Robert Merton was eight years old when he began his entrepreneurial activities. (He created the RCM Savings of Dollars and Cents Company, and collected money from family and friends.) Two years later, he bought his first share of stocks. He was a special kid. So it’s no surprise, he later became one of the most influential researchers in financial economics, generalizing the Black-Scholes formula, which contributed to the rapid development of new financial products and more efficient risk management. Today, he emphasizes how financial markets have made our society better off, and argues that we need to reestablish trust in the financial services industry.
As a PhD student in applied mathematics at Caltech, Robert Merton would get to the local brokerage house every morning at 6.30am for the opening of the New York stock exchange. Before he’d even written his thesis, he realized that things needed to change, and applied to MIT. How did he get into graduate school without ever having taken an economics course? Merton smiles. "You know, I have a favorite phrase. It’s always better to be lucky than smart."
Managing risk efficiently
In the early 1970s, he’d leave his mark in the field by contributing to a pioneering formula for the valuation of stock options. In general, options give the right, but not the obligation, to buy or sell a financial asset in the future at an agreed-upon price. "They give you flexibility, and flexibility is the greatest value when you have uncertainty," Merton explains. But to allow for an appropriate level of risk in market transactions, options have to be correctly valued - which was exactly the problem Merton was working on, as were his colleagues Myron Scholes and Fischer Black.
"At some point, Myron told me the basic idea they had. My first reaction was: That can’t be right." Merton took home his colleagues’ notes. "I came back from the weekend and said: I think you’re right, but it’s much more general than you know." Merton had realized how far-reaching the formula really was and that it could be applied to other financial instruments, such as mortgages and student loans.
"It was a production theory. How we produce all the financial products out there, how we price them, how we figure out their risks." The methodology became widely used by traders and investors. It also laid the foundation for a much broader and more rapid development of derivatives markets. "You could take something you’d never seen before, and you now had a way to attack it," Merton explains.
Get new questions as they launch
Do derivatives threaten the stability of financial markets?
Merton knows that some people think the high number of derivative products today might be superfluous, if not dangerous.
Have derivatives made us safer? That’s not the right question to ask. The question is: have they made us better off? Yes they have
Merton argues, across the globe.
"People say all you need is a simple system. They’ve never been out in the world ‘cause that isn’t true. You need these tools. Because of them we can run systems much more efficiently and effectively." There may be financial instruments suitable for sophisticated investors only. But to Merton, that’s not a good argument against innovation. "If I have someone who says this is too complicated for me to understand, I’d say: If doing this is useful to society, you have two choices: either you try to understand it, or you find someone who can."
What the financial sector needs: trust and competence
Merton emphasizes how both trust and competence are indispensable in financial markets, where you’re likely to face risky situations and where some services, active investing for example, can only be made transparent to a certain degree. "What to put your money in, how much to invest, how often to trade, those decisions are inherently judgmental, therefore inherently opaque."
Fintech - a threat to traditional institutions?
The huge technological developments of our time have had an impact on the financial services industry too. As a result of new financial technology companies (also known as FinTech), processes and products are changing, but Merton seriously doubts that these are going to be huge changes. "Processing is something that Silicon Valley is very good at. But financial services? They talk about computers that will do it for you. Would you do this with your medicine? You wouldn’t take your meds from someone you didn’t know, even if it was delivered to you on your cellphone, very efficiently, 24/7, with the push of a button, here are my symptoms, here it is, boom."
Providing for your own retirement
The father of three knows times are changing fast. As a professor of finance at MIT, he not only keeps a close eye on financial developments, but on his students too. That’s why he also has advice to share when it comes to retirement savings: "If you’ve got the benefit of living longer than your parents, and you want the same standard of living, you’ve got to work longer." But that doesn’t mean young people should worry too much. "They need to understand that there are limits like that. And that there are a lot of good ways that we can do better at saving for retirement."