Peter R. Fisher currently teaches The Arrhythmia of Finance, a second-year elective course in the MBA program at the Tuck School of Business at Dartmouth. See below for a course description.
The objective of this course is to provide you the opportunity to develop and practice analytic skills (principally non-quantitative) that can help you better understand the sources of volatility in financial asset prices: why the heartbeat of finance appears to be irregular.
A former student told me that this course is actually about “how to make a decision” and that certainly is an important part. In order to think clearly about finance, to make wise financial decisions, we need to be able to think carefully and probabilistically about any outcome that is beyond our certain knowledge or control. Understanding prospective variance in financial outcomes, however, requires that we bring our knowledge of accounting, corporate finance, capital markets, economics and business strategy simultaneously together with our knowledge of decision making, probability and epistemology. Clear thinking about how to make a decision is just the starting point for exploring how we understand value through finance.
The challenge of expressing value in finance can be approached by thinking carefully about two ideas: balance sheets and risk. Understanding the world through the binoculars of double-entry bookkeeping and appreciating and applying the complex idea of risk each require that we simultaneously consider both positive and negative values and how they are related to one another. To “read a balance sheet” and to “understand your risk” you need to recognize and overcome your cognitive disposition to respond quite differently to apparent gains and losses. Our conventional means of calculating financial values also depend on our expectations, which may or may not be consciously formed and frequently change, and also on our assessment of the future, which is beyond our certain knowledge and control.
The subject matter of this course lies at the intersection of the conventions of finance and the limits of human understanding. The conventions of finance are a means by which we allocate the consequences of economic activity at the limits of our knowledge. Thus, to understand the conventions of finance we need to be aware of the limits of understanding. It also turns out that the conventions of finance provide a foil that can usefully illuminate the limits of understanding.
There are five conventions of finance we will consider: (a) double-entry bookkeeping and balance sheets; (b) discounted cash flow analysis; (c) money; (d) debt; and (e) equity. You have some facility with discounted cash flow analysis and have been introduced to balance sheets. My experience in hiring and training business school graduates, however, is that only a few of you will have already understood the deeper meaning of double-entry bookkeeping as a way to think about the world. It is also my experience that unless each of these five conventions of finance is understood within the limits of understanding then finance itself, and the limits of finance, will not be understood.
The limits of human understanding is a vast subject touched on by philosophy, psychology – particularly cognitive psychology, evolutionary biology, physiology and body chemistry, neuroscience, the study of consciousness and behavioral economics – the latter reflecting the recent discovery by economics of these other disciplines that have long focused on how humans actually think and behave. We will consider just three particular limits to human understanding that are relevant in estimating financial values: (a) the challenges we face in understanding probability and uncertainty; (b) our cognitive biases in responding to apparent gains and losses and how we are differently motivated by each; and (c) time and the difficulty we humans have in being time consistent in our thinking about the past, the present and the future.
Five challenges we face in understanding finance. I see (at least) five important reasons why we are so often surprised by financial outcomes and these provide an overarching structure for the course. Each of these reflect conceptual limitations on our part that can be overcome with effort to reduce the frequency and severity of our surprises.
First, we need to recognize and understand the role of chance and, particularly, to distinguish probability from uncertainty.
Second, we need to understand the central but elusive idea of risk.
Third, we need to recognize the difference between the intrinsic and the exchange (or market) value of an asset and, to do this, we need to be able to estimate intrinsic value through the binoculars of double-entry bookkeeping.
Fourth, we need to recognize the range of likely, unlikely and uncertain outcomes that are reflected in the values we ascribe to all assets and liabilities and, thus, to recognize the resulting volatility mismatches within our economic balance sheets.
Fifth, to overcome the limits of understanding when we estimate financial values (and in life), we need to recognize how frequently we face the challenge of decision making in conditions of uncertainty and to meet this challenge by making the effort to apply reason and doubt to our own beliefs, choices and decisions, especially when we are taking or responding to risk.