Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.
This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. The successful traders seem to have systems that go beyond the simple systems that they write about. If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. That’s why the books I am mentioning are longer-term investment books.
General Books on Value Investing
- The Intelligent Investor (Ben Graham)
- The Aggressive Conservative Investor (Marty Whitman)
- Margin of Safety (Seth Klarman)
- Accounting for Value (Stephen Penman)
Don’t get me wrong. I like many books on value investing, but the first three are classic. Graham is the simplest to understand, and Klarman is relatively easy as well. Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. But even Ben Graham recognized that value investing needed to change at the end of his life.
Whitman takes more of a private equity approach, and aims for safe and cheap. Can you find mispriced assets inside a corporation or elsewhere where the value would be higher if placed in a different context? Whitman is a natural professor on issues like these, though in practice, the stocks he owned during the financial crisis were not safe enough. Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”
The last book is mostly unknown, but I think it is useful. Penman takes apart GAAP accounting to make it more useful for decision-making. In the process, he ends up showing that very basic forms of quantitative value investing work well.
Books that will help you Understand Markets Better
The first link is two books on the life of George Soros. Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. Why is there momentum? Why is the tendency for price to converge to value weak? What do markets look and feel like as they are peaking, troughing, etc? Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.
Consider what things are like now as people justify high equity valuations. At every turning point, you find people defending vociferously why the trend will go further. Who is willing to think differently at the opportune time?
Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time. They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds by a little and cash by a lot.
For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.
Books on Managing Risk
- The Crisis of Crowding (Chincarini)
- Pandora’s Risk (Osband)
- Risk and the Smart Investor (Martin) also The Nature of Risk (also Martin)
- The Hedge Fund Mirage (Lack)
After the financial crisis, we need to understand better what risk is. Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. For the latter, think of the Chinese using too much margin to carry stocks. For the former, think of Fannie Mae and Freddie Mac. They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. (You can drown in a river with an average depth of six inches. Averages reveal; they also conceal.)
Hot money has a short attention span. It needs to make money NOW, or it will leave. When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.
As for the last book, hedge funds as a group are a dominant form of hot money. They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group. With any individual hedge fund, your mileage may vary, there are some good ones.
These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. A few simple changes have been made, along with a bunch of ineffectual complex changes. The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.
An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.
I chose some good books here, some of which are less well-known. They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of The Most Important Thing, by Howard Marks. Oops, also great, and all for now.
PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. You can figure that out for yourselves. Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.