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Book Review: Financial Risk Management for Dummies

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Financial Risk Management for Dummies. 2016. By Aaron Brown. John Wiley & Sons, Ltd., www.wiley.com. 384 pages, $26.99.

The dummies to whom Financial Risk Management for Dummies is addressed are not outright novices. Rather, they exemplify the maxim that a little bit of knowledge is a dangerous thing. Aaron Brown, chief risk officer of AQR Capital Management, devotes much of the book to dispelling mistaken notions about his subject.

“Risk management is not about predicting or preventing disaster,” he writes. Neither, says Brown, is it about estimating probabilities or outcomes. The “frequentist” approach, with its analogies to casino games, has only limited application. “If all risks were playing roulette or drawing cards,” Brown states, “we wouldn’t need risk managers.” There is little in the book about measuring risk because generally speaking, risk that is measurable can be avoided, insured, hedged, or neutralized via diversification. Contrary to the likely expectations of many investment professionals, Value at Risk (VaR) does not enter the discussion until Chapter 6.

In view of the book’s masterful demolition of wrongheaded ideas, its readership should not be limited to aspiring risk managers. It constitutes essential reading as well for traders, portfolio managers, hedge fund investors, shareholders of financial institutions, and anyone else affected by risk management who has only a vague and probably incorrect understanding of what risk managers actually do. Brown makes his exposition accessible to the non-quants within those ranks by presenting almost no math more advanced than arithmetic. He also supplies valuable insights into the inner workings of trading markets, highlighted by a description of the way in which stop-loss orders prevent prices from moving straight to the level warranted by fundamental news.

When Brown at last takes up the topic of VaR, he disabuses readers of the common misconception that it represents a risk measure or a worst-case outcome. VaR is actually the best-case loss on the worst five per cent of days (in the case of a 95 percent one-day VaR). Many people often become incensed when an institution loses more than its VaR amount, yet it is expected that the one-day loss will exceed that amount more than once a month.

Brown, whose previous books include an exploration of the links between gambling and speculation, The Poker Face of Wall Street, excels at incorporating colorful and entertaining material into his highly instructive text. He reports, for example, that after a supposedly non-fiction book about alien abduction became a bestseller in 1987, the Florida-based St. Lawrence Agency sold more than 20,000 alien-abduction insurance policies.[1] In a discussion of statistical fallacies, Brown notes that if people’s height truly were normally distributed, some would have negative height, since a normal distribution includes all values from infinity to negative infinity.

One oddity of Financial Risk Management for Dummies is that although its author is American, the publisher’s British arm has brought it to market. The results are sometimes disconcerting. Early on, the reader learns that in round terms the stock market has turned £1 into £100 over the past 50 years but an accompanying graph of the distribution of daily returns displays data for the US$-based Standard & Poor’s 500. Elsewhere Brown illustrates a point about Value at Risk with an example involving betting conventions on American football.

This quirk does not detract from the richness of Brown’s book. It covers risk management in banking, asset management and insurance, in addition to addressing such practicalities as communicating with directors and dealing with regulators. The author offers tips derived from long experience in the field, including the counterintuitive advice to listen to idiots. (“Sometimes they say true things for bad reasons, other times what they say is false,” he explains, “but if you think about why they said it, it points to a valid reason.”) As a bonus, Brown debunks the standard narratives of ten famous financial debacles. These include not only Charles Mackay’s long-since-discredited account of the Dutch tulip bulb craze,[2] but also conventional descriptions of the Hunt brothers’ supposed attempt to corner the silver market and the savings and loan crisis.

Under a pedestrian title, Aaron Brown has produced much more than a how-to manual. Few financial books provide so much solid instruction in as lively and provocative fashion. Financial Risk Management for Dummies ranks with the ten great books on risk that the author summarizes in his final chapter.

-Martin S. Fridson, CFA, is chief investment officer at Lehmann, Livian, Fridson Advisors, LLC, New York City.

[1] Further investigation reveals that for $19.95 the purchaser receives a lifetime $10 million policy that pays a benefit of $1 a year for 10 million years or until death, whichever comes first. The claim form requires the signature of an alien who was on board the spacecraft involved in the abduction. Payment is doubled if the policy owner is eaten by the aliens. To date, the agency has paid out two claims, both in New York State. Source: http://www.consumerinsuranceguide.com/st-lawrence-agency/.

[2] See Famous First Bubbles: The Fundamentals of Early Manias (2001), by Peter M. Garber.

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