Chapter 4: Robert C. Merton: “Risk Is Not an Add-On”

Ø Robert C. Merton (Samuelson’s most famous protégé) has in many ways left theory behind: That job is done.

Ø Merton: “The power of Capital Ideas is the way it cuts through to the core – asset pricing and the role of risk. Wonderful things! You can be comfortable with these abstractions because of their power. They can tell you a lot without any reference to institutional elements.”

Ø These ideas all have risk at their core. Risk is not an add-on; it permeates the whole body of thought.

Ø Merton believes the kinds of flaws in the literature on Behavioral Finance are similar in nature to the flaws in the neoclassical theories because so much of the behavioral material also assumes an atomistic market of individuals.

Ø Merton emphasizes that form follows function. The novel institutional impulses (i.e., computerized trading, new instrument, global interlocks and etc) do not change the theory of finance, but they do extend its range of applications in revolutionary fashion. These changes in both form and function are among the most powerful forces shaping the evolution of Capital Ideas.

Ø Just as Behavioral Finance exposes alpha opportunities, so the fluidity of institutional structures and functions has profound implications for how markets work, how investors behave, how investors should behave, and where we should look for improvements and enhancements to what we see around us today.

Ø Essential role of institutions à the functions can actually change the form of the whole investment process.

Ø Merton is convinced that innovations developed by profit-seeking institutions, like mutual funds and insurance companies, can mitigate and even overcome the behavioral anomalies and market inefficiencies created by individual investors in the real world.

Ø The continuous process of institutional creativity is what leads to change and dynamics. At the forefront of those developments are the derivatives markets.

Ø The task now is to go back to the ideas, see how they work in an institutional setting, and and find out how we can do it better.

Ø Merton: “You can move from the unrealistic world of theory in which everybody agrees about asset prices and risks to the real world in which everybody agrees to use institutions.”

Ø To Merton, option markets are the crown jewels of the whole system, because derivative instruments have greatly expanded opportunities for risk sharing, have lowered transaction costs, and have reduced info and agency costs.

Ø Merton’s overriding vision is right there: The process has no borders. It need not stop, and will not stop, in any area of finance. As the process advances, today’s anomalies will shrink under the pressure of institutional competition, new technologies, and the inexorable decline in transaction costs. And then, as pointed out earlier, “the predictions of the neoclassical model [Capital Ideas] will be approximately valid for asset prices and resource allocation.”

Ø Anomalies in Taiwan stock market (late 1990s), here, institutions have been the clear winners, and unsophisticated investors are the clear losers.

Ø Daniel Kahneman: “It is quite remarkable that you have those individuals losing money, and there seems to be an endless supply of individuals, because this is not a transitory phenomenon. So the equilibrium is a very strange equilibrium that seems to exist out there.”

Ø In time, one would expect individuals to figure out what is happening to them. Then these investors would give up trying to manage their own money and would transfer their funds to institutional investors to invest for them.

As a result, competition among institutional investors in the Taiwan market would become more intense, and beating the market would become more difficult as the anomalies of the individual investors disappear.