Book Review: Pandora’s Risk

This is two books in one, and very well done.  The main part of the book explains risk and uncertainty in general terms, such that most people can understand it.  But for those that can deal with complex math, the latter part of the book offers a lot of additional firepower.

Risk is a tough subject because history only vaguely informs you as to how bad things can get.  Past is not prologue.  There are two possibilities, the past contains and event that was so horrible that it can never happen again, or, the past does not tell you how bad things can be.

Market observers took the first view, that the Great Depression could not repeat.  As a result, few prepared for a situation where there was too much debt, and insufficient ability to service it.

The subtitle of the book is rightly “Uncertainty at the Core of Finance.” Not risk, but uncertainty.  The distinct is important, because risks are things that we know some things about the possible economic outcomes, and can control them to a degree.  Uncertainty is where we don’t really understand the dimensions of the outcomes, and have little if any control.

There is fundamental uncertainty to the simplest aspect of finance, money.  Money seems stable enough in the short-run, but every now and then it fails due to hyperinflation, or the slow steady failure in the store of value sense of moderate inflation over long periods.

Wealth itself is uncertain.  Even if you own it free and clear, there’s no way to tell what it will be exchangeable for next year, much less further out.  There are a lot of people who thought they knew what their homes were worth 5-7 years ago that are decidedly disappointed.

Government debt is uncertain, as governments think they can always roll it over, but political and other obstacles can lead to a refusal to pay when debt service becomes high relative to tax revenues.

Banking is uncertain, mainly because of borrowing short to lend long.  If banks limited themselves to facilitating transactions, a lot of the uncertainty would go away.  Banks would be a lot smaller, less profitable, and there would be fewer of them, and the economy would be more stable.  (Entities with longer liability structures, like pension plans, endowments, and life insurers would become the new source of lending. More would be financed through equity.)

Credit is uncertain.  During boom times, corporate bonds behave independently, and diversification evens out results.  As a result, corporate credit seems safer than it really is, and marginal ideas get to borrow.  During bust times, far more corporate debt defaults than would be expected — there’s almost no such thing as an average year.  It’s either feast or famine.

There are things that can be done to try to mitigate uncertainty: credit ratings, or any scoring system for assets, lending at a more senior level, and Value-at-Risk.  Also using more robust assumptions on possible outcomes, which would lead to smaller position sizes, less leverage, or more cash.

The book has a real strength in showing how the the assumption of normally-distributed risks fails dramatically in many cases, and offers alternatives that would work better.  Trouble is, once you realize how volatile the world really is, a lot of strategies either don’t work, or need to be scaled back.

The book praises actuaries as risk managers, with their ethic codes and stress tests, as opposed to quants with Value-at-Risk and no ethics code.  Banks and Wall Street would be better off in the long run hiring actuaries, who think about risk more holistically, and getting rid of the quants in their risk control departments.  Same for the regulators who evaluate banks.

There are other controversial ideas here: is it possible that the strong economic growth of the past is an anomaly?  Is it possible that growth for nations, and the world as a whole follows S-curves, like products and companies?

This is an ambitious book, and I like it a lot because it is willing to cross boundaries and apply the principles in one  area to another that seemingly should not receive it.  I liked it a lot, and would recommend it to many.

Quibbles

On page 17, he thinks of currency as a put option, but I think of it as 0% overnight commercial paper.  On page 37, he confuses Moses and Joseph, having Moses predict the 7 good followed by 7 bad years, when it was Joseph who did that.

Who would benefit from this book: Every financial regulator should have this book.  Every academic burdened by the lies of Modern Portfolio Theory should get this book.  Anyone who fancies himself to be a risk manager should have this book.  Finally, if you want to understand why financial markets are inherently uncertain, this book will teach you well.  If you want to, you can buy it here: Pandora’s Risk: Uncertainty at the Core of Finance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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2 Comments

  • SteveP says:

    Yikes I just found all your book reviews. 155 of them. I’m a bit of a bookworm myself so I’ll have to come back to read your reviews when I have more time. Great Blog BTW.

    • Thanks, Steve. I’m surprised at how many books I get through per year. The “to read” stack is around 15, and the “to write up” stack is around 8. I’m reading “Backstage Wall Street” now. Very good so far.

      Oh, then there are the 26 books that I have read, and most aren’t worth a review. So it goes.

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