Book Review: Risk and the Smart Investor

Risk and the Smart Investor

Not every book grabs me at first.  “Risk and the Smart Investor” was one such book.  But it grew on me.  Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

I was fascinated with the structure of the book, which I found tedious and hokey at first, but I grew to like the intriguing and novel approach.  The author introduced the topic through his experience, then explained the theory, then showed how neglect of it led to failure, and then gave stories of Max and Rob, two very different men whose lives illustrated risk management, and the lack thereof.

Risk control has to be realistic.  You can’t eliminate all risks.  You shouldn’t even want to eliminate all risks.  Anyone who tries to eliminate all risk will end up killing the profitability the business.  As that great moral philosopher James Tiberius Kirk once said, “Risk is our business.”  (For the jobs were I was explicitly a risk manager, I kept that quote on my wall.)

I am going to touch on the themes of the book as I understand them.  In order to control risk, one must first be able to control himself.  Without self-control, there is no risk control.  That process requires humility.  Almost every action of risk control involves limiting the behavior of those that have the power to commit money for investment or to sell assets to raise cash.

Part of that comes down to understanding what are reasonable goals, and what aren’t.  Nothing grows without limit.  Almost every business has a maximum growth rate, which if exceeded materially raises the probability of insolvency.  This is true for individuals as well.  Peter Drucker once said something like, “Jobs should be big enough to be challenging, but not so big that they require superhuman effort.”  In the same way, efforts to grow your personal assets too quickly will lead to decisions with a high probability of large losses.

For risk control the context of large firm, the critical question is cultural issues.  That involves instilling the idea of risk control in every person if the firm – making it a part of the firm DNA.  It must extend to the very pinnacle of management, and not let it be seen as something that is a tradable issue.  It is similar to the idea of a reputation.  You only get one reputation.  Your reputation is your brand.  If your reputation is harmed or destroyed, rebuilding it is desperately tough.  Granted, America is the land of unlimited second chances, but rebuilding is still tough.

We can diversify lines of business.  We can diversify assets.  We can diversify funding sources.  We can’t diversify our reputation.  We only have one reputation.  It is as one of my favorite bosses of the past said, “I’m willing to take lots of moderate risks, but not willing to take an action that has a material probability of destroying the firm.”  This is just another way to say that there are things that can be diversified and things that can’t.

Corporate culture cannot be diversified; it flows from the top and affects all employees.  Good risk control cultures inculcate checks and balances.  They make sure that no one has too much power, such that the work cannot be checked.  They insist on transparency within the firm and transparency outside to the degree that it facilitates business and satisfies regulators.

Such a corporate culture monitors continuously the factors that affect profitability future risks.  It also learns from mistakes, but keeps the risks small early in the process so that learning from mistakes is not an expensive and surprising endeavor.

The structure of the book contrasts financial risks and life risks through the lives of Rob and Max.  They are two very different people, one of whom is careful about risk, and one of whom ignores risk.  Just as we have seen firms that were careful about risk, during the present crisis, and firms that ignored risks, so we have seen the same in ourselves and our friends.  The stories of Rob and Max on the risks that we go through life and the risk that we go through markets.  In my opinion it richens the book a great deal.

Risk is inherent to life.  And, the ultimate risk is death.  You can’t diversify death.  You can’t pay a certain spread over LIBOR in order to engage to death swap on your own life.  The most you can do is build something that may last for some small to moderate amount of time after your death.  Even the great Warren Buffett is trying to do something like this, as I explained in my piece Moat, Float, Growth.

Quibbles

None.  It’s a really good book; very well-thought out.

Who would benefit from this book:

This book would benefit anybody who deals with the question of risk, whether personally or corporately, and that means all of us.  Not only do you get a lucid perspective on the causes of the financial crisis, but you get to see firsthand how corporations deliberately the word sound risk management principles in order to make money in the short term.

The reader also gains perspective on how to deal with risk in his or her own life.  Will you go the way of Rob, or will you go the way of Max?  Or, as most of us, will you do little of both?

I read lots of books on asset allocation, but relatively few books on risk control, because few accessible books get written on that topic.  This in my opinion was a very good book on risk control.  It has my highest recommendation.

If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.  It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

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