The finance industry is highly specialized for a reason – it is inherently complex by nature. There are a multitude of theories and disciplines at play all the time, and choosing one over the other needs to be the result of education and experience. And even that can sometimes go wrong, particularly if you take into account the Global Financial Crisis.
In a recent blog posted to Mawer Investments, Karan Phadke, CFA, global small cap portfolio manager, explores a framework introduced by Oxford Economist John Kay, who argues that other disciplines, like engineering, should be considered in modern financial theory. It is called “Robust and Resilient Finance.”
According to Phadke, Kay argues that modern finance is accident prone due to complexity and interconnectedness as well as a “too big to fail” mentality.
“He posits that much of the fragility that led up to the Global Financial Crisis may have inadvertently been caused by processes initially designed for safety (e.g., complex derivatives initially designed to help hedge exposures) that ultimately created more problems than before because they interacted with other parts of the financial system in unexpected ways,” according to Phadke.
Kay believes that financial experts should learn from the engineering discipline and build systems that are equally as resilient as structures built to withstand stress.
The core principles he believes should be carried over from engineering to finance include:
Simplicity, or having fewer moving parts that interact with each other in a straightforward manner. He provides Steve Jobs’ continued insistence on the usability and functionality of products.
Modularity, in juxtaposition to interconnectedness, means that pieces can be replaced or removed without impacting the whole, similar to Lego blocks.
The third principle he believes should be taken from engineering and utilized in financial investment practices is redundancy. This means that there are alternatives in place in case of failure, even if they might not be ideal during good times, i.e. backup power systems on airplanes, etc.
What all these components should equal is a balancing to the system, a smoothing of edges and while they might not impact predicting, they certainly should help with preparing. His example: carry the umbrella instead of trying to figure out exactly when and how much it will rain.
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