Robert Merton on Financial Innovation

As Dimensional’s Resident Scientist, Robert Merton is passionate about pursuing real-world applications of leading research. He recently visited the firm’s offices in London and Berlin to share his ideas on goals-based investing. Merton also discussed the opportunities and challenges he sees for innovation in technology and finance.

“A well-functioning financial system is essential to growth and development,” Merton said. “All of the technological innovation that is happening in labs around the world will have no impact on growth unless it’s embedded in the economy. That’s what finance does.”

Merton set the stage with historical context. He described the field of finance, which until the 1950s was based mostly on certainty models, anecdotal evidence, and unsubstantiated hunches. “There were no data,” he said. Yet by the end of the 1960s—thanks to the contributions of pioneering academics like Harry Markowitz, Merton Miller, William Sharpe, and Eugene Fama—finance emerged as a real science with risk-based models backed by extensive data. A new wave of break-through academic research in the early 1970s further accelerated the pace of scientific development in finance.

In response to the challenging economic conditions of the 1970s (e.g., double-digit inflation and  interest rates, high unemployment), the financial world introduced a flood of innovations: new option and financial futures markets, electronic exchanges, a national mortgage-funding market, money market and index funds, global diversification, and new retirement savings vehicles.

“There was an explosion of innovation based on financial science,” Merton said. “And these models and ideas spread and were adopted into practice around the world because they were valuable and useful.”

Dimensional has been an implementation leader in this movement from the start. Since 1981, the firm has been applying the insights of financial science to live strategies to help investors pursue their investment goals. Merton believes that people’s lives will benefit from continued innovation in finance.

Merton sees great promise in goals-based investing. He is one of the world’s leading thinkers on retirement solutions that help people plan for anticipated income needs. (In markets around the world, individuals are having to become more responsible for their own retirement planning.) Most recently, Merton has been developing the framework for a form of government-issued bonds that could help individuals pursue their retirement income goals. The key to the program’s success is managing risk.

“There are only three ways to manage risk: diversification, hedging, and insurance,” he said. “And you can use a combination of all three to create the optimal portfolio payoff structure for a specified goal.”

Merton explained the economic theory behind his proposal and cast a vision for how its practical application could bring together governments, insurers, and other wealth management professionals to help people build customized, adaptable lifelong savings programs.

From Merton’s perspective, retirement solutions are just one example of how innovation can help people who are currently underserved.

“Financial technology offers enormous global opportunities for new and improved services at substantially lower costs,” he observed. “But wealth management, which is neither transparent nor easily verifiable, requires trust. And to be trusted requires being both trustworthy and competent. Technology, by itself, is not sufficient to create trust. To succeed, technology has to be paired with entities that have the trust asset. Financial advisors and other wealth-management professionals who are trusted by their clients can provide that essential asset.”

Merton wrapped up by emphasizing the global opportunities for financial innovation. “Financial science principles apply everywhere,” he said. “My hope is that even if you’re not getting all of the lyrics, you’re at least getting the melody: These are executable ideas that can improve outcomes for investors.”