How can we make better investments?

Investment is an important pillar of the financial system. But how can we assess risk, predict the future and avoid mistakes? If we can do these things successfully, we can make smarter investments that could lead to increased profits. We speak with the economic experts who’ve dedicated themselves to understanding human and market behavior.

What can we learn from the financial crisis?

One of the most well-known economists working today, Nobel Laureate Joseph E. Stiglitz carries his signature moral compass everywhere he goes. So it’s no wonder he takes a big interest in the last 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.

Can recessions be avoided?

Nobel Laureate Christopher A. Sims says that even when fiscal policy is applied, it tends to come too late. He says that when an economy goes into recession, and growth starts to slow, we tend not to realize it’s happened until about six months afterwards – this is because of gaps in the data.

"That’s why we have recessions, because if we knew when they were coming, we could take action to avoid them."

How can the financial sector 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?

Nobel Laureate Myron S. Scholes thinks that technology’s going to play a huge part in defining what ‘trust’ will look and feel like. He also thinks it will shape the future of finance..

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 to a restaurant, we can now access the internet to see people’s ratings.”

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. Aged 24, Nobel Laureate Harry M. Markowitz wrote a paper on 'portfolio selection', which paved the way for his new approach to looking at investment, called ‘Portfolio Theory’, for which he was awarded the prize in Economic Sciences. It says investing can be less risky by choosing investments with different levels of risk – and assessing how they work together as a set. Markowitz explained:

“There’s a trade-off between return on the average in the long run and variability of return, so I worked on the mathematics of risk-return trade-off.”

Markowitz explained that in theory, if you diversify enough, risk will go away. Something he said was true of uncorrelated risks. But the theory doesn’t always work in practice. As a man who’s lived through the Great Depression and many more global financial crises, Markowitz saw that there are also uncorrelated risks, which means a certain level of risk remains.

Why is it so hard to beat the stock market?

Nobel Laureate Paul A. Samuelson ultimately knew that the best economists – and the best models – 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’.

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

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. He believes it’s 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?

As stock markets ‘may go up as well as down,’ Nobel Laureate, Robert M. Solow explored what makes them move. The model he developed is capable of including any number of economic growth factors, like population growth or the availability of natural resources. 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 this wasn’t the case.

“To my surprise, for the US it turned out that 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. Which is 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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The value of investments can go down as well as up. Your capital and income is at risk.

When it comes to my own personal investments, am I losing out?

The world of investing is uncertain, but your financial plans needn’t be. In our Life’s Questions series, we look at how to make investing less intimidating, explaining a complex world with its own language, so you can make the most of it.

"You need to put something at stake in order to get something from life."

Alejandro Zaera-Polo,
Professor of Architecture at Princeton

The value of investments can go down as well as up. Your capital and income is at risk.

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