Thursday, October 20, 2011

Brown, Red-Blooded Risk

If you read only one finance book this year, Aaron Brown’s Red-Blooded Risk: The Secret History of Wall Street (Wiley, 2012) would be a good bet. Despite its title and subtitle, it is not a tell-all book and it would make a lousy movie. Instead, it challenges the reader to rethink the way she looks at commonly accepted financial principles. The experience can sometimes be intense, so to give the reader a break Brown intersperses chapters on quant history—and even here he rewrites the history we thought we knew.

This is a no-math-required book. But it is decidedly not a no-brains-required book. It reads easily, indeed enjoyably. At almost every turn, however, it offers an uncommon perspective. Take a concept as basic as risk. First, Brown differentiates risk from both danger and opportunity. Among other differences, risks are two-sided and measurable. As something of a corollary, he contends that risk is good. This does not mean that “risk must be accepted in order to improve expected outcomes. That makes risk a cost, something bad that you accept in order to get something good.” (p. 21) Those who treat risks as costs confuse risk with danger.

Brown, currently risk manager at AQR Capital Management, describes the principles and practice of risk management. The key principles are risk duality (the normal and the abnormal), valuable boundary (think VaR), risk ignition (Kelly’s optimal amount of risk that leads to exponential growth, though only within the VaR limit), money, evolution, superposition, and game theory. The practice, and Brown describes it from its infancy to its current state, depends on where you’re sitting—front-office, middle-office, or back-office. All, of course, involve intense quantitative analysis; the requisite people skills vary.

One of the jobs of the front-office risk manager is to analyze trading performance. Since independent traders are their own front-office risk managers, here’s an insight from someone who has monitored innumerable (well, probably not) trading results. First, two definitions to set the stage. “The accuracy ratio is the fraction of trades that make money. The performance ratio is the average gain on winning trades divided by the average loss on losing trades.” And second, the critical paragraph. “In principle, there is a trade-off between these two. If you cut losers faster and let profits run longer, you’ll have a lower accuracy ratio but a higher performance ratio. In practice, it very often seems to be true that the two are not closely related. The trader can pick a performance ratio, the market gives the accuracy ratio. Attempting to increase the accuracy ratio by sacrificing performance ratio seldom works. Therefore, the usual advice is to target a specific performance ratio, adjusting your trading if necessary to get to that target, but only to monitor accuracy ratio. When accuracy ratio is high, bet bigger, when it’s low, bet smaller or even stop trading until the market improves for your strategy.” (p. 221)

Who should read this book? Those who are interested in the battle between statistical frequentists and Bayesians and possible paths toward reconciliation. Those who aspire to be risk managers or who just want to know what they do and what their role was in the financial crisis. Those who are convinced that they know exactly what happened in tulipmania (read the fascinating chapter “Exponentials, Vampires, Zombies, and Tulips”). Those who have a passion for money—that is, its past and future (derivatives?). Those who want to pick the brain of a top poker player during the 1970s and 1980s, not for poker but for risk tips. Those who are tired of dull ideas expounded by drab people.

Here are a few disconnected closing thoughts about Brown’s book. Red-Blooded Risk is a heavy book, and I mean that in the old-fashioned sense of the word. It weighs in at two pounds for 415 pages. It is a book that makes you think. I highly doubt that you’ll agree with all of Brown’s ideas, but they are worthy of serious debate. It has comic strips provided by manga artist Eric Kim. It has a wonderful bibliography. And it extols those red-blooded risk takers “who are excited by challenges, but not to the point of being blinded to dangers and opportunities.” (p. 4) I have to admit, however, that I felt a sense of camaraderie with Paul Wilmott who wrote on the dust jacket: “His blood is considerably redder than mine, which is looking rather pink after reading this book. I’m not sure I’ve got the nerve to follow all of his advice, but then again I like quiche.”

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