In December 2014 State Street published a thoughtful white paper titled Folklore of Finance, that drove home the idea that there is a need to change the way we approach investment decision making, especially in asset allocation and wealth management.
Trying to create a new folklore of finance may seem like a daunting task and a bar that is set impossibly high. The reality is that we can simplify investing by combining large and small ideas in four distinct yet interconnected fields – finance, technology, behavior and design.
Combining disciplines to create a new folklore of finance
Finance:
- Viewing life as a series of discounted cash flows provides a framework for making decisions
- Option theory and statistics can clarify payoffs when cash flows, returns and discount rates are probabilistic
- Outcomes should drive investment decisions
At its very basic level, investing is about making trade-offs. You give capital today with the expectation of getting it back at some point in the future (hopefully with some return). That is why cash flows, their timing and the uncertainty/risk associated with them form the basis of any financial decision.
There is a trade-off when you sell one stream of future cash flows for another, and a framework that helps you allocate across these competing demands provides a foundation to build an investment methodology upon. [Read more…]
Technology:
you can use basic off-the-shelf technology to dramatically improve your current processes, or you can also use it to transform the way you do business.
- Cloud, APIs and open source provide tools to dramatically increase productivity at a fraction of current technology costs
- Data, and the ease and speed of accessing, linking and analyzing information can improve the quality of decision making
- There is a need for people who can apply these tools to improve asset management
There has been a lot written about how technology, “fintech”, cloud, etc. is changing the world and I won’t repeat that here. The key observation is that we are at a point where technology can easily improve the way you work not just incrementally, but exponentially. Ashby Monk at Stanford introduced the term “invest-tech” in an interesting article and its worth reflecting upon what that means for asset allocators and asset managers.
What excites me is that you can use technology to travel in two equally helpful directions – you can use basic off-the-shelf technology to dramatically improve your current processes, or you can also use it to transform the way you do business. [Read more…]
Behavior:
“when making decisions there are the right reasons and then there are the real reasons” – J.P.Morgan
- Don’t be fooled by randomness
- Human beings are predictability irrational
- Understand the difference between thinking fast and slow
While not exactly famous for his insights in behavioral economics, J.P. Morgan had observed “when making decisions there are the right reasons and then there are the real reasons”. Understanding the real reasons can open up a completely different way of approaching investment decisions. [Read more …]
Design:
- Improving the interface is probably the most important driver of value creation
- Data visualization and improving clarity of presentation can lead to better decisions
- Investment processes can learn from design methods such as agile, Kaizen, etc.
Investing comes with complexity. But to help more people invest better, we don’t need them to understand complexity, we need to design solutions to help individuals and institutions look at investing from their personal viewpoint. For individuals, its about designing interfaces and experiences that connect with their lives, and not excel spreadsheets. With institutional investors, its about fitting investment solutions around their objectives, and not around arbitrary asset benchmarks. For financial analysts, its about providing them with productivity tools that fit within their workflow, and make information accessible easily. [Read more…]
In further articles, I shall try to explore each of these aspects and provide examples of how the interaction of these themes can lead to better investment decisions – or at least help us recognize the limits to our existing processes.