Recommended Investment Reading: "A Demon of Our Own Design"

by: Toro

How prescient is it that Richard Bookstaber's A Demon of Our Own Design was released a few months before a derivatives induced melt-down nearly took down the global financial markets. If Bookstaber's writings our correct, it won't be the last either.

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Part autobiographical, and part contemporary financial market history, Bookstaber borrows analogies from biology and human failures in nuclear power, and airline disasters to demonstrate how complexities of system design increases the odds of failure in financial markets. The first half of the book is Bookstaber's career as a risk manager, giving the reader a front row seat to two market implosions - the crash of 1987 and the collapse of Long Term Capital Management. (It also gives shareholders in Citigroup (NYSE:C)- of which I am one - pause on why we're invested in the stock!) The second half of the book details the complexities of financial markets, how those complexities leads to failure, and Bookstaber's prescriptions for dealing with financial convulsions. Unfortunately, his prescriptions will go unheeded as "less complexity" is certainly the way financial markets are not headed.

There were three general ideas that were either re-emphasized, or struck me about A Demon of Our Own Design:

  • The first was Bookstaber's description of system complexity within financial markets. Bookstaber argues that the more complex the system, the more difficult it is to remedy shocks to the system. Anyone dealing with structured products over the past few months - where it is still difficult getting prices - is certainly aware of the outcomes of system complexity. Bookstaber shows that the more complex the system, the smaller the error needed to derail or destroy the system. Also, the more complex the system, the less adaptive the system is to foreign or unknown elements, and the more prone the system is to collapse with the introduction of foreign elements.
  • Secondly, Bookstaber argues that increasing regulation is not necessarily the answer to increasing complexity. Like the Heisenberg Principle, increasing scrutiny of market players alters investors' behaviour that will have unintended consequences and make the financial system even more unstable. For example, Wall Street, knowing LTCM's positions when the hedge fund was in trouble, sold what LTCM owned and bought was LTCM was short, causing losses to widen at LTCM which eventually led to the collapse of the fund. Had Wall Street not known LTCM's positions, trading desks would not have known to take the opposite side of the collapsing hedge fund. Increasing transparency, according to Bookstaber, makes such events more likely.
  • Finally, Bookstaber argues that liquidity is a prime, if not the main determinant of equity prices, at least in the near term. This should be obvious to equity market participants. However, teachings on stocks usually emphasize characteristics such as value, growth, quality, etc., as deterministic factors in equity pricing, not liquidity. Liquidity, or the lack of it, can at least partially explain, amongst other things, why value stocks get and/or stay cheap for a period of time and why bubbles occur.
  • I thoroughly enjoyed this book. I put A Demon of Our Own Design on my recommended investment reading list, and out of 5 give it