The Wisdom of Finance Summary Part 3: On Value

This summary will be over the subject of valuation. I’m putting a part of the last chapter in here because I think it would flow well with the piece I’m attempting to construct. There is some continuity between diversification and valuation because your portfolio has to be organized with value as a factor. Dr.Desai suggests with the example of the capital asset pricing model that the risk and value associated with an investment cannot be determined without comparing the investment to those surrounding it. The volatility of certain securities can be determined by how they behave relative to market conditions, this measure is called the security’s beta. A high beta asset emphasizes a fluctuation in market conditions (for example, if the market goes up 10%, the high beta asset may go up 15%, therefore the beta of the stock is 1.5), a low beta asset will move almost proportionally to your portfolio but won’t emphasize the change in market conditions (any beta below 1.0 is low beta, so if the market shows a 10% change in the negative direction, a lower beta stock will only show a -5% change). Gold can even be a negative beta asset, one which runs opposite to market trends but minimizes risk in the case that the currency goes belly-up. Desai compares these assets to friendships in the sense that your high beta friendships are ones that show when things are going well, and disappear when things go downhill (your professional acquaintances would be high beta) these friends only love you for the utility you provide to them according to Aristotle. Low beta friendships can be seen as more valuable since they still back you up somewhat, but the most valuable relationships are negative beta since they will pull you down if you go too high, and help you get back on your feet when everything is in a downward spiral. This is one of the best correlations between philosophical and financial terms in the entire book, and the decision to use it was nothing short of immaculate literary execution by Desai. 

Desai begins the next chapter with one of my personal favorite Biblical stories, the parable of the talents. The gist of this story is that a master going on a journey leaves his three servants a total of eight talents (a currency back then) , five, two, and one respectively. The servants with five and two doubled their initial gift, while the servant with one went and hid it, only returning what his master initially gave him because he feared the possibility of losing it. Then the master (who can be interpreted as God) takes the only talent the poor servant had and gave it to the servant with ten talents. Then the poorest servant was removed from the kingdom of God. This may sound like a harsh story from the Old Testament, so that you could excuse it away as our backwards thinking at the time, and that the God in the Old Testament was meant to be brutal since that literary piece is often used more for a disciplinary lens of religion. But this parable is right out of the New Testament, and it isn’t trying to show God as brutal after all, God is simply a judge of the highest ideal, that is his function. So God said:

“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”.

In plain English: People who have everything will get more, and from people who have nothing everything will be taken. 

This is the brutal reality of things. When you live in a truly free society, people will utilize their skill sets differently, and those who execute their talents in the best way possible will be the ones who benefit the most. This is why the three richest families in the US have the same net worth as the bottom half of the country. An even more shocking statistic is that 26 of the world’s richest individuals are richer than the bottom 50% of the world’s population. This is the lesson according to Dr.Desai:

“Everyone has been endowed with the talents and gifts; they are distributed unequally; they are incredibly valuable; and, most importantly they should be exercised to their fullest extent”

Because we are each equipped with our own unique gifts and talents, which by nature are distributed unequally, we need to do best with the hand we’re dealt. That’s the only way we can ensure true freedom. Any disruption in this is against the sort of natural order of things. Ultimately, one has to take risks and make decisions in his life. It makes sense to be held accountable for your use of your gifts which otherwise could have been used to provide to the world. The biggest sin of all in my opinion is not using what God gave you. As much as you’d like to say how unfair the world is and how much it is against you and your odds, there are tons of people around the world likely vying for the position that you are currently in. Even if you are the poorest person in the world, if you don’t take on as many responsibilities as you can possibly bear, your chances of getting out of that situation are not improved. Quit depriving the world of all of its potential talent, and go and create something of value with what you have. According to Dr.Desai, the biggest questions in finance are “how is value created, and how should we measure value?”. Well, most value can be measured in credit, after all most of the money in the US is in credit anyway. Your value creation should be beyond the expectations of investors. If the person lending you money expects 10% back and you just make the minimum expectation, you have not created real value. Desai’s formula for value creation is 1. Surpass the expected returns of your capital providers, 2. Surpass the expectations for as long as possible, 3. And grow so that your returns stay higher than your cost of capital. This mentality of providing the best service to a superior is the nature of interdependence in the market and the current state of the economic system. “Make 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.” Now that there is an established understanding of the origin of value itself, assessing the value is only a short step ahead. In terms of valuation, finance’s approach to it isn’t the same as accounting’s. Finance accounts for what balance sheets cannot see like “brands, intellectual property, and user community”. According to Desai, finance is the aspect pertaining only to the future value, and that’s where value is derived from. A great factor in the stock exchange is what people expect the share’s price to be years down the line, since ultimately the price is determined by the supply and demand. Ultimately, the future’s benefits are the values of today. The WACC, or weighted average cost of capital is simply a measure of how well a company will be able to pay off its debts, and it is determined by market predictions, not the balance sheets of the management. A lot of the value we see today is in terminal value, a speculation on what’s going to happen years and years down the line. 

The optimized utilization of wealth and time is the biggest determinant of value, which leads me to believe that finance is an industry relying on mutual trust. It would seem a system like this is only setting itself up to collapse, but the industry persists. In a similar logic to eBay, there is an understanding that the system can only last if my check doesn’t bounce and you don’t send me an empty box. It’s amazing to take a step back and look at society’s gears and cogs shift perfectly with a simple social contract. Every executed order in the finance world is based on speculation, all topped with tons of depth to its analysis. I hold strong opinions when it comes to using your talents properly because it’s responsible for human productivity and quality of life for everyone, not just people wisely using their talents. This section of the book is one of the biggest keys in finance in my opinion, and the importance of analyzing the intangibles can be perfectly understood by reading this chapter. Understanding that a big part of finance is luck in speculation is more humbling than anything. One should know there’s a reason why that very few wealth management firms can consistently outperform market averages, and that it’s extremely difficult to generate value out of only what one can predict.