If it's true that lessons are learned best when they hit the pocketbook, then my financial education became complete in early 2009, when I received a dry e-mail, with only a faint whiff of apology, from my hedge fund manager. He announced he was shutting down and sending me back the remnants of my investment.
It made perfect sense for him. The standard hedge fund compensation formula is "two and twenty"—2 percent of assets under management and 20 percent of the upside—and he had just lost, along with a hefty chunk of my original investment, his chance at seeing any upside. It wasn't worth his time to strive to get his investors back up to par in exchange for the piddling 2 percent fee.
The lesson for me was that business schools are not doing an awesome job at teaching students about the collision of independent models.
Think about it. My friend's hedge fund was powered by two conflicting sets of business theories. First are financial engineering models that have helped the world understand the power and utility of derivatives. These models, grown initially by finance professors and underpinned by financial and mathematical theory, have helped investors and traders build ever more esoteric instruments for hedging risk—a business' inherent exposure to yen appreciation, for instance—or for making bets on shifts in risks, rates, or returns.
Second is the compensation theory, based on psychology and economics, which holds that two and twenty aligns interests by making sure that if the investors win big, so do the investment managers who made it happen. This theory is conspicuously silent on the lack of alignment when investors lose big—and the only pain for hedge fund managers is the obligation to write short apology e-mails.
I doubt that either the derivatives or compensation theorists appreciated what a potent cocktail they would produce when their theories were sloshed together in the real world. Investment managers use advanced derivatives theory to create instruments with huge and immediate upsides (and of course downsides). In 2007, for example, hedge fund manager John Paulson got Goldman Sachs to create a synthetic portfolio of derivatives, the now-infamous Abacus vehicle, which enabled his fund to make a huge bet against mortgage values. In relatively short order, the investment produced a profit of over $1 billion for Paulson and a commensurate loss for the European banks who bet against him.
Paulson didn't have to worry much about risk. With a flat fee of 2 percent (or more) and $32 billion of assets under management, he would earn $640 million per year even if he lost his clients boatloads of money—hardly the alignment compensation theorists suggested. And the staggering 20 percent upside helped him earn an estimated $3.7 billion in personal compensation in 2007.
For business education, the point is that derivatives theory created the vehicles for taking on massive risk in pursuit of massive compensation, while compensation theory caused managers to have little fear for the downside of that risk. Investment managers chased massive personal gain by incurring huge risks to their investors' capital. By chasing it far enough out the slender tree branch, they crashed the system. Sadly, it was investors, pensioners, and average citizens, not hedge fund managers, who felt the brunt of the fall.
At the Rotman School, lessons of this sort have us redoubling our efforts to help students appreciate how diverse models work together in a broader context. We are teaching them to tear apart the foundations of models, just as an aspiring mechanic would tear down an engine and rebuild it to learn how a car really works. Then they can ask—and answer—questions like: How will the theories I learn in my options and derivatives class intersect with the ones I learn in my organizational behavior class?
We're asking professors and students to tackle complex behaviors head-on, rather than rely on models that assume more simplicity than the real world actually offers. Students need to learn that it is their task to integrate and compare independent systems for themselves, even when academic business theories don't.
We call it Integrative Thinking. We believe it is a habit of mind that will enable students to think their way through the most complex real-world business problems, and even have a fighting chance of averting crises like our current one. On that front, the good news for our first-year students is that in this year's Foundations of Integrative Thinking course, the course of events has furnished them with far more material—real-world examples of clashing and colliding models—than they could have imagined just two years before.