I have been wondering about the role of trust in modern finance. To judge by the academic literature and the dominant rules and formulas, it has no role whatsoever. I find that paradoxical, to say the least, because trust is inseparable from participating in modern society. Everyday we make judgments, including economic and financial ones, based primarily if not exclusively on trust, as opposed to a calculation of odds, risks and rewards, costs and benefits. Academics refer to these daily challenges as exercises in “decision making under conditions of uncertainty.” Modern finance tries (and has failed) to quantify that decision-making down to the third decimal point in a system of rational actors maximizing utility in a context of economic equilibrium (where everything adds up). In recent decades, behavioral finance came along to suggest that most decision making is actually quite poor, but it has not offered up a meaningful alternative model of finance or economic behavior to replace the orthodox model.
I come back to this paradox over and over again in my own work. I ended a prior book with Merton Miller’s famous 1986 dismissal of the human being from modern finance. I quote it again at the very beginning of my current project on the stock market: Miller noted that individual investors not aware of the “science” of finance may view their stocks as “more than just the abstract ‘bundles of returns’ of our economic models. Behind each holding may be a story of family business, family quarrels, legacies received, divorce settlements, and a host of other considerations, almost totally irrelevant to our theories of portfolio selection. That we abstract from all these stories in building our models is not because the stories are uninteresting but because they may be too interesting and thereby distract us from the pervasive market forces that should be our principal concern.” [1] This is not just wrong, but utterly wrong, profoundly wrong.
The same is true in my day job. According to the current academic rules, clients are looking for alpha. Yet, over and over again, clients and would-be clients make it clear to me that I have been hired or my advice sought out not because of any guarantee of outcome, but because, to put it simply, they trust me to do as best as I can to achieve a certain goal. And that goal is often not alpha at all, but just doing what I say I will do as transparently as possible.
Trust goes far beyond making investment decisions. It is central to almost every decision we make: Where to go to school, where to send our children to school, whom to wed, whom to work for, choosing doctors, contractors and just about everyone with whom we associate. We can never know for certain whether we are making the right decision pre factum. Certain observers will suggest that the market and experience holds many answers to this paradox. And they are right to a certain extent. Market signals such as price and size and quasi-market or qualitative metrics such as history and reputation and due diligence go a long way to making decision making under conditions of uncertainty possible at a basic level.
But something is still missing in those models of decision making. And it is trust. We don’t sign a contract with a vendor because we know for certain that the other party will do exactly what we expect. That is after the fact. We sign the contract or push the buy button as an act of trust. The contract terms and the phalanx of lawyers are there to enforce the outcome, but not to generate it in the first place. Would you knowingly engage someone you do not trust, with only the guarantee of an airtight contract and lawyers on retainer? Unless you had no other choice, probably not. Michael Jensen’s theory of agency comes close to addressing these issues, but in a negative way. His is an anti-trust approach, where we consciously incur an agency “cost” by using someone else to do something we cannot or wish not to do ourselves. Jensen’s work is exceptionally important for understanding the functioning of systems in modern finance, but it assumes a degree of distrust, not trust.
Trust in economics and daily life used to be more explicit until being erased by modern finance and by lawyers with their 800 numbers. Remember trust banks? These were institutions specifically designed to allow trustors (providing the assets) to support beneficiaries via the service of trustees. Modern fiduciaries share many of the characteristics of trustees, and are well represented in the practice of investing. That is a very good thing. And then there are the trustees of institutions and estates. Their literal and legal qualification for the position is that they are, pre factum, trusted.
And yet the continuing role of trust in modern economics, and by derivation finance and investing, remains unheralded. Francis Fukuyama constitutes an exception. His overlooked and underappreciated 1995 book, Trust: The Social Virtues & the Creation of Prosperity highlights the necessity of this type of cultural trust to economic success. He proposes a correlation between high-trust societies with their better outcomes, and low-trust societies with their lesser outcomes. Right or wrong in his analysis, Fukuyama asks a question that more than a quarter century later still deserves much greater attention.
Please chime in with your thoughts. I am happy to correct or fill out this narrative. I trust you.
[1] Merton H. Miller, “Behavioral Rationality in Finance: The case of dividends,” Journal of Business, 59 (4), part 2 (October 1986), 467. Miller was addressing the emerging discipline of behavioral finance.