This note is one of a series about the books that have informed and inspired my life and work.
How can financial innovation designed to protect us from risk instead turn minor and isolated actions into catastrophe? A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation walks through the recent market history of how modern capital markets have traded safety for a false sense of security enabled by formulaic computer-driven modeling. Modern risk management tools are good at measuring many things, but they tend to measure the risks that don't matter. The real risks - the risks that permanently impair capital - are the ones that may not fit neatly into models and aren't being measured.
What points did I find most specifically applicable? Here are some quick takeaways that directly impact how I implement my investments:
Price vs. Precision
"There is no such thing as a 99 percent probability of being right. There are too many immeasurables, and any probability assessment is itself subject to error. If you are making a trade that needs better than 95 percent probability for it to make sense, you shouldn't do the trade." - Andy Hall
Following on this point, "A Lesson in Self-Delusion" (p. 64-69) offers a particularly good description of merger arbitrage. It's both good, entertaining, and good, in terms of being true.
Admitting such truths protects a merger arbitrage investor (or any other investor) from getting caught up in an impossibly high standard of precision. Instead, when investing against a lower, ideally much lower, market implied probability, one can invest at prices that already take into account the risks that you don't yet know about.
This book also clarified in my mind that I wanted to be able to exploit this observation, "the party… who provides… liquidity will on average make money for doing so. For the liquidity demander, time is more important than price; he is willing to make a price concession to get his need fulfilled." Having read that, I determined to always be the more price-sensitive and less time-sensitive counterparty. But to be a successful predator in search of misplaced bets, one needs to avoid having any of the characteristics of prey. That means avoiding excessive leverage, illiquidity, and complexity, so that one has a lot of flexibility to transact with counterparties that have those characteristics when they blow up.
The best historical vignette in this book was that of Nathan Rothschild after the Battle of Waterloo (p. 88-90). It is a wonderful story that illustrates this great banker's information edge, his expert gaming of transparency, and the perils of trying to free ride on advantage players without knowing what they know. Mr. Rothschild had a private information network that allowed him to be the first in the London markets to know of Napoleon's defeat. In a dramatic fashion, he managed to increase his family's already considerable fortune by a factor of about twenty between the beginning and end of the Napoleonic Wars.
"Why do markets keep crashing and why are financial crises greater than ever before? As the risk manager to some of the leading firms on Wall Street-from Morgan Stanley to Salomon and Citigroup-and a member of some of the world's largest hedge funds, from Moore Capital to Ziff Brothers and FrontPoint Partners, Rick Bookstaber has seen the ghost inside the machine and vividly shows us a world that is even riskier than we think."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.