The Library of Mistakes: Learning from investment errors

The Library of Mistakes is dedicated to financial history, and first opened its doors in 2014 in Edinburgh, Scotland. There's also a branch in Lausanne, Switzerland, and another in Pune, India, with more locations planned. In addition to its collection of 4500 books, the Library of Mistakes offers courses, lectures, podcasts and webinars. All, except for the courses, free to the public.

So why the focus on mistakes and history? Russell Napier, the founder of the Library, attributes his inspiration for the library to a quote from the American author James Grant who said, "Progress is cumulative in science and engineering, but cyclical in finance."

A trained lawyer, Napier started studying economics when he got a job in investment management, but found that the books focused on theory and the efficient markets hypothesis, and ignored history. Later, when he started working for CLSA in Hong Kong, he realised that his appreciation of financial history was not shared by others in the industry.

Insights spoke with Napier about why investors could benefit from knowing more about financial history.

Why is it important to know about financial history, and what sparked your interest in opening a library focused on the subject?  

Russell Napier: When I got a job in the investment management business, they gave me these books on economics, and I started passing exams on economics, but the books don't really describe what I know to be economic activity. They are very theoretical, very accurate. I don't find them very helpful is a better way of putting it.

Then I started reading financial history, and suddenly I understood the relationship between economics and my job of managing capital better. These are things that have really happened in the real world. A lot of economic theory assumes away much of the messiness of the real world. 

If you listen to an economist, you could go to an economics conference all day, and they'll never mention the stock or bond market, which was the only thing I was getting paid to do. I thought I needed to understand something about where economics and asset markets come together. And one thing I could do is just read the history of how they've come together. I've been using it in my research since 1995.

In 2001, I got a brief to set up a course in financial history which was launched in 2004; it's called the Practical History of Financial Markets. It's about where the financial markets and economics meet. So we started that course in 2004, and that's still running very successfully at the Edinburgh Business School, online and in a two-and-a-half-day in-person version in London.

There's very few people still teaching economic history and a lot of financial history books have been stripped out of university libraries. The prevailing thought in finance is that all available information is in the price - that's called the efficient markets hypothesis. When the time comes to review the books in the finance section of the library, these guys don't believe in history whatsoever, so they would have them removed from the library on the basis that they couldn't possibly help anybody understand the financial markets.

We buy all these books. It’s a mix of finance and history but then we’ve got financial institution history, markets history, history of fraud. 

That's the reason for doing all of this. It was originally to educate myself, but our system is now churning out people from universities with degrees in finance and degrees in economics who don't know any economic history, any financial history, and certainly don't know how the two intertwine. That's the mission; it's to try to redress the balance because it's become entirely unbalanced.  

And why the focus on mistakes?

Napier: When you look at the history of finance, it's littered with mistakes. The only professionals that learn from every mistake they make are pilots. And that's because they're recorded in a black box, so they have to learn from it. So if you have a financial history library, it is going to be dominated by mistakes because mistakes are more likely to be recorded and be the subject of books. That's why it's called the Library of Mistakes.

The bigger picture relates back to Daniel Kahneman, the Israeli-American psychologist and economist, and his Nobel Prize citation, which was for furthering the understanding of human decision-making under uncertainty. That's what financial history is: the study of human decision-making under uncertainty, which often leads to mistakes.

Why is there so little appreciation of history in finance as an industry?  

Napier: The question is, why is it that something once learned in science is not forgotten but something learned in finance is forgotten every seven years, or so it seems. There are good reasons for this. The turnover of individuals (in finance) is actually quite high. So, the people who made the mistakes the last time might not be there the next time. All professionals learn from their mistakes, but finance seems to be the worst at doing it.

The reasons are, ultimately, incentives. If I was a money manager and I could make a lot of money by Christmas, that incentivises me to think until Christmas. So, I'm very happy to ignore lots of mistakes of the past and the fact that I've only got to get to Christmas, and that's it. That's a simplification of the incentive structure, but the incentive structures in finance tend not to have people looking backward toward the mistakes, but they have been looking forward to Christmas. It's not the way capital is supposed to be allocated. Adam Smith, the 18th-century Scottish economist who wrote The Wealth of Nations, certainly wouldn't recognize it as capitalism. Then suddenly - drumroll - we're not incentivized to learn from our mistakes and believe that the next time will be different. 

Businesses can also be too short-term, but the problem is portfolio management, which has the really short-term incentives. Because if your investment is not going well, you just sell your position, and you get out. If you're a corporation and you've made a big capital commitment, it's very hard to exit. But the portfolio manager sits there and knows he can always get out and this option encourages them to take a shorter-term view because there's always an exit.

In the last few years, since the pandemic and record high inflation, there seems to be more looking back to history, to the Spanish Flu and 1970s inflation, for comparisons. Do you think there is more interest in financial history now?

Napier: Everything you've mentioned in your question is more sociology than finance. It's important, but we just kind of ignored it for a long time and said, "it doesn't really matter". We're beginning to realise it does. Finance, the way it's taught at university, I refer to as a distillation based around producing numbers. But when you distil something, you throw away a lot. We're beginning to realise that the other bits are kind of important. So slowly but surely, we're beginning to bring it back in.