How can we make better investments?

Investment is an important pillar of the financial system. But how can we assess risk, predict the future, avoid mistakes, and make smarter, more profitable investments? We speak with the economic experts who’ve dedicated themselves to understanding human and market behavior.

What can we learn from the financial crisis?

Nobel Laureate Joseph E. Stiglitz doesn’t mince his words. As one of the most well-known economists working today, he carries his signature moral compass everywhere he goes. So it’s no wonder he takes a big interest in the recent financial crisis, where he says more could have been done to avoid the worst.

“My theories had explained why it was so important to regulate. And since one of the central problems with the financial market was gathering information, we should not expect the financial sector to work well.”

So Stiglitz at least partly blames the economists whose theories said there was no need for regulations. And while he says there’s no overnight fix, he thinks it is possible to rewrite the rules.

What does the financial sector need to re-establish trust?

Laureate Robert Merton strongly believes that to leave the financial crisis behind us, trust needs to be re-established between the financial sector and the people it serves. He knows this can be done. And it’s to everyone’s benefit that it is:

"If you can create trust, you can create a huge amount of value."

What will trust look like in the future?

Myron S. Scholes thinks that technology’s going to play a huge part in shaping the future of finance, and of trust. Scholes suggests that blockchain technology will revolutionize the way markets work. Instead of trust being invested solely in banks and other institutions, we’ll all become trusted actors in a financial play.

"The trust will come through verification of our transactions, just like when we want to go a restaurant, we can now access the internet to see people’s ratings."

Technology will also speed-up banking processes, "compressing time", which will make it more difficult for anyone to cheat the system.

Can you ever eliminate risk?

"Don’t put all your eggs in one basket," the saying goes. The same, it turns out, applies to investing - although it’s a bit more complicated than that. Nobel Laureate Harry M. Markowitz came up with a pioneering new way to look at investment called 'Portfolio Theory'. It says investing can be less risky by choosing investments with different levels of risk - and assessing how they work together as a set.

"The notion is that if you diversify enough, risk will go away - that is true of uncorrelated risk. But especially one who has lived through the depression, or the stock market crashes, we also have correlated risk…"

And that, he says, always carries a danger.

Why is it so hard to beat the stock market?

Nobel Laureate Paul A. Samuelson’s work appears to agree with Markowitz. When starting out in his career he had a clear vision…

"My dream is to create an economic model that is humane and warm-hearted, but that doesn’t sacrifice efficiency or progress."

Ultimately he knew that the best economics couldn’t rely on mathematics alone. So he used a rigorous scientific approach, which took human and political factors into account too. This produced his 'Efficient Markets Hypothesis', which can be neatly summed up to mean 'it’s very hard to beat the stock market'.

What really influences markets?

Taking Samuelson’s work even further, Nobel Laureate Robert J. Shiller aimed to give “a more truthful account” of how markets work, which ultimately led to his first highly influential paper in 1981. Shiller believes it was wrong to be too rigid when assessing the economy.

In his research, he argues that instead of mathematics, finance and the global economy are actually driven by people’s behavior and thinking.

"[The market is mostly driven by] non-economic things, people’s fears, prejudices, reactions to news-stories, elections and campaigns."

What sparks economic growth?

Though stock markets ‘may go up as well as down,' Nobel Laureate, Robert M. Solow explored what makes them move. When looking into why some economies grow faster than others, he originally thought the answer was the accumulation of capital - the slow process of saving, investing and building infrastructure. But it wasn’t the case.

"[My model] was capable of including as many economic growth factors as you could think of. I could say, well, some countries have faster population growth than others, some have richer natural resources, some countries save and invest more… To my surprise, it turned out for the US, the accumulation of capital wasn’t the most important factor in the American economy’s growth between 1919 and 1949; it was actually the large amount of technological change."

How can we predict the future?

The use of technology can help us predict human and market behavior. In Nobel Laureate Robert F. Engle’s lab, he does just that. They run 60,000 econometric models per day, gathering data from every market in the world. The aim is to examine and prove theories, and explore how volatile markets behave over time.

But there’s a problem with long-term risk. It changes.

That’s why Engle uses stress tests for banks to see how they would perform under particular scenarios, and whether they’d have enough capital.

"How much capital would it take to rescue the entire banking system, in the event of another financial crisis?" Engle smiles. "Today, that number is about $3.5 trillion."

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