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How alpha, beta, gamma can solve my retirement problem

How alpha, beta, gamma can solve my retirement problem
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First Published: Wed, Apr 20 2011. 01 10 AM IST
Updated: Sat, Jul 02 2011. 02 46 PM IST
It was a particularly dense afternoon. Not only was the August humidity making the lecture theatre of the Delhi School of Economics seem like it was hanging in limbo, but the long strings of equations with tiny symbols alpha, beta, gamma and the sponge-like creature epsilon, made the lemonade stall just 50 steps away seem like a very aspirational place to be. Twenty years ago, air conditioners were for the super rich and not postgraduate Delhi University students. As I squinted dully at the board far away and frowned to open the shutting eyelids, I swore never to come back to something so far removed from reality. Here were guys who assumed a perfect world with fully rational players and then made equations that sought to solve macro problems. But the real world outside was chaotic and all the long equations (with the aspirational QED at the end) were not teaching me anything that was closely related to the real world as I saw it.
Both economics as a dismal science and me as a student of pure theory have come some distance. Economics has got more human with the coming of age of the marriage of psychology, neurology, finance and economics in what is called behavioural finance. And I think I have learnt to appreciate the longer-term benefits of pure theory. But nothing prepared me for the one-hour video that I watched this Sunday night. It was that desire to tank up on some pure abstract theory that I clicked the link (http://mitworld.mit.edu/video/881) tweeted by another finance junkie. It promised to tell what the future of finance was going to be. The speaker? None other than the controversial father of structured finance, Robert C. Merton, who was lecturing in January earlier this year at the Massachusetts Institute of Technology where he now teaches. Remembering that Merton won his Nobel for the famous Black-Scholes-Merton model and was one of the directors at hedge fund Long Term Capital Management that lost $4.6 billion in less than four months in 1998 before imploding, I gathered all attention for a heavy one hour of derivative-laced talk that would construct the future in complex equations with plenty of stuff that would go way above my head. I almost fell off my chair, when after 10 minutes of navel gazing about the 2008 crisis, Merton identified using financial engineering to solve real problems as where the future of finance lay. The live case study he used was how financial engineering will solve the problem of funding the retirement of individuals. Most of that hour can be best described as a serious financial planning class.
The attention of rock star academics to solving individual problems is good news for us in our avatars as consumers of financial products. Not enough attention has gone into academic work in looking at the world from the point of view of the individual or in attempting to solve their problems. The assumption has been that an efficient market will make everybody maximize his individual utility. But the world is not so neat and the chaos caused by asymmetrical information, human greed and loss aversion makes individuals take sub-optimal decisions. There is a need to look at the world from the point of view of the individual and offer choices that she can understand. Just try buying a financial product in India today and you will know what you are up against. Not only do you need to know the workings of an Excel sheet, you should be smart enough to decode complex documents that can go on to a 100 pages of jargon-filled fine text. Merton envisages a simpler world in his live case study. All the mathematics and complexity is under the bonnet. The individual has to choose between one of three options to get a fully funded retirement. One, he can save more. Two, he can work longer. Three, he can take more risk. His model looks at designing a “software-based tool for ordinary people, simple on the user end, complex on the provider end, which would serve as a next generation pension solution, offering a way to manipulate the key variables in retirement income and demonstrate potential financial outcomes”. The end user is the person not served by an adviser but the mass of do-it-yourself individuals.
I would look at Merton’s live case study as the beginning of more enquiries into the subject of making finance and economics work for the individual. For example, the question that I would like to find an answer to is this: How do you use incentives to make the seller of a retail financial product fully invested in the financial well-being of the buyer? Or, as a friend puts it: How do you incentivize honesty in the financial sector? Write to me if you have thoughts on this.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and can be reached at expenseaccount@livemint.com
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First Published: Wed, Apr 20 2011. 01 10 AM IST