Notebook for
The Wisdom of Finance
Mihir Desai

Author’s Note
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This book is about humanizing finance by bridging the divide between finance and literature, history, philosophy, music, movies, and religion. This book is about how the philosopher Charles Sanders Peirce and the poet Wallace Stevens are insightful guides to the ideas of risk and insurance, and how Lizzy Bennet of Pride and Prejudice and Violet Effingham of Phineas Finn are masterful risk managers. This book looks to the parable of the talents and John Milton for insight on value creation and valuation; to the financing of dowries in Renaissance Florence and the movie Working Girl for insight on mergers; to the epic downfall of the richest man in the American colonies and to the Greek tragedies for insight on bankruptcy and financial distress; and to Jeff Koons’s career and Mr. Stevens of Remains of the Day for insight on the power and peril of leverage. In short, this book is about how the humanities can illuminate the central ideas of finance. But this book is also about how the ideas of finance provide surprising insight on common aspects of our humanity.
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This book takes the unorthodox position that viewing finance through the prism of the humanities will help us restore humanity to finance. The problems that finance addresses, and the beauty of the approach it adopts, are most easily understood by attaching finance to the stories of our lives. More than regulation or outrage, fixing finance requires practitioners to return to the core ideas, and ideals, of finance—which can help them ensure that they are creating value and not extracting it. By linking those core ideas to literature, history, and philosophy, we give them deeper resonance and make them more resistant to corruption.
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As one example of the alternative view, the philosopher Friedrich Nietzsche notes that the whole idea of duty and personal obligation is rooted in “the oldest and most primitive personal relationship there is, in the relationship between seller and buyer, creditor and debtor.
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Here the oldest form of astuteness was bred: . . . the human being describes himself as a being which assesses values, which values and measures, as the ‘inherently calculating animal.’”
The Wheel of Fortune
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In the middle of The Maltese Falcon, Dashiell Hammett interrupts his breakneck plot development and spare prose to tell a curious little story. The Flitcraft parable is,
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Peirce was able to keep two seemingly contradictory ideas in his head at the same time—chance and randomness were everywhere (the insight from the former type of fatalism, think Flitcraft), and patterns emerged that suggested regularities in the aggregate (the insight from the latter type of fatalism, think Flitcraft as Pierce). The universe was full of chance and fundamentally stochastic (randomly determined)—but patterns could help us navigate the world.
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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. It wasn’t always so—insurance executives were once heroes, such as the characters played by Fred MacMurray and Edward G. Robinson in the greatest film noir ever, Double Indemnity. Now, we have the forgettable, irritating Ned Ryerson of Groundhog Day pitching single premium life insurance.
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As with many innovations in finance, insurance originated with the risks of traveling, often on the seas.
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The other big risk facing commercial shipments was the possibility of running aground and being forced to jettison goods in order to salvage one’s voyage. “Rules of jettison” were developed around 1000 BC, known as Lex Rhodia for the island of Rhodes. They persist today and are now called the law of general average. The spirit of this practice is well captured by how it is discussed in the Code of Justinian from more than a thousand years ago: “The Rhodian Law provides that if in order to lighten a ship, merchandise is thrown overboard, that which has been given for all, should be replaced by the contribution of all.”
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The practice of general average is a pooling of risk, which is the essence of insurance. Insurance binds people together by mutualizing risk: we’re all in this together.
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For Romans, the critical risk they faced was an afterlife filled with discontent. And the only way to prevent that outcome was to have an appropriate burial. But how could they be assured that their burial would be taken care of? Enter insurance! Roman burial societies were voluntary associations, particularly common among old soldiers, where the problem of funding funeral expenses was mutualized and shared with people of similar beliefs and social status so you could be assured of having an appropriate burial . . . and, therefore, of salvation.
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As England and France battled through the eighteenth century, they were forced to finance large expenditures on wars, including the very expensive Seven Years’ War.
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France, in contrast, continued to be a fiscal mess and began depending more and more on providing annuities to their populace. The kicker was that they were so desperate for financing that they decided that individuals of all ages could get the same annuity. The same annual payments were offered to a five-year-old as well as an eighty-year-old—for as long as they lived. The annual payment was set based on the idea that the typical group of investors would be interested in these annuities, so, on average, a uniform annuity rate would be okay.
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Guess who provided funds to the French government by buying annuities? Unsurprisingly, old people didn’t take up the offer, but young people flocked to it—precisely those who would be the most expensive annuitants for the French government. It gets better. In probably the earliest example of financial engineers bringing havoc to the world, a group of Swiss bankers bought annuities on behalf of groups of Swiss five-year-old girls who were found to come from particularly healthy stock. They then allowed people to invest in portfolios of these annuities, in what is likely the earliest example of securitization. By the time of the French Revolution, these annuities were the dominant source of financing for the government and the majority of annuitants were below the age of fifteen.
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Remarkably, one such annuity, one that was extended to the descendants of the buyer in a particularly generous giveaway, remains outstanding today. There is still a budget line item for the French government of €1.20 for the “Linotte rente” issued in 1738, testament to the fact that we still live in the world created by the French Revolution.
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In fact, economists Amy Finkelstein and James Poterba have shown that the United Kingdom’s large annuity market still demonstrates this same tendency: people buying annuities live longer than people who don’t. That means pricing of the annuities has to try to anticipate how much adverse selection there will be—and that’s not easy.
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But what organization is best suited to pool risk and counter the effects of moral hazard and adverse selection? It should be one where membership isn’t a choice, so that adverse selection isn’t operating, and one where you can closely monitor each other’s behavior to make sure moral hazard doesn’t work against you. Well, of course, that’s the family. You don’t get to choose your family, so that takes care of adverse selection. And families provide the intimacy for making sure behavior isn’t changing to take advantage of the insurance.
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The first lesson from Peirce comes simply from the embrace of randomness. For Peirce, this embrace led to one of his most important discoveries. He employed a deck of cards in the middle of an experiment to ensure that subjects were being assigned randomly, so that the results were not biased and more credible. This is the first instance of randomization in scientific trials, a tool that is now a gold standard of intellectual inquiry. Rather than deny it, Peirce understood that embracing the omnipresence of risk was a powerful approach—it can actually be the foundation of wisdom.
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The more experience an insurance company has with a population, the better their understanding of probabilities and the more successful their business. That’s why, in effect, we’re all insurance companies—experience is the critical method for understanding how to thrive.
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If our own experiences are inherently limited, understanding the world requires incorporating the experiences and welfare of others. Reacting against the idea of social Darwinism, Peirce instead thought that the logic of insurance and sampling inexorably led to “that famous trio of Charity, Faith and Hope, which, in the estimation of St. Paul, are the finest and greatest of spiritual gifts.” We must embrace others to understand the world—the imperative of experience gathering demands it. For Peirce, insurance teaches us that experience and empathy are the key methods for dealing with the chaos of the world.
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Stevens declined the offer to become the Charles Eliot Norton Professor of Poetry at Harvard and, instead, spent most of his days figuring out how the Hartford Accident and Indemnity Company should settle or litigate insurance claims. Fellow poet John Berryman, in his elegy to Stevens, poked at him by calling him a “funny money man” “among the actuaries.” So, what did Stevens see in insurance? As we’ve seen, insurance tries to make sense of the chaos of human experience by capitalizing on patterns and then creating pooling mechanisms for us to be able to manage that chaos. For Stevens, poetry had the same aim of addressing the chaos of the world.
Risky Business
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Insurance, as we saw, is a powerful tool for managing the risks of mortality, longevity, or natural disasters. But what about the risks we face in the labor market or marriage market? There aren’t insurance policies available for those risks. Fortunately, finance has adapted the logic of insurance to create the two most important risk management tools available to us—options and diversification.
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In fact, the person who beat Albert Einstein to the punch by five years was Louis Bachelier, a doctoral student in Paris. Rather than studying the movement of particles, he studied the movement of stocks and derived the mathematics to describe all kinds of motion, including the motion of pollen particles observed by Robert Brown.
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As such, the idea that finance, a study of markets and inherently social phenomena, lost its way by aping physics, a “hard” science of precision, is plain wrong. Instead, as philosopher and historian Jim Holt has described, “Here, then, is the correct chronology. A theory is proposed to explain a mysterious social institution (the Paris Bourse). It is then used to resolve a mid-level mystery in physics (Brownian motion). Finally, it clears up an even deeper mystery in physics (quantum behavior). The implication is plain: Market weirdness explains quantum weirdness, not the other way around. Think of it this way: If Isaac Newton had worked at Goldman Sachs instead of sitting under an apple tree, he would have discovered the Heisenberg uncertainty principle.”
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Thales of Miletus, acknowledged as the father of Greek philosophy by no one less than Aristotle himself, is often credited both with the phrase “know thyself” and with originating the first options transaction.
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In part, people in finance love options because of the nature of this asymmetric payoff. Losses are contained and gains are unlimited. And experiences that create optionality—educational experiences, for example—are valued precisely because of the asymmetric nature of the payoffs.
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A story from the beginnings of Federal Express, the global logistics company, manifests this relationship between options and risk-taking. In the company’s very early days, the CEO, Fred Smith, was struggling mightily to convince suppliers, investors, and customers of the virtue of expedited delivery. On one Friday, things got so bad that fuel suppliers were threatening to shut off supplies, thereby ending the young company, because of an unpaid $24,000 bill. Smith only had $5,000 in the bank. How did he respond? As the owner of the company, Smith recognized that if he went bankrupt, he would get nothing—but that if he was allowed to live another day he had the possibility of victory. That sounds a lot like an option—an asymmetric payoff with little to lose and much to gain. So, how do you behave if you own an option? Well, you seek out volatility and risk. And where can you find that? FedEx still survives today because Smith went to Las Vegas and converted the $5,000 into $32,000 at the blackjack table.
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Of course, there are fascinating ethical issues here. By going to Las Vegas, Smith effectively stole from the suppliers, because he was gambling with the money that he owed them. But he was also responding to the incentives in place—incentives that are always in place as any company teeters on the edge. Owners who are underwater become holders of options with little to lose and everything to gain—so why not go to Vegas? This vignette makes clear that creating options and having them as part of your portfolio allows you, even encourages you, to undertake greater risks.
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The remarkable “open field” agricultural system of medieval England was a response to this risk management problem. Serfs tilled narrow strips of land that were spread far and wide across a lord’s manor rather than one large piece of land.
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Stringer Bell, the business mastermind of the Barksdale Organization in the television show The Wire, employed diversification as a method of risk management. In his cat-and-mouse game with the police, protecting communication was critical, so he used temporary “burner” cell phones. But Bell went further than simply not relying on one phone line to avoid detection—he ensured that the purchases of burner cell phones were spread across multiple stores, so that no clerk would remember a large sale, and he also used multiple SIM cards.
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From medieval agriculture to the techniques of drug dealers, diversification has been a powerful way to manage risk. Much as options can be understood as a way to get insurance, diversification also relies on the logic of insurance. With insurance, insurers pool risks across individuals and they rely on the regularities of large populations and that magical normal distribution to price risks. With diversification, you atomize your resources and spread them across travel routes, pieces of land, cell phones, or rental car agencies.
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But the logic of diversification has been intuitive to many for millennia; the advice in Ecclesiastes is to “invest in seven ventures, yes, in eight; you do not know what disaster may come.” And in the Talmud, R. Isaac recommends “one should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.”
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That lesson on the virtues of diversification also extends to our personal lives. A dear friend framed his portfolio problem to me in this way: “I know that the most important thing I can do with my time is to spend it with my children—but if I spend all my time with them, I’ll screw them up terribly and probably go crazy myself. Why is that?” The finance take on this is that diversifying our experiences and relationships is precisely what we should be doing—relationships don’t crowd each other out but they enrich each other. Being a good friend and colleague doesn’t diminish your efforts as a parent but may well benefit those efforts.
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Gold is a good example of a very low or, even, negative-beta asset. I don’t exactly know why people buy gold, but one logic is this: when paper money becomes worthless and we all devolve into a hellish world akin to Mad Max, you really want to be holding gold.
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So, who are the high-beta, low-beta, and negative-beta assets in your life? The high-beta assets in your life are likely your LinkedIn network or professional acquaintances. These relationships are largely instrumental; in other words, these individuals are likely to show up when you do well and disappear when things go poorly. Accordingly, they should be given low values—it’s not that they can’t be a source of great benefits; it’s just that they compound the risks you face and don’t provide much insurance. When you’re down on your knees, these assets provide no relief. Low-beta assets are considerably more valuable—they are the steady friends who are there for you no matter what happens to you. In fact, this classification of friendships closely mirrors the taxonomy of friendships provided by Aristotle in Nicomachean Ethics. The lowest form of friendship, for Aristotle, is the high-beta, transactional friendship where individuals “love each other for their utility” and “do not love each other for themselves but in virtue of some good which they get from each other.” These are friendships that are thin and fragile as “if one party is no longer pleasant or useful the other ceases to love him.” When you’re succeeding, these high-beta friends surface, but they disappear when you stumble because you become less valuable to them. The much higher notion of friendship is the low-beta friendship where good individuals wish each other well without qualification based on the goodness that these friends feel toward them. But Aristotle reserves his highest praise for the love that is unconditional—the negative-beta assets in your life. When you stumble the hardest, these people are there for you the most—and when you fly too high, they manage to pull you back down to earth. Noting that “most people seem . . . to wish to be loved rather than love,” Aristotle contrasts that typical sentiment with mothers who “take delight in loving” and “they themselves love their children even if these owing to their ignorance give them nothing of a mother’s due.” That sounds just like the negative returns we are willing to live with for negative-beta assets. When we love our negative-beta assets unconditionally—we give and give and give and expect nothing in return—that’s negative expected returns.
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The reason that the logic of diversification, the capital asset pricing model, and the idea of betas matches the Aristotelian taxonomy of relationships is that the underlying portfolio problem is the same. In finance, we are trying to figure out how to invest our assets and manage toward the best risk-return tradeoff. In life, we are trying to figure out how to allocate our time and energies across many people. It also matches because the underlying logic of insurance is present in both settings.
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With risks investigated and returns well established, Lizzy gets a second bite at the apple as Darcy presents the option yet again, and now Lizzy doesn’t hesitate. Instead of thinking of how much the loss of optionality would cost her, she “hits the bid.” She seems to have understood that risk management is not a goal in and of itself—but rather a set of strategies to ensure that one can take the big bets one needs to take to truly create value.
On Value
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What does this Biblical tale have to do with finance? The big questions in finance are: how is value created, and how should we measure value? In particular, when we think of companies whose value goes up over time, it is because they are presumed to be creating value.
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In short, finance has a simple recipe for value creation—1) surpass the expected returns of your capital providers; 2) surpass those expectations for as long as you can; and 3) grow, so you can keep generating returns that are higher than your cost of capital. That’s all that really matters for creating value. There are at least two striking parallels between this logic and the parable. First, we are stewards of resources for others in both cases. That logic of stewardship and obligation is central to finance—we are overseeing the capital that others have entrusted to us, just as the servants must take care of God’s talents. As Bob Dylan sang in his gospel classic, everyone’s “Gotta Serve Somebody.” We are all stewards—links in a chain of individuals charged with tending to our resources. Second, that role of steward comes with high expectations, is risky, and can be characterized by great outcomes (high returns/salvation) or terrible outcomes (value destruction/damnation). There is a harsh and challenging logic to both: make the most of what you are given, be aware of how much you’ve been given and how much is expected of you, and make every effort to exceed those expectations. The finance recipe for value creation can also easily be mapped to the way we think about our lives. The first step, “surpass the expected returns of your capital providers,” can be understood as saying that you should give more than you take; that is, return much more to the world than the considerable talents you’ve been given. The second step, “surpass those expectations for as long as you can,” is simply another way of saying never stop giving more than you take. Finally, “grow, so you can keep generating returns that are higher than your cost of capital” is just another way of saying that you should never stop investing in yourself and continue to grow. Postpone harvesting as long as you can—because the returns to investing in your efforts can be enormous.
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In the case of the parable of the talents, there are several pieces that still puzzle me. First, there is the unequal distribution of the talents to the three servants, explicitly suggesting that this distribution reflects the principle of “each according to his ability.” Second, there is the redistribution of the talent away from the poorest and toward those who have more—and this is explicitly the goal: “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.” And finally, there is the harsh punishment of damnation meted out to the poorest servant. This “worthless servant” is cast “into the outer darkness. In that place there will be weeping and gnashing of teeth.”
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Here is where I find some lessons of the parable more mysterious. Why did the talents get distributed initially the way they did? Why redistribute toward the richest servant? Why deliver the ultimate punishment to the poorest servant who is guilty of, at most, fear?
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Many practitioners of finance pride themselves on the meritocratic nature of their endeavors: the market is a harsh master and the results accord with ability. But is this necessarily true? And if we don’t know for sure, is it a good set of operating beliefs? In order to explore this, it’s useful to consider two remarkably talented and productive people who, as it happens, were obsessed with the parable of the talents. Samuel Johnson—who in eight years single-handedly created a dictionary that was the precursor of the Oxford English Dictionary—was haunted by the parable. And John Milton, author of the epic poem in blank verse Paradise Lost, repeatedly mentioned the parable in his writings and lost many hours of sleep to its logic.
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Johnson, a man blessed with innumerable talents, took inspiration from a man with little material wealth or natural ability, but with the sole talent of providing care and affection to those around him. For Johnson, the parable is not a recipe for worshipping the “great men and women” of the world who have been given much, but rather a lesson in humility and a reason to appreciate the contributions of those who provide so much despite not being endowed as richly as he was. Milton went even further in interpreting the parable. The son of a scrivener (a bookkeeper and a money lender), Milton was obsessed with his incalculable debts to his earthly father, who had invested so much in his education, and to his heavenly father, whom he saw as the source of his poetic talent. Milton repeatedly worried that he wouldn’t be able to settle these debts and used the parable to voice his concern. He, like many of us, bumbled around for years looking for what at the time was called “credible employment.” This concern reached a climax in Milton’s forties when he discovered he was going blind. While he had already accomplished much as a pamphleteer for free speech and republicanism during the English Civil War of the 1640s, he had yet to use fully the talents he knew he had for poetry—and the progression of his blindness made him worry that he never would.
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The lesson from this experiment is that it is very difficult to disentangle skill from luck in finance. First, there is the nature of randomness that will make any measure of success unreliable. Second, there is the inability to identify cleanly which risks have been undertaken, creating ambiguity over what expected returns should have been. Finally, there is now plenty of evidence that indicates that few money managers consistently beat the market, after consideration of their fees.
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The logic of valuation is the logic of stewardship and obligation, giving back more than you take, working for future generations, and not confusing outcomes with efforts. The philosophical aspects of finance’s approach to valuation should come as no surprise—aren’t we all trying to create value in our world? Finance’s search for value parallels our own search for meaning.
Becoming a Producer
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Positive reactions to unexpected CEO deaths, in addition to being vaguely ghoulish, are a manifestation of the basic problem that arises when owners delegate authority to managers—those managers don’t always do what they’re supposed to, and shareholders struggle to control these managers. This is the problem of corporate governance and a manifestation of the principal-agent problem. It’s also the fundamental problem of modern capitalism.
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The problem has two dimensions—first, they may be motivated to help us but they undoubtedly have their own agenda (providing for their own families, the desire to leave work early); second, we can’t always know if they’re working on our behalf—we simply can’t watch them all the time and they may know much more than we do (Do I really know the quality of concrete they used in my home? Do I really know if I need that MRI? Or, who owns that MRI center?).
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It is a series of principal-agent relationships—we (the ultimate principal) save through pensions funds (our agents), which appoint David Einhorn (the agents of the pension funds), who monitors Tim Cook (the agent of David Einhorn), who appoints Jony Ive (Cook’s agent as Apple’s chief design officer), who appoints . . . you get the idea. Once you become attuned to the principal-agent relationship, it’s hard not to see it playing out everywhere in life. In many ways, the biggest debates today on what is wrong with capitalism are actually debates about finance and agency theory. For some, the big problem is that the proponents of agency theory have been too successful: managers now only care about their owners! They should be looking out for workers, customers, and the environment, too. If only managers would be more capacious in their thinking and not just pursue profits, the world would be a better place.
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I’ve found the lens of principals and agents very helpful in understanding the muddle of life on four dimensions. First, and most obviously, in professional settings, the principal-agent lens is a guide to understanding our roles: When we serve as supervisors, are we empowering our subordinates to fulfill their obligations? When we are delegated a task, are we pursuing it as our supervisors wanted or in a way that serves our own agenda? Second, our roles in families lend themselves to a principal-agent lens, though the actual roles we play at different times shift as we age and take care of children and aging parents. While these first two settings are about our relationships with particular individuals, the next two applications are about how we navigate our relationships with social expectations and with our own past experiences. Are we serving as principals who articulate our own agendas or as agents of hidden principals? In each case, as with the muddle of modern capitalism, we take up the lens of principals and agents not on a quest for conclusive answers but in order to generate the right questions.
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One of my favorite cases to teach—so good that even a finance professor can teach it—is about a young hotshot executive with an MBA who has risen quickly and is now struggling with an older subordinate who isn’t performing to the executive’s expectations. The case is rich in setting the stage, including how the executive has tried to provide feedback to the subordinate. I usually begin the discussion by polling the class on whether they would 1) fire the subordinate, 2) try to coach the subordinate, or 3) work around the subordinate by creating parallel positions. When I press them into role-playing their preferred choices, students who once glibly advocated their answers are usually humbled by the prospect of actually undertaking any of these actions. But the biggest payoff of the case comes from the ultimate realization that the problem likely isn’t the subordinate at all. There are obvious clues littered throughout the case, but students generally just aren’t sensitive to them—it usually takes forty minutes or so for someone to realize what has actually been going on. The problem is that the hotshot executive has delegated responsibilities to the subordinate and then proceeded to undercut him at every turn. As a result, the subordinate is frustrated and demotivated—and ultimately leaves the company and industry. The hotshot executive then gets his comeuppance (in the case update), as this obsession with control is persistent and his senior managers have noted it. The ability to delegate to agents successfully is a critical managerial building block, but the hotshot doesn’t appear to know how to do it. He’s penalizing his agent for not fulfilling the agenda that he gave him, but at the same time, he is subtly not allowing him to succeed in that role.
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Most parents, myself included, like to think of ourselves as dutiful agents on behalf of our children. We want them to be “all that they can be” and the “best versions of themselves.” When we speak like that, we are thinking of our children as our principals whom we are merely helping toward their own self-realization. But in practice I find that version of parenting pretty superficial. Inevitably, children become agents of our agendas as well. Sometimes, that happens innocently—the children become accustomed to choices that reflect parental preferences and then internalize those preferences. They’re much more likely to follow our professions and enjoy the things that we like, relative to some random draw from the general population. In fact, for many of us, the chief responsibility of parenting is the act of imprinting a set of values on our children—if that’s the case, who’s the agent and who’s the principal in parenting? Sometimes the reversal of principal and agent roles happens not so innocently or consciously. Many of us parent with the best of intentions but are guilty of projecting our unrealized ambitions or hopes onto our children. In those situations, we pretend to be agents of our children’s dreams and potential, but we are actually the principals trying to force our agents/children into a mold.
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The tension between “should” and “must” drives not just A Room with a View but has many precedents in literature. In fact, Leo Bloom of The Producers was, as you might have guessed, named after Leopold Bloom of James Joyce’s Ulysses.
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For me, the lesson of that book is that many of our problems as adults are reflections of unresolved experiences that we had as children. As adults, we turn into unwitting agents of sublimated experiences and much of adulthood is just about figuring out that you are, in fact, an unwitting agent of those experiences. Ultimately, it’s about learning to not be an unwitting agent—and to be conscious of those past experiences and to become a principal, a conscious architect of your own life.
No Romance Without Finance
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From the financing of Renaissance Florence to the rise of the Rothschilds to the creation of the automobile industry to the early days of the internet, finance and romance have been inextricably linked—and the accumulated financial folklore and wisdom about mergers can provide some hardheaded insight into what makes romantic relationships work.
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In 1425, the government of Florence inaugurated the Monte delle doti. Citizens could loan money to the state for fixed interest rates at the time of their daughter’s fifth birthday, and these accounts would mature ten years later, along with their daughters (giving new meaning to the idea of “yield to maturity”). The account could only be redeemed upon consummation of a marriage and would be paid directly to the groom by the state. In this way, the state had a powerful new fundraising tool, fathers were insured against rapid dowry inflation by generous interest rates as well as a precommitment to save, and grooms were guaranteed the payment of the dowry by the state rather than by a father who might renege.
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Facing even more fiscal pressure, the government revised the Monte delle doti in 1433 to allow for repayment of the principal upon the death of daughters and raised interest rates to as high as 21 percent. The Dowry Fund then exploded in popularity and became a dominant form of the financing of Florence in the fifteenth century. In a city with a population of fifty thousand, nearly twenty thousand accounts were established over one hundred years. Art historians have speculated that The Arnolfini Portrait by Jan van Eyck that opens this chapter, one of the most famous paintings of a wedding, actually reflects the payment of a Monte-linked dowry. Ultimately, the Monte delle doti proved unstable—like many government-funded deals that appear too good to be true—and had to be restructured . . . several times.
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Indeed, these scholars point to the Monte as the reason for the durability of the elites of Florence relative to other elites in other city-states. The dowry fund encouraged what is known as “assortative mating,” where individuals mate with people like themselves rather than at random. As a result, elites could stay in power by creating strategic alliances between elite families. Marriages were, in effect, mergers between powerful families, and the Monte was the financing mechanism that allowed them to keep pursuing those mergers.
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During an era when marriages became more romantically oriented, the Rothschilds chose a different path. While many families viewed marrying within their community as important, the Rothschilds took that process much further. As the individual responsible for transforming a family firm that traded antiquities into the largest banking empire of the nineteenth century, Mayer Amschel benefited enormously from his marriage. He married the daughter of a court agent, a critical person responsible for the financial dealings of local peerage. As historian Niall Ferguson puts it: “In addition to the benefits of association with her father, the match brought Mayer Amschel vital new capital, in the form of a dowry of 2,400 gulden. It was to prove the first of a succession of carefully calculated Rothschild marriages, laying a foundation of prosperous kinship every bit as important as the foundation of royal patronage represented by the title of court agent.” During a critical phase in the family’s dominance on the financial scene, the Rothschilds were inspired by royal examples to inbreed, to a degree that was unprecedented at the time. Beginning in the 1820s, there were nearly twenty marriages within the family, largely between uncles and nieces, designed to ensure that the five branches of the family stayed together and that power and wealth remained consolidated. In short, their standards made it appear, as Ferguson puts it, that “only a Rothschild would really do for a Rothschild.”
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If you think marriages as mergers of economic interests are something relegated to the distant past or to sovereigns and quasi-sovereigns (like the Rothschilds), think again. In a fascinating study of the role of marriages in the business elite of Thailand, several Thai scholars found that for family businesses that rely on connections (such as construction), almost all the children of those families marry other elite families in those connected industries, as opposed to children in non-connected industries. And it pays off. When children of elite family businesses marry the children of other elite family businesses, the share price of those family businesses appreciates significantly on the announcement of the marriage. No such stock price appreciation happens when these children marry “commoners.”
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Modern America is increasingly characterized by marriages of individuals with similar financial power. In fact, one of the major drivers of increasing income inequality recently has been the revival of assortative mating. With more marriages happening between individuals of similar earning power and educational pedigree, economic power has become more concentrated. Some estimates suggest that if mating were to happen as randomly as it did in 1960, household income inequality would have changed little over the last fifty years.
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While the AOL–Time Warner debacle provides a cautionary tale about mergers and serves to embody the folklore around mergers and marriages gone wrong, it leaves open many deeper questions. Why merge at all? When should firms combine operations and when can they simply do business with each other? In finance, these questions reflect the problem of the “boundaries of the firm.” When should we draw the boundaries of an organization so that a given customer, competitor, or supplier is outside the boundary or inside the boundary? This framing makes clear that there is always an alternative to a merger, such as contracting with an outside party. If you can contract with someone for given services, why should companies merge at all?
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To frame this in a more personal setting, consider your daily transportation needs. Putting aside mass transit, how can you fulfill those needs? Today, one can wake up in the morning and decide to use Uber and contract with them on the spot. There is no membership fee to Uber, and I can transact at will and immediately, or not—that’s a spot market transaction. Alternatively, I could enter into a twelve-month lease with an automobile dealer. I don’t own the car but I have the ability to use it at will within certain parameters, such as mileage limits. Finally, I could buy a car and have complete control of that asset. That continuum—from a spot market transaction to a contractual arrangement all the way to ownership of the asset—is the continuum that we all live on for everything we need from another party. Very roughly speaking, this continuum of spot markets (Uber) vs. contracts (car leases) vs. mergers (car ownership) corresponds in the personal relationship setting to Tinder vs. living together vs. marriage.
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The story of General Motors and Fisher Body in the 1910s and 1920s is, for economists, Anna Karenina, Middlemarch, and Jane Eyre all rolled in one—the classic story that explains the nature of flirtation, commitment, marriage, and love.
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By 1919, GM needed Fisher to invest a fair amount to manufacture these new bodies, particularly as open metal bodies (think convertibles or imagine a Model T) were giving way to closed metal bodies. These technological changes in body manufacturing required a change in the relationships between Fisher and GM. Previously, GM was effectively transacting in a spot market for bodies, putting in orders for bodies as they needed them. But, in 1919, GM and Fisher entered into a ten-year contract for buying bodies, and GM bought 60 percent of Fisher, though the Fisher brothers would continue to run their company. The contract had two major provisions—GM committed to buying all of their closed metal bodies from Fisher (an “exclusive dealing” provision), and Fisher guaranteed a price that was their cost of manufacturing and transporting a body, plus a 17.5 percent markup of those costs, or what they were charging for comparable bodies to other auto makers (a “price protection” provision). By the mid-1920s, closed metal bodies were exploding in popularity, far beyond GM’s expectations, as they came to constitute two-thirds of the overall market. And Fisher had a 50 percent market share in the closed bodies market. GM wanted Fisher to build a new dedicated plant closer to GM’s operations in Flint, which would reduce transportation costs and also result in lower average costs, given the much larger scale they could now operate at. But Fisher had no incentive to do that—and in fact liked things as they were. Because of the nature of the price protection provision, they had every reason to keep transportation costs and manufacturing costs high, given the predetermined markup—and GM had to buy from them under the exclusive dealing provision. By 1926, GM decided that the situation was intolerable and merged with Fisher Body, making it into a division.
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This merger happened when their dependence on each other grew so much that it was important to curtail distinct one-sided incentives and to create one entity. For Fisher to take the next leap to a completely relationship-specific investment (a new, dedicated factory for auto bodies right next to GM’s Flint operation) required a level of certainty and commitment that was beyond the scope of a necessarily incomplete contract between two separate parties. That leap, and all the attendant investments it would generate, would create a much larger joint surplus for both parties. But that leap of faith required a merger.
Living the Dream
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As the founder of utilitarianism, he established the idea that social policy should be evaluated by the improvement in human welfare aggregated across all individuals. The simple maxim that “the greatest happiness of the greatest number is the foundation of morals and legislation,” a phrase Bentham attributed to Joseph Priestley, was remarkably radical for its time and still serves as the foundation of much economic and philosophical analysis. Bentham was also the first great defender of the use of credit and the idea of leverage. In his showdown with Adam Smith on lending, they take quite uncharacteristic positions. The typically eloquent exponent of markets (Smith) advocates for limits on markets, while the radical reformer (Bentham) embraces the unfettered market for debt.
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In a series of letters to Smith that were published, provocatively, as a “Defence of Usury,” Bentham decimated Smith’s arguments for limits on interest rates. Bentham pointed out that Smith had overlooked how lenders would have an incentive to select and monitor borrowers to protect their capital.
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Auden concludes that “in The Merchant of Venice, you are free to form the relationships you choose, but your obligations are then enormous.” Debt, it turns out, is about much more than money—it is about the ties that bind.
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So how much leverage should a company take on? The simplest finance answer for firms is that they trade off two contrary impulses—the tax advantages of using debt versus the risk that debt imposes on organizations.
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The central question facing borrowers—how do I access opportunities beyond my current resources?—is analogous to a question that inspires many of us: How do I live the fullest life? Much of what life has to offer requires the help of others. Being married, starting a family, engaging in meaningful friendships, working in organizations, starting a business are all value-generating activities that one simply can’t do alone.
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The parallel between firm leverage decisions and the commitments we take on in life is evident in the stories of two very different artists—George Orwell and Jeff Koons. Orwell’s journey to completing 1984 demonstrates the costs of interdependency and the virtue of a low-leverage life. It’s the story of just how important solitude and independence are to achieving great things—and how important it can be to insulate yourself from the world.
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To write 1984, he knew he had to retreat from the world. He wrote to his friend Arthur Koestler, “Everyone keeps coming at me wanting me to lecture, to write commissioned booklets, to join this and that, etc—you don’t know how I pine to be free of it all and have time to think again.” In 1946, Orwell retreated for several years to the island of Jura in the Scottish Hebrides—a location he described as “extremely ungetatable.” And there he found the recipe for creativity and for the writing of 1984.
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Koons describes himself as “the idea person. I’m not physically involved in the production. I don’t have the necessary abilities, so I go to the top people, whether I’m working with my foundry—Tallix—or in physics.” His large installations require him, as Schjeldahl describes, “to constantly escalate deluxe materials and expert fabrication in his work, with a pattern of selling works in advance in order to secure the cash to execute them, usually in small editions. (Collectors have waited years for their purchases.) The more money he makes, the more he spends, maintaining a Chelsea workshop that employs a staff of a hundred and twenty-five.” Koons characterized the leverage of his production process as “a system to control every gesture as if I did it.”
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As writer Felix Salmon describes, Koons sold work to collectors before he even knew how to build it—thereby turning the traditional business model of artists upside down.
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What kinds of mistakes do people make in levering their lives? Most obviously, they can take on too many commitments and obligations and may not be able to live up to those obligations.
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There exists no more gut-wrenching a portrait of debt overhang—and the shadow of preexisting commitments—in our personal lives than Kazuo Ishiguro’s portrait of Mr. Stevens in The Remains of the Day.
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Leverage is dangerous for two reasons—as we’ll see in the next chapter, it can lead to bankruptcy where the commitments you’ve made become untenable. But the danger of debt overhang is much more general. Negotiating our existing commitments to allow us to take on new ones is the critical life skill that finance highlights. Debt overhang is the manifestation of not being able to renegotiate those commitments to take on new opportunities—and the resulting loss for everyone involved. And Mr. Stevens is the manifestation of the fear that taking on new commitments is inconsistent with preexisting commitments—a belief that leads him to a life of emotional poverty. Fortunately, even if lenders are sometimes too silly to change their expectations, we can renegotiate our commitments—to loved ones, to jobs, to society—when we need to so that we can invest anew. Sometimes, as with Mr. Stevens, fear is the only thing that is stopping us from trying to do so.
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When one of my daughters comes to me at age twenty-four and says she wants to get married and start a family, I’m not sure what I will say. I know in my heart I’ll be thinking that the commitments she is about to undertake will crowd out investment in herself . . . and there will be time later to lever up her life. But then I’ll just think about the possibility of another terminal value and will jump for joy.
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Indeed, the problem of self-control is fundamental for many of us, and the best solution to it, as much research has documented, is to make meaningful commitments to others to ensure that we do the right thing. These commitments might be expensive bets with friends, costly memberships in health clubs, or forced savings plans. Such commitments effectively do the same thing that debt does in the modern corporation—they restrict choice to increase the odds that you’ll do the right thing.
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In offering advice to young people, Thomas Watson, the founder of IBM, said, “Don’t make friends who are comfortable to be with. Make friends who will force you to lever yourself up.” Commitments to smart and demanding people keep us from doing stupid things—we gain from those commitments. Leverage is not a zero-sum game.
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Vaillant’s other main interest is the power of relationships. “It is social aptitude,” he writes, “not intellectual brilliance or parental social class, that leads to successful aging.” Warm connections are necessary—and if not found in a mother or father, they can come from siblings, uncles, friends, mentors. The men’s relationships at age 47, he found, predicted late-life adjustment better than any other variable, except defenses [mechanisms for reacting to adversity]. Good sibling relationships seem especially powerful: 93 percent of the men who were thriving at age 65 had been close to a brother or sister when younger. In an interview in the March 2008 newsletter to the Grant Study subjects, Vaillant was asked, “What have you learned from the Grant Study men?” Vaillant’s response: “That the only thing that really matters in life are your relationships to other people.”
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As a coda, casino magnate Steve Wynn purchased Popeye for $28 million in 2014. Wynn’s father had built a small empire of bingo parlors in Connecticut on leverage. When Wynn was nineteen, his father died more than $300,000 in debt, which led to Wynn dropping out of college. Wynn, undeterred by this trauma, went west to Las Vegas and built an empire of his own, starting with the Golden Nugget, through the savvy use of leverage. Popeye stands today at the entrance of the shopping esplanade of the Wynn Hotel in Las Vegas, the home of dreams fueled by leverage.
Failing Forward
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The first national bankruptcy law, which the young nation had struggled to formulate for ten years, came to pass quickly in 1800, as explained by Bruce Mann, in direct response to Morris’s imprisonment. “That Morris could fall so far was, for many, inconceivable . . . When Congress finally met to take up the bill in December, it did so in the shadow of ‘the great man’ himself, pacing the prison courtyard two blocks away. For the first time the debate was substantive.”
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As one example of this shift, creditors were historically the only ones who could put a debtor into bankruptcy. The 1800 act opened the door to allowing debtors to put themselves in bankruptcy. Today, we take that as a given—companies and individuals can opt for bankruptcy, rather than being chased into declaring it. But until the 1800 act, debtors couldn’t seek protection through bankruptcy—the law had been all about protecting creditors from ruthless and irresponsible debtors.
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This reorientation of the legal attitude toward failure has a deeper resonance. Failure, when we encounter it in ourselves or in others, should not be understood or seen as a moral defect. Inevitably, risk-taking will lead to failure, and failure should be viewed as a bad outcome with an abundance of lessons. Conflating the bad outcomes of risk-taking with a sense of moral failing limits our willingness to take on risks and we lose out on the opportunity to learn from failure. If we punish ourselves for our failures, this is no different than pillorying debtors or placing them in jail.
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His commitment earned him many admirers. The New York Times published an op-ed about Arpey the day after the bankruptcy titled “A CEO’s Moral Stand.”
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The hardest moments in life are about competing duties and obligations and how to navigate them—just as the essence of the bankruptcy decision is how to navigate the competing, and seemingly unsustainable, set of commitments that a company or an individual has made.
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Ultimately, individuals who bought American shares and bonds at the filing made five to ten times their investment in two years. Equity holders who hadn’t sold quickly recouped all their losses. Labor, though, fared worse: estimates suggest that American saved more than $1 billion annually by renegotiating labor contracts. Today, American Airlines is the world’s largest airline. At the time of the bankruptcy filing, American Airlines and US Airways (including their regional airlines) together employed 115,530 people, 100,896 of whom were full-time workers. By the end of 2015, American Airlines (including regional airlines) had grown to 118,831 employees, 102,744 of whom were full-time workers. In 2015, American Airlines reported profits of more than $7 billion, a figure that the CEO claimed was the largest profit ever reported by an airline.
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So, what do these tragic tales of a bankrupt patriot, a failing airline, and a father who sacrifices his daughter tell us about how to live a good life? Nussbaum suggests that the lesson is not to shirk the struggle of competing obligations but to embrace it. In her discussion of Euripides’s Hecuba with Bill Moyers, she distills what it means to live a good life. The story of Hecuba is hardly a story to which one might think to look for inspiration. Hecuba suffers a tremendous fall in grace—losing her husband and transitioning from queen to slave—and reacts with equanimity to her fate. But when she sees that her youngest child has been killed by her friend King Polymestor, to whom Hecuba had entrusted him, all equanimity is gone. She revenges herself on her friend by stabbing him in the eyes and killing his two children. What lesson does this appallingly violent tale teach us? Here is what Nussbaum suggests:
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I think it’s pretty clear that this comes about not because she’s a bad person, but in a sense because she’s a good person, because she has had deep friendships on which she staked her moral life. And so what this play says that is so disturbing, is that the condition of being good is such that it should always be possible for you to be morally destroyed by something that you couldn’t prevent. 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, in circumstances for which you are not yourself to blame. And I think that says something very important about the condition of the ethical life. That it is based on a trust in the uncertain, a willingness to be exposed. It’s based on being more like a plant than like a jewel, something rather fragile, but whose very particular beauty is inseparable from that fragility.
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Returning to American Airlines, Arpey seems to have considered himself a jewel, perfectly resolute with unshakable confidence in how to navigate the future, and a Kantian, with categorical rules of duty. But Nussbaum suggests that, while such absolutism is appealing, in fact it is a cop-out to not acknowledge all the competing obligations and struggle with the hard choices they present. In that sense, Horton may well be the plant struggling with all these competing obligations, wrestling in the muck of a bankruptcy proceeding, to figure out a way through the morass for a struggling airline. Perhaps Horton is the CEO who more fittingly deserved the New York Times op-ed on his “moral stand.”
Why Everyone Hates Finance
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If the ideas of finance are as noble as I’ve made them out to be, why does the impression of finance in the world tend to be so one-dimensional and negative? To take it further, if the ideas of finance are so life-affirming, why does everyone hate it? And what do we do about it?
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The last line of the tale, written by Leo Tolstoy, answers the question that is posed by its title, “How Much Land Does a Man Need?” “Pakhom’s workman picked up the spade, dug a grave for his master—six feet from head to heel, which was exactly the right length—and buried him.”
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The story of insatiable desire in Tolstoy’s tale is a widely held cultural frame on finance. This is particularly true for stories that are explicitly about finance.
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What was Dreiser trying to capture in The Financier? For Dreiser, post–Civil War finance reminded him of the fall of Rome. Dreiser considered Cowperwood’s story, and finance more broadly, as evocative of “the strange, forceful ruthlessness of the human mind when it has freed itself from old faiths and illusions, and has not accepted any new ones. There you get mental action spurred by desire, ambition, vanity, without any of the moderating influences which we are prone to admire—sympathy, tenderness and fair play.” This characterization sounds very much like the way many view finance today.
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But 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.
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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.
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Ultimately, all those attribution errors result in successful people who are susceptible to developing massively outsized egos and appetites.
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O Pioneers!, Willa Cather’s portrait of Alexandra Bergson, is the story that truly belongs in every finance textbook. Alexandra is a first-generation immigrant from Sweden living on the plains of Nebraska, responsible for a family farm and three younger brothers at the turn of the last century. She is a model financier who employs many of the lessons of finance without slipping into the traps that those antiheroes do.
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Alexandra Bergson is our ultimate finance hero. She is a master risk taker who knows how to assess risks through experience and imagination and how to use leverage to change the lives of the people she loves. She values diversification and sees option value, but doesn’t hesitate to make the big decision. She knows how value is created and she knows that she is ultimately only a steward for the capital she is entrusted with. She is filled with forgiveness for those around her who fail, and she knows her success is difficult to attribute to her skill. She is not addicted to risk-taking and does not develop insatiable desires. She remains invested in her deepest relationships with close friends and family.
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There is now a rich literature on recent trends in assortative mating: Greenwood, Jeremy, Nezih Guner, Georgi Kocharkov, and Cezar Santos. Marry Your Like: Assortative Mating and Income Inequality. Working paper no. 19829. National Bureau of Economic Research, January 2014; and Eika, Lasse, Magne Mogstad, and Basit Zafar. Educational Assortative Mating and Household Income Inequality. Working paper no. 20271. National Bureau of Economic Research, July 2014. Journalistic summaries are provided in Bennhold, Katrin. “Equality and the End of Marrying Up.” New York Times, June 12, 2012; Cowen, Tyler. “The Marriages of Power Couples Reinforce Income Inequality.” New York Times, December 24, 2015; Miller, Claire Cain, and Quoctrung Bui. “Equality in Marriages Grows, and So Does Class Divide.” New York Times, February 27, 2016.