The future of finance: Stephen M. Schaefer

Finance was a relatively new field when you first came to London Business School. What was it like back then?

It was at a fledgling state; in fact, at the School 'finance' meant Dick Brealey and Harold Rose and it was Harold who established the Institute of Finance and Accounting, the School‘s first research centre.

It was a time when modern portfolio theory (which was first explored by Harry Markowitz back in the 1950s) was becoming a big deal. My estimate is that, in the UK there were one-and-a-half to two people who truly understood what this was all about, of whom one was Dick. There was just nobody else.

Wasn’t finance theory at that time coming out of the States?

Completely, yes — but keep in mind that also at the time, there were far fewer schools doing research and developing financial theories. There were, perhaps, a half dozen or one two more, including MIT, Chicago, Stanford, Berkeley, Wharton and Carnegie Mellon.

You went to the States yourself at that point, didn’t you?

Yes, after hanging around the School quite a bit and having nearly finished my PhD, I spent a year in the States. Then I came back here. Not long thereafter, I left again to go to Stanford, where I stayed for three years before coming back. I explored the field of finance by exploring a lot of geography.

Did your travel experiences change your thinking about finance or about London Business School?

It all had a huge impact because, first of all, London Business School was still very small: so being in large, very well established and high quality institutions such as Chicago and Stanford was just fantastic. It also allowed me to meet a large number of the people who were doing research in finance and this turned out to be very helpful. In some ways, it was something of a 'golden age' of financial research.

Better than now?

I actually think that this is a much better time to be studying finance. In fact, I gave a talk recently to a conference organised by the CFA Institute and, in response to a question, I think I said — I hope they weren't too offended —that the field of finance had finally 'grown up'.

That had to have been provocative. What did you mean?

In those early days, many people in business schools had a rather unsophisticated understanding of some of the issues in the real world and markets. This didn‘t apply to Dick Brealey who actually had a lot of practical experience — so he was coming to the field with a hands-on sensibility. But at the same time people in the real world at that time didn‘t measure anything, so they would make statements – for example about the performance of investment funds – that were completely counterfactual but with complete conviction.

Dick used to run courses on portfolio theory and people from the City would sit in, not because they believed a word of it but because they enjoyed it. What he was providing was a week of intellectual stimulation, a week when people could talk about the world they knew but from an entirely different perspective.

Today, there are many more people in the industry who have had some form of formal training in finance; they have had exposure to the key ideas are and they measure things in ways that are closer to the way things are done in research. So there can be much more constructive debate about what is happening in the markets. And I think academics also understand much better the ways in which actual markets deviate from the useful but abstract theories that we talk about.

This closer debate between theory and practice is also reflected in our teaching. We tell students how important it is to not only think about finance conceptually but also how to apply concepts to reality. The objective is to provide a balance between developing, on one hand, a sound conceptual framework and, on the other, market understanding and insight. We regard both as essential to the informed practitioner. All of this is what I mean when I say that the field has 'grown up'.

But despite the fact that the level of financial knowledge and awareness and training has never been higher than it is today, we have a serious financial crisis. Does that mean that we need more financial training — or less?

I think there are a many lessons to be drawn from the financial crisis. For example, one of my particular areas of interest is fixed income markets; and one of the things that we learned from the crisis is that there are risk exposures in some of these markets, that have some of the characteristics of earthquake insurance: most of the time nothing happens and then, very occasionally, something awful happens. The interesting thing is that it seems that you could actually detect some of those exposures before the crisis.

Did you actually predict the current crisis?

No. Being able to measure risk is not the same as saying you can predict a crisis to come. The distinction is between telling someone that – though they don‘t realise it – they are in the business of writing earthquake insurance versus predicting when an earthquake will occur. The first is difficult but doable up to a point; the second is much more difficult or not doable at all.

Can you provide an example that contrasts ‘measuring’ versus ‘predicting’?

Much of my recent academic research has studied the world of corporate bonds. Between 2003–2007, for example, I worked on a paper with Ilya A. Strebulaev of Stanford titled 'Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds' in which we said, 'It is well known that structural models of credit risk provide poor predictions of bond prices. We show that, despite this, they provide quite accurate predictions of the sensitivity of corporate bond returns to changes in the value of equity (hedge ratios). This is important since it suggests that the poor performance of structural models may have more to do with the influence of non-credit factors rather than their failure to capture the credit exposure of corporate debt.' The point of the paper was to show that the relation between the prices corporate debt and equity is predictable even though the prices of both are unpredictable.

Has the evolution of the field of finance actually changed the way executives manage companies?

So much of what we do in finance has to be translated in order to impact the so-called real world. In this regard, I really admire Dick Brealey, whom I believe deserves a lot of credit for making our field 'public'. He has this fantastic ability to communicate research ideas, and he did two things that I think had a really big impact. One is he wrote (obviously very early on, in the late 60s) a book that brought together portfolio theory and efficient market theory at a readable level, so intelligent people who were not wizards in finance could grasp the essential ideas. An Introduction to Risk and Return from Common Stocks is now a classic. So, yes, I believe efforts like this demonstrate that finance can affect the way people both invest in and manage companies. His book had a big impact because it brought these ideas out to an audience that would never have encountered them on their own.

What about his textbook?

That‘s had a huge impact. Principles of Corporate Finance, which he co-authored with Stewart Myers of MIT, is the leading textbook in our field and has been since the early 1980s. I used rough drafts of his book early in my career in the mid-1970s. Why? Well, as in his earlier book Risk & Return Dick is able to describe important ideas with complete clarity while not compromising on the logic. Many books – even some quite good books – end up falling short on one of these objectives but Dick and Stew‘s book doesn‘t.

You know, John Maynard Keynes, who died some 60 years ago, once made a comment (and let‘s remember that he was the leading economist of his time) that 'practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist'. He was on the mark as usual: a huge amount of what people actually do on a day-to-day basis is dictated (or at least, influenced) by someone else‘s ideas, their theorising or thinking about the world. Very little ever gets really resolved by empirical evidence alone, so at the end of the day, what people actually do is very much influenced by theory.

Can you think of an example to illustrate that point?

A really good example of that is the 'efficient markets' idea. When Eugene Fama came up with the concept in the 1960s, he essentially said that no investor could beat the stock market because every stock price reflected all relevant information, bundled as it were: the price of a stock right now reflects, by this theory, what everyone thinks knows it. What made this idea so controversial is that it said that people looking for undervalued, ?bargain? stocks were wasting their time.

Now this concept has been debated for some 40 years, and all this debate has not really resolved the issue. Academicians looking at the performance of mutual funds, hedge funds and pension funds have one view; practitioners often take a different point of view. The point to observe is that the idea of efficient markets is still driving people‘s behaviour in one way or another. Intellectual pioneers do leave a legacy, and it often shows in what you or I do on a daily basis. This is true not only in investing, but in how managers allocate resources inside a corporation in order to maximise the chance of making profits.