragile understanding of fundamental financial ideas.

The title, The Wisdom of Finance, caught my eye because there are many things I have thought about finance and financiers, and wisdom wasn’t the first that came to mind. I have always reserved that adjective for philosophers, theologians, and poets.

What adjectives would you apply to finance?

The common rhetoric about “Wall Street vs Main Street”, and the South African variations, reflects an attitude towards finance as an industry that extracts more value from the economy than it creates.

For all concerned citizens, finance has never been more important, and ignorance of it has never been more expensive. Fortunately, Desai’s book is engaging (yes, engaging!) because he explains the main ideas of finance without a single equation or graph.

He uses literature and other art forms such as the works of Chaucer, Jane Austen and even the film Working Girl to highlight and explain complex financial issues.

This book takes the unorthodox position that viewing finance through the prism of the humanities will help us restore humanity to finance. Conversely, Desai shows how the ideas of finance provide surprising insights into aspects of our humanity.

Finance is a way to understand the role of risk and randomness in our lives, and to use the emerging patterns to our advantage. To demonstrate this, Desai begins with insights into understanding the nature of risk and the idea of probabilities, the foundation of insurance.

“Finance ultimately,” he explains, “is a set of tools for understanding how to address a risky, uncertain world.” This is important because business promises high returns if risk can be well understood.

For centuries people had been fatalistic, whether because of the role of divine forces or because of the discovery of so-called laws of nature. But as statistics advanced, more and more phenomena were shown to have a bell-shaped normal distribution. Chance was just a perception in the absence of knowledge that could, with time and sufficient occurrences, be clear, and order would be created.

This view contains two seemingly contradictory ideas: chance and randomness, and patterns that emerge when occurrences are aggregated.

“Risk is everywhere, it is undeniable, and it shouldn’t be ignored or surrendered to - it should be managed.” Insurance tries to provide a way to navigate such a world, and is a foundation concept in understanding finance.

“Going into insurance is the ultimate contrarian bet, given the popular image of insurance executives today - boring, nerdy, and vaguely evil as they profit from the woes of others,” Desai has observed. However, one of the most venerated capitalists of our time, Warren Buffett, built his business on insurance.

Many innovations in finance, such as the limited liability company mentioned in this column last week, originated with the risks of venturing beyond one’s home, often overseas.

• READ: BOOK REVIEW: 50 inventions that changed the world

If the ship was in danger and the captain had to throw some goods overboard to save other goods, it would be fair to expect the owners of saved goods to compensate the owners of the goods that were jettisoned. The practice of general averaging is a pooling of risk, which is a basis of insurance.

Insurance has another, unexpected consequence: it binds people together by mutualising risk, and forces a sense of being part of a collective. We can’t predict our individual outcomes because of the nature of randomness, but we can predict aggregate outcomes, as we see from normal distribution curves.

With various views of what happens after death, many saw the need for an appropriate burial. To be sure you would be buried properly, Romans soldiers formed burial insurance societies. These early insurance formations solved the problem of funding funeral expenses, by mutualising and sharing the expense with people of similar beliefs and social status.

A related form of insurance that dealt with after-death insurance was the 17th century French philosopher Blaise Pascal’s wager: people have to take the risk as to whether God exists or not. Weighing the risk and reward, he held that disbelief was not worth taking the chance on an eternity in hell, and so advocated belief as an insurance. The cost of such a belief is forfeiting some pleasures.

Several scholars have attributed the decline of the reports of witchcraft to the rise of insurance.

By its nature, insurers lack knowledge about who buys an insurance contract. When Louis XVI and his finance ministers offered insurance for people who were worried about living too long so that their assets were depleted, they got the pricing of this insurance very wrong. And they paid for it, dearly. (A familiar problem?)

Annuities at the French court

The French court had offered annuities - contracts where you invest a lump sum and where the insurer pays you a fixed annual amount until you die. Annuity contracts were, at the time, a dominant form of public finance for England and France.

]The problem was adverse selection — being unable to make sure that the people who become insured conform to your expectation of who will buy insurance. The old and sickly tended not to buy, but the young and healthy did.

A positive outcome of this was that governments started keeping records of births and deaths. If we know when people of different ages would die, on average, we could then make sure that the pricing of annuities would work.

The organisation that was suited to pool risk and counter the effects of moral hazard and adverse selection was the family. Large families offered the aged better chances of being cared for well, so families were the most important source of insurance for millennia. As Robert Frost said, “Home is the place where, when you have to go there, they have to take you in.”

However, families aren’t ideal mechanisms for providing insurance. The benefits of pooling are limited by their small size and complicated by the fact that families are, well, complicated.

“How does understanding the omnipresence of risk and the nature of insurance help us understand the world?” Desai asks rhetorically. Once you accept that randomness is everywhere, probabilities are left as the only way to make sense of the world, and find patterns that can guide your behaviour.

Our own experiences are inherently limited: understanding the world requires that we also understand the experiences and welfare of others. Insurance tries to make sense of the chaos of our lives by capitalising on patterns, and creating pooling mechanisms so we are better able to manage that chaos.

“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.”

Desai covers many other key concepts in such an engaging manner that you rapidly forget that you are getting a great education in finance.

• Ian Mann of Gateways consults internationally on leadership and strategy and is the author of Executive Update. Views expressed are his own.