How Does Financial Invention Manage Risk in Society?

TL;DR

Finance works like engineering: it invents devices that solve problems and help people manage big risks while maintaining incentives. Because these inventions are run by imperfect humans, psychology and behavioral finance are fundamental to designing them well. Since 1970, finance has transformed, adding options exchanges, financial futures, and swaps.

Transcript

good morning. Today I decided not to use PowerPoint, I'm using index cards. This is traditional lecture style. I want to talk today about -- this is our third lecture for financial markets. I wanted to talk today about invention in finance. I think of finance, I don't know whether this will encourage you to be interested or not, but I think of it a... Read More

Key Insights

• Finance is a form of engineering: it is all about inventions, devices that solve problems and help people get on with their purposes in life, built from many small details like the parts of an airplane.
• Engineering requires a human element because devices are run by imperfect people. Engineering schools teach Human Factors Engineering, designing machines so human beings won't mess up when using them, which connects finance to psychology.
• The fundamental problem financial inventions address is maintaining incentives in the face of risk. Inventions are examined for how they solve this risk problem across society.
• Return on an investment has two components: capital gains, the increase in the price of the investment, and the dividend, which arrives separately as a check or electronic entry.
• The central limit theorem states that averages of independent, identically distributed random variables with finite variance converge to the normal distribution, which is why the bell-shaped curve fits so many things observed in nature.
• The normal distribution has thin tails that drop off fast, so after two to four standard deviations the probability is essentially zero, meaning it fails to account for the big outliers that appear in finance.
• The 2007 financial crisis relates to people's failure to understand the limits of the independence assumption and the normal distribution, especially their failure to consider outliers.
• Finance has changed dramatically since 1970, when there were no options exchanges, no financial futures, no swaps, and no electronic trading. Trading was done by word of mouth on exchange floors.

Questions & Answers

Q: Why does Professor Shiller describe finance as a form of engineering?

Shiller thinks of finance as engineering because it is all about inventions, devices that solve problems and help people do things and get on with their purposes in life. Like an airplane made of many parts worked on by many people, financial inventions have many small details and are so complicated you might doubt they work, but somehow they do. This framing sets up the lecture's focus on financial invention.

Q: What is Human Factors Engineering and why does it matter in finance?

Human Factors Engineering is a course taught in engineering schools about designing machines so human beings won't mess up when they try to use them. It matters in finance because engineers know their devices will be run by people, and people are imperfect. This human element connects engineering to psychology and, in finance, to behavioral finance, which Shiller calls fundamental to the inventive side of finance.

Q: What are the two components of the return on an investment?

The return on an investment has two components. The first is capital gains, which is the increase in the price of the investment. The second is the dividend, which comes separately in the form of a check or an electronic entry. Together these make up the total return an investor earns, a concept reviewed from the previous lecture on probability theory and its applications to finance.

Q: What does the central limit theorem say about averages?

The central limit theorem states that if you have independent, identically distributed random variables that all share the same distribution and have finite variance, then the distribution of their average converges to the normal distribution as the number of elements increases. In other words, averages are approximately normally distributed. This explains why the bell-shaped curve works so well, since many things observed in nature are averages or sums of many effects.

Q: Why does the normal distribution fail to predict financial crises?

The normal distribution has thin tails that drop off really fast, so after two, three, or four standard deviations the probability is basically zero that an extreme event will occur. It does not have fat tails. But in finance, big outliers appear from time to time. The central limit theorem assumes finite variance, an assumption that may be wrong, which is why the normal distribution fails to anticipate crises.

Q: How was the 2007 financial crisis related to probability assumptions?

The financial crisis that enveloped the world starting around 2007 seems to be related to people's failure to understand the limits of the independence assumption they were making, and to the limits of the normal distribution, namely their failure to consider outliers. Investors assumed returns behaved independently and followed a thin-tailed bell curve, but reality can surprise you with correlated events and fat tails, and that is when crises occur.

Q: Who first developed the theory of fat-tailed distributions?

The theory of fat-tailed distributions was first developed by Paul Pierre Levy, a mathematician who lived from 1886 to 1971 and worked at the Ecole Polytechnique in France. Shiller corrected himself, noting he had earlier credited Benoit Mandelbrot, but Mandelbrot was actually Levy's student. Both are among the great mathematicians of the twentieth century, and knowledge of fat tails passed by word of mouth from Levy to Mandelbrot.

Q: How has finance changed since 1970?

Since 1970, roughly 40 years before the lecture, finance has changed dramatically. In 1970 there were no options exchanges, though options existed they were not traded on any exchange. There were no financial futures and no swaps. There was also no electronic trading; people traded by word of mouth, meeting on exchange floors to shout and talk, using telephones, words, and writing on paper. The proliferation of financial instruments since then is stunning.

Summary & Key Takeaways

• Professor Shiller frames finance as engineering, a discipline of inventions and devices that solve problems and help people pursue their purposes. Like an airplane's many parts, financial systems are complex yet work, and they require a human element because imperfect people operate them, linking finance directly to psychology.

• The lecture reviews probability theory: return as capital gains plus dividends, random variables, central tendency, variance, covariance, correlation, and regression separating market risk from idiosyncratic risk. The central limit theorem explains why the bell-shaped curve appears so often, since many observed quantities are averages of many effects.

• The normal distribution's thin tails ignore outliers, and the central limit theorem fails when underlying variables have infinite variance. Fat-tailed distributions, first developed by Paul Pierre Levy and passed to Benoit Mandelbrot, explain crises. Since 1970 finance added options exchanges, futures, and swaps, transforming the field.