Book Reviews – Page 19 – The Aleph Blog

Book Review: Outperform

Posted on 24 September 201024 September 2010 by David Merkel

There are some books, when I read them, that strike me wrong at first, but end up being satisfying in the end.? This book was one of those.? What I expected was a book that would give novel insights to individual investors, showing them how they could do better in the markets by imitating endowments.

This book came to the bold conclusion that there wasn’t much that individual investors could learn from endowments.? I appreciate such honesty, even though that will lead to fewer book sales.? Why is this true?

We all look for simple formulas that can improve our investment returns.
Endowments have balance sheets that allow them to invest longer-term.? Retail investors have a greater need for short-term liquidity, or, at least have a greater tendency to panic.
Retail investors are not large enough to invest in sophisticated asset classes.? Alternative investments have higher minimum dollar amounts.
Most endowments have invested in staff that are capable of analyzing complex investment opportunities.? Here would be my challenge for an average retail investor: hand them a copy of an asset backed securities prospectus, and see if they can make heads or tails out of it.
Endowments that have large staffs are also capable of analyzing third-party managers, without being slaves to the common theories that dominate the minds of most consultants.

The book begins with a basic explanation of endowments, moves through historical performance of endowments and asset allocation, and then explains the various strategies that endowments use.? After that, it interviews a large number of chief investment officers from public and private universities.? I appreciated the fact they chose lesser-known chief investment officers.? It gave me a better feel for the mindset of the average chief investment officer of university endowments.? Some were very smart, some were not so smart, most were in-between.

After that the book interviewed advisors and managers that would aid the chief investment officers of university endowments.? I felt that this was a weaker part of the book.? I came to that conclusion because they are consultants.? Does that make money in the short run, regardless of what the best results are, tend to be less reliable in their opinions than those that have their necks on the line.

One of the topics that was hot in the book was the question of liquidity.? As I have written about in a number of my blog posts, when the bull market in risk assets was running hot, many endowments and pension funds neglected the value of liquidity.? Some of the chief investment officers were prepared, and some were less prepared.? Regardless, most of them learned their lessons.? It’s similar to what happened after LTCM.? When you see bright investors get skinned as a result of neglecting the value of liquidity, you take notice.? All of a sudden, arbitrage does not seem so easy.? In the same way here, imitating Harvard and Yale is not a road to easy riches.

Another theme in the book as I see it, is that alternative asset classes are not as rewarding as they seem.? Many of them involve leverage.? Many of them are limited in terms of their capacity.? There are large variations in manager quality.? Late imitation is a recipe for disaster, as it is with almost all investment strategies.

This is a very good book, but for the average investor, it will not be useful.? Yes, it is useful to understand that endowment strategies are not useful for retail investors.? But you don’t need to buy a book to know that; you have read that here.

Quibbles

If I had been the authors of the book I would’ve spent more time with the introduction.? That said, they make up for it by having good conclusion.? I also would have eliminated most of the advisors and managers, and instead, interviewed still more chief investment officers.? They have valuable opinions; their necks are on the line for the decisions that they make.

Who would benefit from these books:

This book would be valuable for people who think that there are some great secret about investing, and think that the big guys have all the advantages.? It’s not true.? The big guys have the advantage of having balance sheets.? Retail investors have the advantage of being flexible.? This book is valuable in my opinion for investment professionals that want to get into the mind of the chief investment officers of endowments.

If you want to, you can buy it here: Outperform: Inside the Investment Strategy of Billion Dollar Endowments.

Full disclosure: Without asking, I was mailed a 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.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Review: The Elements of Investing

Posted on 21 September 2010 by David Merkel

This is a basic book.? A very, very basic book.? Did I mention this is a basic book?? Well, it is a basic book.

Sorry about that.? When you read a lot of sophisticated stuff on investing regularly, and then read The Elements of Investing, you know that you have to take a step back and re-think investing for everyone.

Written by Burton G. Malkiel & Charles D. Ellis, two notable investment writers favoring low cost indexing, and with a forward from David Swensen, you know that it will be a traditional buy-and-hold analysis.? (Though there is something funny here.? The authors criticize using the complex asset classes that Swensen uses, and Swensen criticizes buying individual stocks, which the authors use in small measure.)

The book has five sections:

Saving
Indexing
Diversify
Avoid Blunders
Keep it Simple

The section on saving is excellent, and offers many ways that people can cut their spending without ruining their lives.

The indexing section is fine, though it overstates the inability of investors to beat the indexes.? Yes, the market can’t beat the market as a whole, but dedicated investors following value and momentum can beat the market, until too many copy those unpopular strategies.

Diversification is wise.? But there are limits.? If one is going to be active, be active, and ignore the index.? Otherwise, be passive and index.? What’s that, you say: “If I miss by too much, I will lose a lot of assets.”? Sorry, but that is the price of being an active manager.? If you are going to do it make the most of it; don’t hug the index.? But the wag will say, “just avoid being in the bottom quartile.? You only get fired in the bottom quartile, so hug the index.”? The behaviors that benefit managers are not the same ones that benefit clients.

They recommend rebalancing, which I do as well.? They also recommend value investing in moderation.

I am totally in agreement with the chapter on avoiding blunders.? You win by not losing, and compound it over time to really build value.

The section on keeping it simple focuses on asset allocation, tailoring investment returns to individual situations, and is pretty basic.? I found little objectionable here, but I would spend some time analyzing when asset classes are cheap or dear.

They have an appendix on saving on taxes which is valuable, but if I had been in their shoes, I would have described additional strategies to lower tax liabilities off of both capital gains and losses.

Quibbles

They treat international investing as a free lunch, which it is not due to confiscation, currency risks, war, plague, famine, financial failure, etc.? The last forty years have been special, because of peace in developed economies.? That may not be true in the future.? I invest internationally, but only 25% of assets at most, and only in places where I trust the rule of law.

Who would benefit from these books:

This is the perfect book for your dumb brother-in-law (or similar) who has excess cash flow, and always seems to lose money on his investments.? Given the section on saving, it could also be valuable for your spendthrift brother who is constantly complaining about being in debt.

This is a very basic book.? Give it to the clueless; it cetainly won’t hurt them, and it might help them a lot.

If you want to, you can buy it here:?The Elements of Investing.

Full disclosure: Without asking, I was e-mailed a copy of the book.? Personally, if I were the publisher, I would send a physical copy.? Not that I am going to post it for free use, but I know that many will.

Asset Allocation Book Reviews: 7Twelve and The Flexible Investing Playbook

Posted on 21 September 2010 by David Merkel

When I get a book on asset allocation in the mail, I say to myself, “Another book on asset allocation?? What is there to say that is new on the topic?”

Tonight I review two decidedly different books, and end up praising the conventional book, and dissing the unconventional book.? Since I am not a fan of most conventional asset allocation, I am personally surprised by this result, but now let me explain why I reached this conclusion.

Where’s the Meat?

I don’t know about you, but personally, I hate books that talk big, and don’t reveal any of the significant details of their theories.? Can I figure out approximately how they did what they did?

Now, I am not looking for simple rule-based books either — “Follow this simple formula and make money!”?? But there should be enough to allow someone reasonably well-attuned to the markets to be able to say, “Yes, this is reasonable.? I don’t know all of the details, but I have some reasonable idea of how they did it.”

I don’t have that reasonable idea with The Flexible Investing Playbook.?? From what I can gather, they propose Dynamic Asset Allocation that is rather aggressive, trying to catch turns in markets.? I say aggressive, not because they advocate large moves; they don’t.? But the efforts to catch turns is a difficult endeavor, and they don’t give me enough grist for the mill, that I could set up my own approximate model for switching, if I wanted to do that.

One strength the book has is identifying alternative asset classes that can smooth the ride for investors.? Sadly, they don’t offer easy ways for investors to pursue these strategies.

On the other hand

7Twelve is static in asset allocation, urging investment in index funds (or active funds if you must), and rebalancing regularly.? The book urges investment in 12 index funds, which gives a very diversified mix.? The reason for the book’s name, is that the 12 funds have a limited track record, lasting from 2000-2009.? But an approximation to the 12, with only seven indexes, has a track record that goes from 1970-2009.

The twelve asset-subclasses are:

Large, Medium and Small US Stocks
Developed Foreign Stocks
Emerging Foreign Stocks
Natural Resources Stocks
Commodities
REITs
Barclays’s Aggregate Bonds
Inflation-protected Bonds
Foreign Bonds
US Cash

And the seven asset classes are:

US stocks
Foreign stocks
REITs
Resources
US bonds
Foreign bonds
US cash

And the book shows how in the past, an equal weighted blend provided? better total performance, and even better when compared to return volatility.

One additional note, the clever cover art helps prove that seven is half of twelve at least if using Roman numerals.? No wonder Rome fell.

Quibbles

In 7Twelve, there is a lot of “past is prologue.”? It ignore the factors that made 1970-2009 a special environment:

General peace.
Declining volatility
Increasing globalization.

It also ignores that not everyone could follow such a strategy because there would be scaling problems.? We would run out of small and midcap stocks, and emerging market stocks, and REITs and commodity stocks.? Even commodities would run up in price, and then provide subpar returns.

But if few follow such a prescription, such diversification could be wise, so long as there is no major war.? WW III can’t happen, right?

Who would benefit from these books:

I am not sure who could benefit from The Flexible Investment Playbook.? As for 7Twelve, those lacking a sound diversification strategy could benefit.? The strategy is simple enough to implement.

Both books provide significant and clever commentary in investing, if that is enough to commend buying books.

If you want to, you can buy either here: 7Twelve: A Diversified Investment Portfolio with a Plan, or The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success.

Full disclosure: I received each book from the publisher; I don’t think I asked for either one.

Book Review: Early Warning and Quick Response

Posted on 16 September 201016 September 2010 by David Merkel

If you are not into accounting, you can skip this review.? Before you skip it, though, ask yourself a question.? Do you rely on financial statements?

Most of us do whether we admit it or not, but accounting rules for most of us are like plumbing.? We need to use bathrooms, and sinks in our kitchens, but that doesn’t mean we would know how to set up the plumbing in a kitchen or a bathroom.

In the same way, most users of financial statements don’t have the vaguest idea of all the assumptions underlying financial statements.? Modern financial reporting today is a hodgepodge of rules straddling two eras: the Renaissance/Reformation era, and the modern era.

In the R/R era, accruals were almost always short, liquidating within the next few accounting periods.? Few items on the balance sheet were traded, or would have prices that would adjust materially before they would be used or sold.

In the modern era, accruals are frequently longer and less certain.? Many items on the balance sheet are tradable, and prices often move materially before the items are used or sold.? What is more, there are often hybrid financing instruments that make the estimation of equity versus liabilities difficult.

David Mosso grasps the nettle, and says that modern accounting must move entirely to a fair value basis.? Net worth is the difference between the fair value of assets and liabilities.? Net Income is the change net worth.? No more obfuscation.? No more AOCI.? No more goodwill.? The values of assets and liabilities derive from the future cash flows they will generate.? Even claims against equity must be done on a fair value basis, where hybrid instruments get decomposed into an equity claim and a debt claim, and the split gets re-evaluated each period as market prices change.

All measurable assets and liabilities must go on the balance sheet, and all nonmeasurable assets and liabilities must be disclosed.? Beyond that, financials should be segmented by major lines of business or marketing channel or geography in order to give users a greater sense of what is going on.

Measuring wealth, and the increase in wealth is the main metric.? This would apply to all entities — nonprofits, governments, etc.? No longer could we do a monstrosity like “cash for clunkers,” where we destroy autos and do not record the loss in GDP, but we add to GDP the sales of autos generated.? I can think of many transactions at a usually scrupulous company that I worked at, where the new and unscrupulous CEO and CFO found ways to convert capital losses into operating income, giving ROE a big boost –> R up, E down, and letting management take home large bonuses as a result.? That said, the only real loser was another mutual life insurer that bought the company after insufficient due diligence.

The book has much more to it than this.? It delves into how to set accounting standards better, and spends time more closely defining fair value with respect to assets, liabilities, and equity claims.

The changes would be sweeping, and widely opposed by much of industry, as well as utility and financial businesses.? The government would never let such standards be applied to them; honesty is alien to them.

I have a hybrid proposal, which I would view as transitional, that I proposed to a commissioner of IASB at a Society of Actuaries meeting five years ago.

I said, “I am a user of financial statements, and we need an upgrade in the quality of data that we receive from accounting.? What we need are five main financial statements.? Book value balance sheet and income statements, supplemented by Fair value balance sheet and income statements, with a cash flow statement to round them out.? This would give us the flexibility to chose our own accounting basis.”

The lady had a horrified look on her face, and said “But that would be so costly to do.”

I replied, “Most of these estimates are being done already by companies.? This would formalize it.? Besides, to my friends here (turning around to the back of the room, catching grins, and then looking at her) this is the actuarial full employment act, because the work of estimating long-dated accruals is something that needs professionals like actuaries.”

No comment, and they went to the next question.

Quibbles

The devil is in the details here.? Anyone who has read me closely for a long time knows that I am of two minds when it comes to Fair Market Value accounting.? My experience is that managements, when given freedom to estimate the value of assets, tend to estimate them too high, and liabilities too low.? Historical cost accounting may be wrong, but it is relatively determinate.? There is comparability when managements don’t have a lot of latitude to change values.? After that, it is the job of investors to figure out how good the accruals are.

But on the plus side, fair value accounting does give the snapshot view of net worth, which managements resist in a crisis.? They want book value accounting that presumes the likelihood of reversion to all claims being paid.? Sorry that doesn’t always happen, and accounting should probably reflect it, even if it ruins comparability across firms.

Who would benefit from this book

Users of financial statements that want to think a little more broadly about accounting should buy this book.? Note that the sticker price of this book is stiff, at roughly $1 per page.? Accounting mavens, whether they like the ideas should buy the book so that they can understand the issues involved.? Even if they never become the standards, the ideas are the exemplar for fair value, and represent the opposition view in accounting.

If you want to, you can buy it here: Early Warning and Quick Response: Accounting in the 21st Century (Studies in the Development of Accounting Thought).

Full disclosure: The publisher sent two copies, after I asked to receive a review copy.

PS — The book looks mush nicer than the cover that I scanned, with the abuse that I gave the book.

Book Review: The Club No One Wanted To Join

Posted on 15 September 201012 February 2011 by David Merkel

When life gives you lemons, make lemonade.? Over two dozen people that survived losing a lot of their money in the Madoff Ponzi scheme wrote down their stories.? For one thing, I’m sure it was cathartic to do so.? Something that many regarded as being one of the most dependable parts of their lives ended up proving utterly undependable.

Out of loss, many of the writers rediscovered the simpler joys of life — family and friends.? Even new friends, as many of them banded together to figure out which end was up.

The tales that the authors tell are not identical, but they certainly rhymed.? Here would be my stylized example of the outline of one of their stories:

Growing up in a lower-to-middle class family
Being taught to work hard and be frugal
Achieved some degree of success
Was not sure what to do as the excess assets grew
A family member or friend introduced me to Madoff
Looked like a smart deal; Madoff always seemed to do well, so the person put most to all of his investable assets there.
Sometimes even borrowed money rather than tap the Madoff funds.
Life was good; he was charitable, enjoyed life, was generous with friends.
The shock came that Madoff was a fraud, a Ponzi scheme.
Adding insult to injury, learned that the SIPC would not pay off much at all of the losses, seemingly contrary to their prior actions in other cases.
The best option for many was to file as a total loss, and recover back taxes.
Retirement dreams turned back to work, and who would hire an old person?
Friends and family often proved helpful, but it is hard to go from being a giver to being dependent.

Personally I would like to meet most of these people, give them a hug, and affirm to them that true wealth isn’t money, but relationships.? Poor people are poor because they lack the connections the they can trust, and have the power to help them.

Now, I don’t want to say they should not have seen this coming.? This blog is about risk control in investing.? Remember, you are your own best defender when it comes to investing, and saying “no” is almost always safer than saying “yes.”? Let me quote from a piece written near the time that Madoff was sent off to the pokey:

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record ? impressive, though he doesn?t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?

Who checks the results?? (Auditing ? should not be a small firm.)

Who has custody of the assets?

Is the trustee a reputable third party?

Is liquidity proportionate to the asset class invested in?

Is this under US law?

Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?

Is this marketed to everyone, or just a select few suckers?

Is the profit motive of the sponsor obvious and standard?

How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

You are ultimately responsible for losses that you receive.? Yes, no one can know everything, but if you don’t have any idea of how someone investing for you is making money, you probably should not invest with that person, because you are incapable of evaluating what they do in broad.

No one with a serious risk control discipline invested with Madoff or Stanford.? These are cases where paying a little for expert help would have paid off big.

Does that mean I look down on those that lost?? Not at all.? Most ordinary investors don’t have the vaguest idea what they are doing.? They are blessed because no one they knew would introduce them to Madoff.? For those that lost, I only have sorrow and pity.? I wish that you had friends and family that would have steered you better.? We all rely on friends, but there is still a danger in that reliance.

Quibbles

As I read more of the book, it felt like some of the authors had rehearsed story lines with each other.? Now, that is natural, because they talked with each other and planned strategy together regarding the SIPC and other hurdles.? So, I don’t begrudge that much.

What I do begrudge is the 8-page investment “analysis” at the end of the book that says that no one should have been suspicious of an 11%/year return, because equity funds from many major mutual fund companies earned 11%/year over the same period.? Total hooey.? Few would have invested with Madoff given the lack of disclosure had not the returns been so regular on a monthly basis.? The mutual funds had large runs up, and large drawdowns.? Investors, not savers, would buy such mutual funds.? The attraction of Madoff’s scam was that it was designed for savers, not investors.? No volatility, high returns, no worries.? Thus someone with the personality of a saver could put money there, and not worry, because Uncle Bernie was a genius who was taking care of them.

And indeed, Madoff took care of them, with malice.? The underfunded SIPC could do little to help, given the enormity of the fraud.

Who would benefit from this book

Anyone who wants to sympathize with and support those who lost to Madoff would benefit from this book.? It does a fairly complete job, and is not long at ~230 pages.? As I write this it is, out of stock at Amazon, but when available, you can buy it here: The Club No One Wanted To Join-Madoff Victims In Their Own Words Barnes & Noble does have copies.

Full disclosure: An author sent me a copy, after asking if I would like to receive a review copy.

Book Review: Fault Lines

Posted on 31 July 201012 February 2011 by David Merkel

Raghuram Rajan made a name for himself at the Jackson Hole conference in 2005, which was a kind of send-off for the victorious Alan Greenspan.? Alas, but the paper he brought was not appreciated at the time, as it pointed to imbalances in the financial system.

He was ahead of the curve.? Thus his book on the economic crisis deserves our attention. More than most, he sees the problems in a global way, across nations and across asset classes.

His view is that for a variety of reasons, income inequality grew in the US, and in order to paper over that, the government encouraged a credit-oriented society to allow people to stretch for prosperity, hoping that the debts would not catch up with them.

It was a fool’s bargain.? Debt deceives average people.? They overestimate their ability to repay, and end up defaulting at high frequencies.

Like me, he is critical of the Fed’s monetary policy during the ’00s as being too easy.? The “Great Moderation” was a result of over-stimulus, not of sound policy.

Similarly, he faults banking regulation for being too easy, leading to private profits with public risk.

This is a well-written book from a man who was ahead of the curve.? I recommend it.

Quibbles

Where I differ with Dr. Rajan is how easy it would be to fix income inequality in the US.? He suggests a number of policies, many of which sound good, but have the Federal Government intervene in matters that they can’t handle effectively.? Persistent unemployment is a problem, but should that be handled by the Federal Government.? Far better in my opinion that it be handled informally and locally, by family and friends, that there would be more urgency, and more willingness to compromise in finding work.

Retraining is a good thing, but also not something the Federal Government does well.? One of the beauties of the US is that we have community colleges, which can retrain people at modest costs.

He also levels a decent amount of the blame at Fannie and Freddie and the Community Reinvestment Act, for making too many lousy loans.? He is correct in direction, but not likely in degree.? Yes, they were problems, but not the leading problems.

But these are mere quibbles on an otherwise excellent book.? If you want to buy the book, you can buy it here:? Fault Lines: How Hidden Fractures Still Threaten the World Economy

Who would benefit from this book

Anyone who wants a comprehensive view of the crisis would benefit from this book.? It does a fairly complete job, and is not long at ~230 pages.

Full disclosure: The publisher sent me a copy, because I met the author at a conference, and asked to receive a review copy.

Book Review: Book of isms

Posted on 21 July 2010 by David Merkel

This book is different, and it will get a different book review from me.? I have not read it, but I have scanned it.

This book aims to give extended yet compact explanations of the definitions of words that end in -isms.? It does so with varying success.

Here is my thesis: the more you care about a given ism, the less you will like the explanations in the book.? The entries are long compared to a dictionary, but short compared to an encyclopedia.? Personally, I found entries in areas that I have detailed knowledge of to be too short, and in some cases inaccurate.? This applies to many of the entries on Christianity, and some on economics.

Aside from that I found that it was less than consistent to add in isms that were not belief structures.? In that were a variety of diseases, and words like prisms and schisms.? Also there were behaviors, like Bushisms and Spoonerisms. I would have stuck to belief structures, and expanded them.? A brief volume focused on comparative religion and philosophy would have been more valuable.

Then there are the accidents of spelling: Cataclysms and Paroxysms.? Why don’t they get into the book, if prisms and schisms can get in?

I did not find this to be a book that one can sit down and read.? It is worthy for reference to understand the basics of an ism.

If you want to buy the book, you can buy it here:? The Economist Book of isms: From Abolitionism to Zoroastrianism

Who would benefit from this book

This book impresses me as a good book to give to someone that you’re not sure what he would like.? Even new, the book is modestly priced, interesting, and doesn’t poke anyone in the eye, at least too hard.? The book is small at ~240 pages, and 4X6″.? It would make an excellent small gift for those for which you have no idea what to get.

Full disclosure: The publisher sent me a copy, but I did not ask for it.

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

Book Review: Complicit

Posted on 15 July 201010 December 2010 by David Merkel

I am not sure how many current economic crisis books I have reviewed.? I think I am getting close to a dozen and I am currently reading “Fault Lines.”? I’m not sure I want to do many more crisis book reviews.? Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.? This book from Mark Gilbert is no different.? As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.? It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.? Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.? Risk is transitory; we originate to sell.? Regulators don’t want to stand in the way of seeming prosperity.? Nor do politicians.

Leverage gets higher in explicit and implicit ways.? Credit spreads get tight as a drum.? It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.? Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.? They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.? Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.? There were too many parties willing to make fixed commitments, because they needed to earn a lot.? Balance sheets were ignored, and income statements were everything.? History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.? All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.? At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.? I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.? I think not bailing Bear and Lehman out would have led to the best outcome.? After Bear failed, other banks would have moved to straighten themselves out.? We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.? I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.? I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.? An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

Most people would benefit from this book on the crisis.? The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

Brief Reviews of Three Books

Posted on 10 July 201012 February 2011 by David Merkel

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.? It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.? It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.? Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.? It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.? To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.? Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.? For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.? The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.? The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.? It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.? If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.? It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.? A better title would have been: “Fueled: The Effects of? Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.? It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.? Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.? The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.