Michael Hanson

Book Review: Fear and Volatility

By, 07/06/2012

When Genius Failed – Roger Lowenstein

The Fear Index – Richard Harris

Margin Call – Directed by J.C. Chandor

Let’s set something straight: We’re not living in a “new” age of increased volatility. The middle of the last decade, which saw very low volatility, seems to have made many (pros and amateurs alike) weak in the knees tied to recent times. Which is understandable—it has been one a heck of a ride lately, and I’ll admit my knees don’t always feel so sturdy either.

But this is why investing is far more discipline than genius: Markets are always a heck of a ride. We get this backwards all the time—looking for geniuses to divine the next great investment. Really, the best of the best in the long run are those who make fewer miscues than others; who remained disciplined when others go with their gutty entrails.

A simple view of annual dispersion of stock returns reveals wide swings are the norm. The long-term average, around 10% nominal, is the part that’s deceptive. Stocks swing! Zig and zag! They rarely ever end up with a casual, linear 10% return each and every year. That’s a central reason they pay off in the long-run: good, old finance theory, which claims a binding relationship between risk and return, is an eternal truth, no matter what the pundits posit.

In today’s pop-investing vernacular, volatility seems to be defined only as downside. Wrong! Volatility works both ways, always has. 2009 was a great, volatile year—up over 30%! But started down big. 2010 was another very good ride, including a good-sized correction. 2011 saw up 10%, then a big correction, then a recovery to a little under even. Volatile! This year’s proving no different (one of the best first quarter’s on record, then one of the worst May’s ever, followed by a bounce-back June), but I’d bet we’re set up for a big rally in the back half. Good volatility!

The simple reality is that most folks need stock exposure to meet their growth goals for retirement. So they’ll have to live with volatility if they want to meet those goals. As MarketMinder’s admonished for years, you’ll go nuts unless you learn to filter media noise. But, admittedly, this is a tough prescription to stick to; we’re not wired to do it. Most will get caught up in whatever seems dire and desperate and breathless here and now: be it pols dueling over deficits, Eurozone bail-out/bail-in scenarios, China slowing, China quickening, dollar strength and weakness and what about that dang oil!

My favorite tactic is to let my Wall Street Journals stack up for a week at a time and buzz through ‘em all in one sitting. I’ll bet your mind will be totally and utterly blown away by how 95% of the news is completely irrelevant (and probably never was relevant) after just a few days.

Maybe we need a Dr. Strangelove moment: stop worrying and learn to love the swings. In the meantime, there’s nothing like a little perspective. Two books and one movie:

When Genius Failed – Roger Lowenstein

This is the definitive recounting of the 1998 “anomaly” in volatility, which Lowenstein beautifully and deftly reveals to be not so anomalous at all. Less than 15 years ago, the trials of the so-called Asian contagion and the Russian Ruble crisis blew apart notions of how volatility worked and the idea that risk can be hedged by considering volatility as an “asset class.” This remains one of the most foolhardy notions—gaining steam, mind you—in finance today. I especially like the thundering condemnation of math-based risk control as the end-all-be-all. Nobel Laureates were ruined in this process. But still we don’t learn—“quant” analysis based on expected volatility is still a thing.

In an oblique sort of way, When Genius Failed is one of the best books I’ve read to explain 2008 and even today’s European crisis from the standpoint of the banks—there’s quite a cogent passage about mortgage securitization and liquidity. Mostly though, the book explains how banks and funds dealt with “bear raids.” It also explains how Long-Term Capital Management (the hedge fund that famously went kablooey in 1998) was dead in the water—even when it still had half its equity—once other so-called risk arbitrage desks figured out what their books looked like (hello, recent JP Morgan follies?). All this shows what liquidity really means when correlations go to one and credit spreads blow out—and how that process can destroy math models.

The part to really see in this book, though, is that this all happened in 1998. All! Should torpedo markets, right? And global markets fell over 20% in the matter of a few weeks late in 1998—yet ended up over +24% for the full year. Volatility … the good kind! It’s similar in so many vital ways to recent history, and yet it’s already out of our minds. We somehow think everything about now is different.

The Fear Index – Richard Harris

You can knock this one out on a plane ride. It’s a fun read! And absurd. But that’s why it’s fun! It’s a fiction thriller about a CERN physicist turned hedge fund manager who creates a trading algorithm so smart it not only makes billions … its achieved sentience! Which sets up an ominous (and often unintentionally hilarious) duel between genius physicist and ruthless artificial intelligence. The stakes: global markets!

Harris is mostly accurate in his description of how hedge funds work, but don’t look for an education here. This is a pulpy thriller at core. What it does, through its hyperbole as fiction, is put into relief the hysteria over volatility in recent years. Hey, maybe it’s the algorithms gone AWOL like some Kubrick-ian Hal-ish nightmare. “I can’t sell that stock, Dave.” This book, seen correctly with shades of satire, should give one pause about all the bluster in today’s real media, and, yes, volatility too.

Margin Call – XX, J.C. Chandor

This small-run film with a few big name actors explains the problems of liquidity, leverage and solvency better than most other writings I’ve seen on the 2008 panic. Also, it links the issues of 1998 with 2008 very well. With a great performance by Jeremy Irons as a grizzled bank CEO who’s learned to trust his experience over the kids on the quant desk, the sweetly defeated airs of Kevin Spacey and Stanley Tucci and the ruthless ambition of Simon Baker’s junior executive, or the pitch perfect nerdy quant in Penn Badgley—this is one not to be missed if you’re curious about 2008.

Book Review Special: Summer of Sci-Fi

In Other Worlds: SF and the Human Imagination – Margaret Atwood

Margaret Atwood’s quasi-autobiography, quasi-review of science fiction literature is either a light and airy entry into the study of imaginative literature or a somewhat loose and often shallow rehashing of ideas about the genre. You’ll have to take your pick which it is for you. It certainly is well crafted, as we’ve come to expect from anything she pens.

The first third of the book is personal essays; the second third is quasi-reviews of what she regards as “high” sci-fi literature. So, rarely is there anything really fun, it’s mostly Gulliver’s Travels, Island of Doctor Moreau, etc. All fairly mundane, but she revives with rousing enthusiasm Orwell’s 1984 and Animal Farm, particularly tying Orwell’s gift for social criticism with sci-fi. The third part is miscellaneous, short-form pieces and meditations on sci-fi, which you can easily skip or enjoy at your leisure.

Sad to say, this book leaves the feeling Atwood has done more to tarnish her lauded fiction than deepen it; her stories seem somehow shallower than we’d given them prior credit for with this commentary. Such is the risk of letting readers peek behind the curtain. Conversely, a book like John Steinbeck’s journal while writing East of Eden broadens, deepens and impels our enthusiasm for his fiction. In Other Worlds, alas, does not.

Existence – David Brin

David Brin did a lot of things for me. As a 19-year-old kid, I went to a book reading of his in the heat of a dusty Fresno summer day, and like the stupid 19 year old I was, I brazenly handed him my first manuscript. He pretended to thumb through it and read a few passages, and then, with a warm smile, encouraged me to keep writing. And I’ve done a lot of that ever since.

He also taught me great science fiction is about learned speculation—it’s not fantasy or far-out magic and myth. It’s thinking cogently about what the future could really be like—toying with the moral, economic and sociological implications. True sci-fi is an important venue for thinking about the future.

His new book, Existence, is a doozy, more or less about the many ways human extinction might come about … and about 1000 other things in between. It’s hugely dense, and long, and turgid—in ways both good and bad. Brin not only creates his own futuristic world, but nearly an entirely new lexicon to describe it in the tradition of Neal Stephenson. The sheer mental power required to deal with so many facets of science and civilization is spectacular (not to mention the acuity needed just to read it), and you’ll learn tons in his narrative. But in this megalith of sci-fi wizardry, the story and its characters are often flatter than pancakes. In its way, it’s a great book, but only the dedicated sci-fi fan should attempt this one. Mr. Brin will always have my attention, regardless.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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