Book Review: Risk
Rare is the book that is instructive and entertaining, that appeals to a diverse readership, and that accomplishes these feats within 200 pages. Risk: Your Global Guide is such a book. Intended to be the first in a series of qualitative finance texts that render abstruse financial concepts accessible to the lay reader, the book serves as a guide to risk management and fraud detection. It is a blunt critique of systemic failure that gives no quarter to cheats and schemers of all stripes. It is a worthwhile and — the arcana of structured finance notwithstanding — quick read. Moreover, it can serve as a timeless reference. It should be required reading for CEOs of financial institutions and their risk officers, compliance personnel, traders, and portfolio management teams. Its content is equally suited to institutional investors, regulators, and policymakers, most if not all of whom, in the author’s estimation, have done little more than enable financial chicanery and malfeasance. Add to these groups the general investor, who is most exposed to these risks and needs to become “Street” smart.
Author Janet Tavakoli is a long-standing specialist in structured products and credits whose earlier reference works probe these subjects with a high level of granularity. She wanted this slender volume to instruct the ordinary investor in the basics of best practices, with an emphasis on risk management and fraud detection. The book could serve equally as a primer on its own or as an introduction to her more detailed and recondite volumes on the subject.
The book’s message is simple: Understand the basic principles of finance, reduce unintended risk, and obtain a level of reward commensurate with the level of risk that you assume. Organized into a brief introduction and six readable and easily navigated chapters, Risk: Your Global Guide offers a tour through the financial mishaps and deceit that were part of the recent financial crisis, the legacy of which seems to persist through ineffective regulation and misguided practices. Of particular concern is that securitization is rearing its head again. The book also explains the basic concepts and tools of risk management and, in the process, debunks common misperceptions about them. Brief discussions of diversification, correlation, and value at risk are well constructed.
The first chapter sets out to correct readers’ understanding of what really took place in the latter half of the past decade. It admonishes them not to consider the abuse and “rigged game” of collateralized debt obligations and credit default swaps to be rare black swans but, rather, to name them as the frauds that they are. In the author’s estimation, these products are weapons of mass obfuscation. This chapter, the longest in the book, does wax technical in its discussion of structured products and assumes a basic knowledge of them. The worked examples of investment math are helpful, however, and compelling.
Although Tavakoli chronicles financial abuses at the company level, her insights apply as much to the individual investor as the institutional one:
- Diversification is no panacea.
- Know what you are diversifying against, lest you diversify into greater risks.
- There is no substitute for due diligence when analyzing an investment.
- Leverage can not only magnify gains but also amplify losses that do irreversible damage.
- Models are only as good as the people who design them. As recent history attests, the standard models are flawed.
The author observes that, although modern portfolio theory appears to offer a neat and clean explanation of how investing works, the world is anything but efficient. Inconveniently, return distributions are often asymmetrical. Tavakoli uses numerous examples in support of her arguments, providing perspective and a refresher on recent financial boondoggles. These examples include the blowup at Amaranth Advisors just before the onset of the crisis, the fiasco of AIG, and former Goldman Sachs CEO Jon Corzine’s ill-fated MF Global.
A useful reference tool in the second chapter is a brief taxonomy of red flags for fraud. All of them would seem to be common sense, yet they have, both intentionally and unintentionally, usually escaped the scrutiny of practitioners and regulators. Another lesson is that regulation is useless if not enforced. The failures of the Sarbanes–Oxley Act of 2002 offer a teachable example of this point.
The final chapter takes a wide-angle look at systemic risk. It offers sound remedies, none of which any regulator will undertake in all likelihood. They are as follows:
- Eliminate taxpayer subsidization of banks.
- Separate investing and lending activities of banks as Glass–Steagall did.
- Revise compensation arrangements to better align incentives.
- End guarantees and subsidies that enable moral hazard and only kick the can down the road.
Writing in a trenchant style that evokes H.L. Mencken, whom she actually references early on, Tavakoli takes on the investment and regulatory establishment and calls everyone to account. Professional investors, risk officers, government agencies, and regulators have all been complicit — through sins of omission and commission — in engendering fraud and heightening systemic risk. Misdirected groupthink was also to blame. Yet within risk lies opportunity for the savvy investor. A brief but thought-provoking analysis of the opportunities in subprime auto loans is instructive.
For its modest number of pages, Risk: Your Global Guide is unusually ambitious by embracing subject matter that has a wide scope and a complex history. Yet this perspective from five miles up allows the reader to see the big picture and understand how fraud at the highest levels of finance and government affects ordinary citizens. Sadly, little has changed in this picture.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.