[{"jcr:title":"Robert Merton's classes at Insper","cq:tags_0":"area-de-conhecimento:economia"},{"richText":"In celebration of the 20th anniversary of our M.Sc. in Economics, we welcomed the 1997 Nobel Prize in Economics. A pioneering figure in finance, Merton continues to pave the way for innovation","authorDate":"26/06/2024 18h35","author":"David A. Cohen","madeBy":"Por","tag":"area-de-conhecimento:economia","title":"Robert Merton's classes at Insper","variant":"imagecolor"},{"jcr:title":"transparente - turquesa - vermelho"},{"themeName":"transparente - turquesa - vermelho"},{"containerType":"containerTwo"},{"jcr:title":"Grid Container Section","layout":"responsiveGrid"},{"text":"“Work hard, play hard.” According to Google’s research site Books Ngram Viewer, this expression began gaining traction in the late 1970s, with its usage exploding around the turn of the millennium. Generally, it is interpreted as advice to dedicate oneself entirely to one’s duties while also remembering to enjoy life to the fullest.   This was not the principle that guided the celebration of the 20th anniversary of Insper’s  M.Sc. in  Economics, which took place on June 4th. Well, at least the first part was – it marked two decades of impressive work: over a thousand students, publishing more than 400 technical or academic articles, participants evolving into an alumni network that includes 135 directors of large companies and 20 vice-presidents, as well as 27 economists (5 of whom are chief economists) at renowned institutions, as its current coordinator, Paulo Sérgio Oliveira Ribeiro, pointed out. But the institution decided to celebrate all of this… with more work.   Perhaps what explains this decision is a conception of work as a mission and as something enjoyable. This, at least, is the perspective of the guest of honor at the celebration, the American economist Robert C. Merton, Nobel Prize in Economics in 1997, professor at MIT’s Sloan Business School, member of the US National Academy of Sciences, and member of the American Academy of Arts and Sciences. “This is a field with technical, mathematical problems, challenging issues; if you solve them, you improve people’s lives and society,” he said in an interview.   With the support of the Brazilian Finance Society, the CFA Society Brazil (an association of holders of the CFA certificate in the country) and the companies Stone, XP and Constância Investimentos, Merton gave two lectures at Insper’s auditorium,  [at noon](https://www.youtube.com/watch?v=UW1h0Ni2E-s)  and in the  [early evening of](https://www.youtube.com/watch?v=1g4Vpu5U0gI)  June 4. Here are some of his key messages:   Main Street, Wall Street   It’s common to hear that there is an opposition between the financial market and the “real” market. This is nonsense. “This is a false dichotomy,” said Merton. The economist Robert Solow (who was his professor, later colleague, and also a Nobel Laureate in Economics) demonstrated that more than population growth and savings, technological progress leads to economic growth. “But if the technological progress created in universities and other centers doesn’t reach the economy, it won’t lead to growth,” says Merton. “It’s the field of finance that allows this technology transition from laboratories to companies and society at large.”   The start of finance   Finance has been around for centuries. However, it was only in the 1950s that it began to be understood as a science, with theories, hypotheses, and data analysis. The starting point is usually identified with a 1952 paper by Harry Markowitz on risk identification, with the idea of portfolio diversification. This was followed by articles on risk analysis and management, asset pricing, derivatives… and by Merton himself, who is at the root of the work of investment banks and hedge funds.   But all this science only had a significant practical application from the 1970s onwards, when the United States and the world experienced the impact of a series of crises: the end of the Bretton Woods agreements, which established a system of fixed exchange rates between currencies; the oil crises at the beginning and end of the decade, the period of American stagflation (double-digit inflation, the highest since the 1920s, accompanied by high unemployment), a lack of mortgage credit; and a decline in stock values.   The response to this set of crises was an explosion of innovations: insurance on the capital market, the futures market, the creation of Nasdaq, the first electronic stock exchange, corporate pension funds, index funds for passive investment, institutional diversification with international assets.   From then on, the pace of financial innovation only increased.   Boosting the real economy   A clear example of how financial innovations enable significant economic gains occurred in the early 1990s with the reunification of Germany. The former East Germany, which had spent decades under communist rule, was severely lagging behind West Germany. To close the gap, production had to be stimulated, and access to new energy sources was needed.   There were then two proposals to bring natural gas into the country. The first was to build a pipeline to import gas from the UK, Netherlands, and Norway. The second was to create a much longer pipeline to Russia. The longer pipeline was five times more expensive, but the Russians would sell the fuel at a fixed price, with payment in German marks (the euro had not yet been created). The first pipeline was much cheaper, but Germany would be subject to a double risk: exchange rate risk (payments would be in dollars) and gas market risk (the price would follow the market value).   In the case of a deal with the Russians, there was, on the other hand, a geopolitical risk (being dependent on a not-so-friendly regime, a hypothesis that came true a decade later) and a risk of not fulfilling the contract.   Faced with this dilemma, a third solution emerged, based on financial calculations made by the investment bank JP Morgan. The offer was a contract in which Germany would build the cheapest pipeline, to northern Europe, and pay the bank half the amount saved by not building the pipeline to Russia. In return, JP Morgan undertook to pay the difference in price every time the market value of a ton of gas exceeded the predetermined value in German marks. In other words, it bought the risk of the first deal.   Precision finance   There are three types of action that make it possible to manage the risk of an investment, says Merton. The first is to diversify your portfolio: the good old recommendation not to put all your eggs in one basket. The second is hedging, an investment in an asset related to the one you already have but which moves in the opposite direction, so that if your bet goes wrong, the loss is mitigated. The third way to contain risks is to take out insurance – giving up part of your expected profit in favor of security.   Normally, said Merton, investors seek for their clients (or themselves) a capital allocation with the best possible Sharpe ratio (i.e. a paper that provides the best return compared to the risk associated with it). But this is not always the best strategy. “It depends on the objectives of the portfolio,” explains the professor.   This is where precision finance comes in, an analogy with precision medicine – which is about replacing a universal remedy with a treatment specific to that patient, aiming for greater efficiency and fewer side effects.   “Let’s say that the investor considers the risk of the portfolio to be too high and wants a guarantee that their return will be, for example, at least 90% of the index that measures inflation.” In this case, says Merton, one solution would be to buy insurance and add it to your diversification mix. You sacrifice a little of the potential gain, but guarantee a minimum return.   “But let’s say that the purpose of the portfolio is to guarantee funds to pay off a future debt,” he continued. In this case, the aim is to guarantee a certain profit in the future. “If the profit is higher than necessary, great, but the extra gain is not essential.” An alternative, then, would be to offer put options on the market for results above a certain level. It’s the opposite of insurance: it puts a ceiling on your profits. The advantage is that this compensates for the price paid to guarantee a return floor (while giving up profits above an established range).   This is one of the directions in which financial innovations are heading: increasingly tying the risk-return curve to the investor’s specific situation.   Allocating risk, not resources   A second trend in financial innovation is in the strategy for allocating a portfolio’s resources. Today, it is common to manage investments with a practice of asset allocation. In general, it is recommended to buy 60% in risky securities, 40% in conservative securities. Or 70% to 30%, or 50% to 50%, depending on your risk appetite (generally defined by “bold”, “moderate”, “conservative” profiles).   However, when an investment gives a good result (the shares you bought in a company rise in value, or the currency devaluation you predicted happens), your share of capital invested in variable income automatically exceeds the set percentage. Then the prevailing recommendation is to rebalance the portfolio, i.e. sell the shares or the currency position, realize the profit and return to the original split between fixed and variable income investments.   “Nobody says this explicitly, but I think the idea behind it is to stabilize the risk of the portfolio,” said Merton in the evening lecture. “It doesn’t make much sense, it would only be right if the risk remained constant, which is almost never the case.”   Instead of stabilizing the allocation of resources, he suggests, it’s better to try to stabilize the risk of the portfolio. “If the volatility of your equity investments decreases, the same level of risk would point to a greater share of them in your portfolio. Calculating risk is never that precise, but doing so can improve the performance of your portfolio.”   To demonstrate the point, Merton presented the case of an investment portfolio between 1993 and 2023. The strategy of stabilizing risk (with an approximate forecast for volatility over the next 30 days) month by month resulted in a 32% lower volatility for the portfolio.   This means that, with the standard asset allocation strategy, you often subject the client to a much lower or much higher risk than they accept. And you’re probably leaving money on the table.   Again, said Merton, these portfolio risk calculation techniques are only in their infancy. “Future innovations will make the forecasts much better.”   The risk-free investment   Merton also proposes innovations for the minimum-risk portion of the investment portfolio. These are even more impactful innovations – not just for the individual or corporate investor, but for society. He proposes a retirement security bond (RSB) that could help create future income for informal sector workers, facilitate infrastructure development in the country and reduce government debt and risk, among other things.   This is a bond with deferred payments, similar to a pension plan. The payments, adjusted according to an index that reflects per capita consumption, protect the investor’s purchasing power when they stop working – assuming that a primary goal for retirement is to guarantee a standard of living similar to that at the end of their working life.   It’s a line that Brazil has begun to follow, with the launch of the National Treasury’s RendA+ program in January last year. “I’m thrilled to say that Brazil is the first country to adopt, completely independently of my suggestions, a plan very similar to the RSB,” said Merton.   The correction of bonds here doesn’t protect against the loss of purchasing power as effectively as Merton would like, and withdrawals have a defined term of 20 years from the date they start (rather than extending to the end of the investor’s life), but this should improve. “This is version 1.0. I hope that in the next iterations of the program it will be improved, to a version 2.0, then 3.0…” he said. “That’s how innovations work, nobody gets everything right the first time.”"}]