The essence of finance
If finance is the problem of allocating resources efficiently over time, then quantitative finance is how we find an optimal solution using math and data.
From The Wisdom of Finance by Mihir Desai:
underneath all of finance is this underlying idea: the pursuit of more will yield less and less. And any expectation other than that is not consistent with the ideas of finance. The game of accumulation is one that will leave one less and less satisfied as one gains more and more. To search for ever-greater satisfaction through accumulation is folly. That is the bedrock idea in finance. And it runs completely counter to how individuals in finance often act and how they are perceived.
Why, then, does this bedrock idea of finance get lost amongst practitioners, as perceived by much of the world? To me, this is the big question-and it’s one that I don’t have an answer to, at least not a complete one.
One overly simple answer is that everyone gets finance wrong. It is actually a noble profession where people are behaving by worthy ideals but being slandered nonetheless. The slander reflects an age-old bias-dating back to Socrates’s characterization of money as barren-against activities that don’t produce tangible goods. The demonization of finance has been with us forever and reflects this ignorant bias.
Another overly simple answer is that finance attracts people who are one-dimensional and who have deep, insatiable desires. The practice of finance is not bad. It just attracts a disproportionate share of bad eggs.
I think there are grains of truth to these possibilities-and I wish they were the whole story.
But I’m afraid they’re not. I think that finance can breed insatiable desire in people who venture into it. I think the experiences of Pakhom and Cowperwood are ones that we are all susceptible to. Outsized successes fueled by leverage create enormous wealth at all-too-early ages-just as with Pakhom and Cowperwood. The problem then becomes how to make sense of that success. The human tendency, as well documented by psychologists, is to attribute it to oneself as opposed to the situation. People will most naturally view their successes as related to their abilities as opposed to luck. So-called attribution errors occur everywhere in life.
But the scope and magnitude of those errors is nowhere greater than in the world of finance. People in finance are continuously fed feedback by the markets on their decisions. And those decisions result in both significantly good and significantly bad outcomes. Bad outcomes are rationalized quickly as being the result of situational factors, while good outcomes are understood to be the result of one’s own actions. And it’s entirely feasible to continue in this pattern of self-deception for years. Indeed, one needs to continue in this mode to stay confident and succeed in finance. Otherwise, it is simply too humbling. My most successful friends in finance never seem to talk much about their losing investments.
The frequency and magnitude of attribution errors differentiate finance from virtually all other endeavors. In business, law, teaching, and medicine (with the exception of surgery), we are confronted only after months and years with measures of our success or failure. In finance, particularly for investors, these attributions can happen every day, in perfectly quantifiable ways, and with amounts that are far larger than any individual would usually command. Moreover, the “discipline of the market” shrouds all of finance in a meritocratic haze. Investors come to see their outcomes as reflecting their ability, given the chaotic, competitive market they work in, rather than acknowledging the dominant role of chance. Ultimately, all those attribution errors result in successful people who are susceptible to developing massively outsized egos and appetites.
Of course, not everyone in finance evolves in this way. There are plenty of humble, wonderful people in finance-and there are some people who are truly skillful in finance. But there are enough real Cowperwoods and Pakhoms to create the stereotype. Financial markets can even allow this pattern to spill over into other parts of the economy. Consider the Silicon Valley entrepreneur who comes to believe the hype of ever-escalating valuations. Financial markets, with their patina of quantitative accuracy, let loose our desire to link our outcomes with our character.
Consider this the asshole theory of finance. It’s not finance that’s bad. It’s not the people who finance attracts who are bad. It’s just that finance fuels ego and ambition in an unusually powerful way.
If that’s the case, then the real question becomes: How do we protect our selves from the particular kind of personal risk a life in finance creates? I think the best way to insure ourselves against that risk is through works-and the work-of imagination, just as Wallace Stevens suggested. Finding narratives that allow us to stay attached to what is meaningful in finance can insulate us from the feedback loops of attribution error-and perhaps help save us from becoming caricatures like those in the more common and dispiriting depictions of finance.
Finance has convulsed the economy repeatedly, and there is tremendous skepticism about its value. Indeed, it has become fashionable to deride the value of finance in intellectual circles, political campaigns, and even amongst businesspeople. All this would be fine if that skepticism weren’t built largely on an edifice of ignorant conceptions of what finance actually is.
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