Five books for the investor or economist on your last-minute shopping list
With Christmas right around the corner, Financial Post Family Finance columnist Andrew Allentuck brings you five worthy books for the investor or economist on your last-minute shopping list.
Adaptive Markets: Financial Evolution at the Speed of Thought
By Andrew W. Lo, (Princeton University Press, 2017).
483 pages, $47.95.
When we make an investment, we set up the adrenalin-fuelled fight or flight reaction that can take over from the rational evaluations business schools teach. The adrenalin reaction — save yourself at any cost — may lead an investor to cut and run, taking a loss rather than waiting for the stock to bounce back. Emotion trumps mean reversion, an intellectual understanding. Our glands win and our portfolios lose.
But the reasons why investors make the wrong decisions is more than just psychology packaged with asset prices.
In Adaptive Markets, author Andrew Lo, who holds an endowed chair at the Massachusetts Institute of Technology and also practices quantitative investing at a hedge fund, demonstrates that risk management is a moving target that should be adjusted continuously as our exposure to financial hazards changes.
The financial crisis of 2008, for example, was a liquidity crisis in which most investments collapsed simultaneously, as investors sold all they could to raise cash to close their leveraged positions.
“The fossil record is filled with examples of species that over-optimized for their environments and became extinct when those environments changed,” Lo notes.
In other words, some risk management that worked before 2008 did not work in 2008 and beyond — investors had overestimated their strengths and underestimated the enemy of volatility.
Since not all financial calamities, larger or small, have the same characteristics, Lo’s model for risk-controlled investing is to first examine the big picture odds of failure for a deal or financial situation, and then to apply risk management techniques, adjusting the loss-to-reward ratio accordingly.
This turns the emotional into the cerebral. It seems obvious, it should work, but it takes an adaptation to circumstance which, when frightened, investors are often unable to make.
Lo’s work is clear and easy to understand, and the application of behavioural economics to risk management might even help you make a buck in the stock market, if you have the discipline to see it through.
Speculation: A History of the Fine Line Between Gambling and Investing
By Stuart Banner (Oxford University Press, 2017), 352 pages, 2017, $30.95 hardcover.
In Speculation, Stuart Banner, a professor of law at UCLA, takes the side of the little guy screwed by the big, the rich, the powerful and the connected, when it comes to their investments.
Take the use and misuse of insider information. As Banner explains it, early twentieth-century American law took the view that directors had a duty to the corporation, not necessarily to other shareholders. Trading on inside information for profit was not illegal so long as it did not injure other shareholders.
It took a century, but attitudes have changed — just ask drug company executive Sam Waksal and his then friend, Martha Stewart, who both wound up in jail as a result of an insider trading case in 2001.
“At the beginning of the (20th) century, speculators’ ability to exploit their superior access to knowledge was considered at worst inevitable and at best a positive good. By the end of the century, exploiting one’s knowledge in this way was a serious crime.”
That pace of change, however, doesn’t really help the little guy.
Uncertainty and unfair advantage are still the partners of almost all trading. Banner illuminates the issues with a walk through American jurisprudence.
Banner notes that speculation above market variation, the kind of thing one sees when stocks are pushed to bubble levels by the outs wanting to get in, almost always hurt the late entrants. His evidence is heavily American, though he could have brought in Bre-X and Nortel Networks as examples of disbelief suspended.
Speculation offers entertainment and provides a life-jacket of awareness when it comes to the potential pitfalls of investing.
Economics for the Common Good by Jean Tirole
Translated by Steven Rendall (Princeton University Press, 2017), 576 pages, $37.95.
Jean Tirole, winner of the 2014 Nobel Prize in Economics, brings the dismal science back to the ethical questions and roots that led Adam Smith to transition from his first work, The Theory of Moral Sentiments, to his better known Wealth of Nations. The former attempted to deal with being self-centered; the latter created the “invisible hand” to explain how pursuit of self-interest can provide for common good.
In this book, Tirole, who has specialized in economic issues in banking and corporate finance, raises ethical questions that the mathematical core of economics ignores.
How, for example, to address companies that prefer to hire workers on temporary contracts, rather than providing job security through permanent employment? (Of course, French labour laws that make it very hard to fire workers are partially to blame.)
Much of Tirole’s criticism of his fellow economists is sociological rather than methodological. Yet sound policy ideas exist, such as two-stage taxation for polluters: first, a tax on whatever crud comes out of smokestacks or waste pipes and second, a charge for what it does downstream to others.
It is not the first time the two-part penalty concept has been used. Much existing public policy has cascading taxes in which one tax becomes part of the price base for the next tax. That’s why a bottle of Scotch — with sales taxes piled on to import taxes — ultimately costs as much as a very nice lunch in a good restaurant.
Tirole also criticizes economic theory for being too mathematical, though much of his own work is heavily laden with equations. In the end, this is a door stopper of a book economists can read for perspective and non-economists can read for insights into how a profession went from focusing on questions of public and private morality to ignoring morality in favour of methodology.
Whether you find the book sleep inducing in its comments on such things as Finnish banking or astonishing in its ethical insights into cross-subsidization depends in part on how much you care about what economists do. This is an important book, but it takes dedication to get through it.
The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality
By Brink Lindsey and Steven M. Teles,
(Oxford University Press, 2017), 221 pages, C$27.50.
Decades ago, the American novelist Gore Vidal, a patrician and distant member of the Kennedy clan, said America operated with “socialism for the rich and capitalism for the poor.”
The Captured Economy, a contribution to the literature of inequality spurred by Thomas Piketty’s global 2013 bestseller, Capital in the Twenty-First Century, provides more evidence of the consequences of this polarity.
The authors, Brink Lindsey, vice president of the Niskanan Center, and Steven M. Teles, a research fellow at the organization, are classical libertarians who oppose excessive government regulation, subsidies of healthy industries and protection of the affluent.
“There is a well-established link between economic downturns, such as we are now experiencing, and rising levels of intolerance, racism, and political extremism,” they write. Their point: economic inequality creates social divisions. “When life seems like a zero-sum struggle, gains by other groups are interpreted as losses by one’s own group,” they add.
Some of the cures they suggest, such as restrictions on professional licensing and things like copyright law, which they say have gone too far, seem right out of Ayn Rand.
If Western governments really want to return economic power to the people, they argue, then they also need to protect the strong less and reward those who want to join the ranks of the successful by work rather than by collecting rents on skills that are not so rare.
The authorities should make those who are protected by law — physicians as a model case — responsive to patients rather than to their insurance companies when it comes to what treatments will be paid and therefore administered.
The Captured Economy is welfare economics packaged as a contemporary battle between the protected and everybody else.
Between Debt and the Devil: Money, Credit, and Fixing Global Finance
(rev. ed.; Princeton University Press, 2017) 302 pages, C$21.95 paper
By Adair Turner
The 2008 financial crisis, which started with stressed bank balance sheets loaded with mispriced derivatives and far more leverage than banks’ capital could support, was the inevitable result of the conceits of theoretical economics, argues Lord Adair Tuner, former chairman of Britain’s Financial Services Authority. His 2015 book, Between Debt and the Devil: Money, Credit and Fixing Global Finance, a revised edition of which was released this year, focuses on the inadequacy of interest rate controls as a way of managing the supply of money.
Turner suggests several cures for bank-driven credit crises. First and foremost, he suggests, quadruple the capital requirements for their loans to as high as 100 per cent. That would limit or end leverage that turns what is mostly real estate speculation into broad economic catastrophes. This is radical stuff for sure and very unlikely to happen.
The problem of banks jeopardizing the world economy continues, Turner suggests, because they still create towers of debt on real estate, supposedly indestructible and based on acreage God doesn’t make anymore. “Credit and real estate price cycles have been not just part of the story of financial instability in advanced economic; they are close to the whole story,” he explains.
The cure is not higher interest rates alone, for a project designed to return 20 per cent or 30 per cent of invested capital won’t be snuffed out by a quarter of a per cent rise in interest rates, Turner argues. He wants interest rates raised to at least the 5 per cent rate of growth of global GDP in raw (not inflation-adjusted) money. In fact, low-to-zero rates accelerated the risk and collapsed market process and were, of course, paid by savers who central banks worked to ensure got almost nothing for their thrift.
Between Debt and the Devil is wonderfully well written, its analysis incisive, and its implicit prediction awful — 2008 can and will happen again if suggestions limiting bank credit expansion are not taken by heart by monetary authorities.