“Risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you.” – Theodore Roosevelt
The world of investments is one about the detection and sizing-up of risk. The iron-clad rule of finance is that with a higher expectation of return, you need to take on additional risks. That being said, the smart investor knows how to identify, measure, and manage this risk. Therefore, if one is to be a serious investor of any kind (be it stocks, bonds, gold, real estate, or small business) a study on the subject of risk is necessary.
So with that in mind here is your curriculum for learning about risk, with a focus on its application in financial markets.
This is one of my very favorite books – not just about risk, but of all time. It’s a wide scoping history of man’s attempt to measure and analyze risk and it’s told in Peter Bernstein’s signature easy to read style. The stories of the familiar founders of the field of statistical analysis, (Pascal, Fermet, Bernoulli, and Bayes) are interspersed with some lesser known but very interesting figures.
This book, while easy to read, is best absorbed by people with at least a familiarity of statistics. After all, knowing the text book reason about the importance of Bayesian probability will tend to make the story behind its creation a bit more interesting.
Overall, this is a great walk through of all the greatest breakthroughs in the measurement of risk. This is a must read for everyone in (or aspiring to be in) the finance industry.
“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”
If Bernstein’s book were written today, it would undoubtedly contain a chapter about Taleb; that’s how important he has become to the canon of risk. His two books, The Black Swan and Fooled by Randomness are on every single must read list for traders, gamblers, and any other professional chance taker in the world. This is another absolute must read for anyone going into finance. In fact, it’s hard to find a book that has had more influence on the finance history in the last 30 years than this one. The phrase “black swan” has now become a part of the general risk lexicon to indicate the chance of a very low probability event happening.
My favorite anecdote, which I use all the time with students to explain the danger of relying on (even very sound) statistical analysis, is the one about the turkey. Every morning the turkey wakes up and the farmer gives him corn. Statistically speaking, the odds of getting corn would come in at 100%. That is, until Thanksgiving morning, when instead of corn, the poor turkey gets an ax.
One of the biggest take-aways from this book is how people can error by treating a low probability event as a no-probability event. This kind of thinking can lead to huge errors in judgement. This is similar to people believing that the odds of their house burning down is so low that they do not need insurance. Obviously, if enough people started acting that way, a portion of them would get nasty surprises. The lesson is that we need to be cognizant of risks that may appear unlikely and that it is dangerous to treat “improbable” the same as “impossible”.
“If you survive until tomorrow, it could mean that either a) you are more likely to be immortal or b) that you are closer to death.”
When talking about risk it is often instructive to see how it gets applied in real life. Chancellor’s book takes a full tour of historical episodes of financial crises – from the Tulip Bulb mania in Holland in the 1630’s to the Japanese stock market in the 1980’s (interestingly this book was written in 1999 which excludes both the tech bubble and financial crisis of ’08. Apparently the lessons of history are not learnt well.)
This is another staple, and my favorite among a bevy of options in the “history of financial crises” category. Others may cite Manias, Panics, and Crashes by Charles Kindleberger or the original Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay back in 1841. All of them are worth reading but Chancellor’s was the most entertaining for me.
The most interesting thing I observed is how the headlines from events like the South Sea bubble in 1720 or the railway stock crash in the 1840’s, to the Great Crash of 1929, could have easily been pulled out of the past and applied to the coverage of the financial crisis of ’08. It is fascinating to me to see that no matter how far we progress as a civilization, there are things that are apart of human nature that have been, and always will be, present.
From the preface “When I was young, people called me a gambler. As the scale of my operations increased I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time.” Sir Ernest Cassell, banker to Edward VII
Out of the many books that discuss some of the more technical details of the financial crisis, I selected this one simply because Michael Lewis is such an excellent storyteller. This book follows a few different traders who identified problems in the securitization of housing loans and how they tried to profit from it. There are many lessons that can be gleaned from the narratives in this book, not least of all is that mis-measuring risk can lead to very disastrous results – or extraordinary gains, depending on what side of the table you’re on.
Anyone serious about studying risk needs to understand the major concepts of financial derivatives. After all, they are, at their core, the monetization of risk. Michael Lewis’s ability to explain some of these highly technical concepts on complicated securities in such an easy to understand manner is an incredible gift. This book will help people without an academic or work experience exposure, to better grasp these instruments. Furthermore, seeing how these securities and financial concepts fit into the financial system, (and how they almost blew it up) is an important lesson to take away.
For people wanting to know more about the basics of derivatives, books like Demystifying Derivatives or Getting Started with Options are good primers. For those with a sound technical understanding of the derivatives markets but want a better understanding of their application in financial markets, A Demon of Our Own Design by Richard Bookstaber and Traders, Guns, and Money by Satyajit Das are excellent books and worthy of honorable mention on this list. For people wanting to know more about the origins and high-level play-by-play of the financial crisis, Too Big to Fail by Andrew Ross-Sorkin is great. If you have HBO, watch the movie.
In terms of story-telling, explanation of derivatives, and getting into a trader’s mentality, The Big Short is an essential part of the curriculum.
“They had stumbled either upon a serious flaw in modern financial markets or into a great gambling run. Characteristically, they were not sure which it was. As Charlie pointed out, “It’s really hard to know when you’re lucky and when you’re smart.”
The Age of the Unthinkable – Why the New World Disorder Constantly Surprises Us by Joshua Cooper Ramo
This book is the dark horse on my list. While all the others are sure to be found on similar lists elsewhere, I don’t think many will point to Ramo’s book as essential reading on the concept of risk. However, I selected it because it applies risk thinking to the geo-political scene. Instead of probability and statistical analysis, this book talks about complex adaptive systems and game theory. After all, the Kraken philosophy is all about approaching ideas from all angles.
My favorite chapter is the one that profiles a researcher named Bak, who studied sandpiles – more specifically, the collapsing of sandpiles. He found that even the methodical dropping of sand, one grain at a time, would not produce identical avalanches. The observation seems like a simple one, but its explanatory for the world at large. Often the world can tilt in one direction and become off balance but seem fine in this “poised critical state” (as Bak calls it) until a small disturbance or event occurs and causes an avalanche.
Looking at the world as a potential collapsing sandpile can be very instructive. Searching for fault lines and pressure points can be very useful for an investor. What would happen to your portfolio of investments if one of these pressure points caved? What would happen if tensions flare in the South China Sea? What about if a major oil company closes due to the low oil price? The answer is that since it is nearly impossible to predict when an event will occur, it is necessary to be prepared to handle it when it happens. This is what risk management is all about.
The book goes on to explore how one should navigate in such an unpredictable world, and the answer seems simple enough – build resilience into your systems. However, the evidence and stories from spy masters to venture capitalists give a more in-depth insight. It offers a clearer view of the world at large and provides clues on how one should observe and examine possible outcomes of a situation (figure out how to see the trees and the forest). All in all, this will be too esoteric for some, not ground-breaking enough for others, and an amazing new view on the order of the world for people like me.
“There was something profound and amazing in the dynamics of the piles, he thought: their ability not only to translate order into chaos, but also to translate chaos into order. Sand grains, stocks, pieces of the earth’s crust – these moved not according to some simple input and output formula but rather because of a complex logic, where dense internal forces were as important as any outside forces. Avalanches and earthquakes expressed that logic, but what got Bak excited was the same physics was also at work when the sandpiles produced California from pebbles, or great fortunes from the movement of markets. The sandpile seemed to make things, maybe even most of the world.”
There it is. Your curriculum for better understanding risk – how it’s understanding has evolved, how it’s mismanagement has impacted our world, and how to view it in today’s environment. Each of these lessons are necessary for better navigating the world, and especially important for anyone looking to get into the field of finance.
Let me know what I missed. What books shaped your thinking on risk and its application? I would love to hear back.
Until next time….
“He who doesn’t risk never gets to drink champagne” – Russian Proverb
Now go buy the books!
Further reading – The Single Best Investment for Beginners