The Wisdom of Finance Book Summary

Wow, this was easily the best book I've read all year. Mihir Desai is simply a phenomenal writer and thought leader. In The Wisdom of Finance, Desai uses principles and practices from the finance industry to explain how they relate and apply to every day life. If you haven't already, read my last Book Summary, "How Finance Works ", also written by Desai.?

My Top 5 Takeaways

#1 Humans are natural risk calculators and use different forms of insurance to pool/mitigate risk.

For most of human history, people have used different forms of insurance to protect themselves from the possibility of disaster. Historically, the family was the primary vehicle used for mitigating risk. If someone didn’t have a place to stay, the family opened their doors until they got back on their feet. If a family member got too old to work, they lived with a relative.

Today, in addition to the family, we use different forms of for-profit insurance to help mitigate similar risks. We use life insurance to cover the possibility you’re unable to work due to a sickness or injury. We use retirement plans like 401ks to mitigate the risk of not having enough to retire.?

But insurance is not new. I was fascinated to learn Christopher Columbus had an insurance policy for his ships and items he sailed with across the Atlantic to the Americas. This policy was expensive due to the high-risk and unknowns related to the voyage.

Finance professionals mitigate exposure to risk by diversifying their stock portfolio. Business owners mitigate risk to their corporation by diversifying their customer base. All these strategies are forms of insurance against the possibility of disaster.

Key takeaway:?

Insurance premiums are always a function of risk. Humans decrease exposure to risk by pooling resources with others engaging in the same activity. Similarly, finance and business professionals evaluate risk. They mitigate it by diversifying their sources of revenue. Insurance is generally a good idea for medium to high -risk activities.

The pooling of risks is a natural human impulse, as these risks - for example, how will my family survive if I can’t work to provide income? - are too burdensome for most individuals to bear alone. - Mihir Desai

#2 Create value or be banished, saith the Lord

In finance, value creation is the measuring stick money managers are judged on. Not only must value be created, it must exceed the cost of capital incurred for lending it. What does this mean? Lenders have many options for where they invest their money. They can invest it in the stock market, real-estate, individual companies, government bonds, gold, etc. Lenders generally want the highest possible return on their investment.?

Smart lenders evaluate the risk associated? with each investment type along with the projected returns. Ultimately they choose the investment option with a risk they’re comfortable with and which has the highest potential for return. The opportunity cost for capital is linked to the return they could’ve generated had they invested their funds elsewhere.

When analyzing the performance of money managers investment decisions, their performance is compared with the opportunities missed out on. For example, if an investor puts his money in a business projected to return 20%, yet instead, it returns 8%, one may think, “that’s still pretty good”. At least they made some money. However, when compared to the 10-12% generated by a generic S&P 500 Index Fund, the investor missed an opportunity to get a higher return. This is unacceptable.

Desai uses a story from the Bible to illustrate this point. The parable of the talents. In the story, Jesus described 3 men. Each of which received money according to their ability and stature. The first two men used innovative ways to grow the money they were lent and provided their master a return on his investment. The third, out of fear of losing money, simply hid his in the ground and returned the same funds provided back to his master. The master responded saying:

?‘You wicked and slothful servant! You knew that I reap where I have not sown and gather where I scattered no seed? Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest. So take the talent from him and give it to him who has the ten talents. For to 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 cast the worthless servant into the outer darkness. In that place there will be weeping and gnashing of teeth.’ - Matt 25:26-30

?Not only was he banished, the little he had was taken and given to the individual who grew the money more effectively. The same phenomenon happens in the stock market. When companies fail to meet investor’s expectations. Investors take their money elsewhere. Investors expect companies in their portfolio to exceed the S&P 500’s return every year. The logic being, “I could’ve made more money, with less risk, elsewhere”.

Key Takeaway:

When using money lent from others, work to surpass their expectations of return. Surpass expectations for as long as you can. Make the most out of what you’ve been given.

#3 Are you the Principal or Agent in your life?

"The principal–agent problem refers to the conflict in interests and priorities that arises when one person or entity (the "agent") takes actions on behalf of another person or entity (the "principal").

Common examples of this relationship include corporate management (agent) and shareholders (principal), elected officials (agent) and citizens (principal), or brokers (agent) and markets (buyers and sellers, principals).In all these cases, the principal has to be concerned with whether the agent is acting in the best interest of the principal."

Desai uses the principal agent problem to pose a question to readers. Are you the principal or agent in your personal life? Meaning, are you acting on behalf of your own desires and aspirations? Or, are you pursuing the interests others have given to you? Few people are principals of their own lives. Most are agents on behalf of childhood guidance and sometimes trauma never confronted.

Key Takeaway: Evaluate whether you are the principal or agent in your life. Live your life on purpose.

…our childhood experiences end up serving as the hidden principals whom we end out serving whether we know it or not. - Mihir Desai

Life is, in part, about challenging what is expected of us and given to us in order to find ourselves. - Mihir Desai

#4 You are not your failures. Bankruptcy law.

During medieval times, business owners unable to pay their debt to debtors went to debtors prison. That’s right, if a business filed for bankruptcy, the business owner would be sentenced to prison. In those times, it was a moral issue. Those who failed to pay their debts on time were deemed untrustworthy, thieves, or corrupt. Your morality and reputation was tied to your ability to make good on your debt.

Eventually, societies realized this isn’t the best approach. Bankruptcy law and limited liability corporations helped to ensure business owners wouldn’t be subjected to debtor’s prison if bankruptcy occurs. This allowed owners to take on more risk with less fear of failure. Societies came to the conclusion our morality is not tied to our business failures, except of course for extreme gross negligence. If a business underperforms and is unable to meet their lender commitments, bankruptcy is an option that gives shareholders the opportunity to regain some of their losses.

Key Takeaway:?

In life, you are not morally tied to your past failures. When you fail, use it as an opportunity to learn and grow.

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. - Mihir Desai

#5 Leverage a life worth living

Leverage or the use of debt to finance a business, plays a crucial role in our financial ecosystem. Many businesses that exist today would not if it weren’t for the ability to access capital to fund operations. It takes time to build a profitable business. Without leverage, you growth is severely limited, unless you have a lot of cash (most people don’t).

Some people see debt as extremely negative. They fear their inability to service/meet the minimum payments required by the lender. This is a valid concern. Highly leveraged companies often go out of business due to their inability to pay. Yet companies with little to no leverage miss out on opportunities to grow. There’s a balance. Analysts use debt to equity or debt to income ratios to determine a person’s ability to service their debt.

Desai makes the point that many of life’s greatest opportunities are not achievable without leverage. For example, owning a home. If everyone was forced to only live in a home they could buy with cash, few people would have homes. Mortgages are leverage. Business owners use funding from banks and venture capital to fund their business. Startup capital is leverage. Student loans are also a form of leverage. All leverage is not bad. However, if you use debt to finance a future investment like education, be sure you will get a return greater than the cost of the capital you borrowed.

The book cover is a depiction of a man using an actual lever to move a boulder. A boulder he would otherwise be unable to move without the lever. A good illustration of how leverage is used to accomplish goals otherwise unattainable without it.

Key Takeaway:?

Don’t be afraid to use leverage. All debt is not bad. To make a large impact, oftentimes leverage is required. Perform a rigorous evaluation on whether or not you can beat the cost of using that capital. And remember, we must exceed the lender’s expectations.

Thanks for reading this edition of Waller’s Reading Room! If you enjoyed it or have thoughts, you can reply directly to this email and let me know. Don’t forget, I’m always taking recommendations, let me know what I should read next.

Waller’s Reading Room Rating (W3R) for this book:

Purpose/Persuasiveness - Did the author convince me to adopt his/her point of view? - 5 out of 5 stars

Clarity/Conciseness - Does the author have well thought out and clearly articulated ideas without a bunch of fluff? - 5 out of 5 stars

Ideas/creativity - Does the author have a unique perspective and convey the message creatively? - 5 out of 5 stars

Total: 5 Stars

Purchase The Wisdom of Finance: https://amzn.to/3MmVCZq

Yours Truly,

Omar Waller