Upside, Downside: Simple Rules of Risk Management for the Smart Investor - Hardcover
From Ron Dembo, advisor to leading banks and hedge funds, and Daniel Stoffman, co-author of the revolutionary bestseller Boom, Bust and Echo, Upside, Downside is an accessible guide to the biggest danger facing investors in an increasingly uncertain world: financial risk.
As a generation of investors knows, financial markets are vulnerable to events – from terrorist attacks to epidemics – that are guaranteed to occur, yet impossible to predict. As markets become more complex and intertwined, investors feel increasingly unsure: how can you safeguard your financial prospects when you can’t know what the future will look like?
Upside, Downside is a toolbox to protect yourself from financial risk. Co-authored by a leading financial journalist and a pioneer in the field of risk management who advises the world’s major banks, it gives investors access for the first time to the most advanced risk management strategies available, distilled into three simple rules for managing risk. These rules – Knowing What You Own, Using Multiple Scenarios, and Anticipating Regret – will allow you to take control of your financial future. You can’t banish all the dangers of the world, but Upside, Downside will give you the skills to manage them.
As a generation of investors knows, financial markets are vulnerable to events – from terrorist attacks to epidemics – that are guaranteed to occur, yet impossible to predict. As markets become more complex and intertwined, investors feel increasingly unsure: how can you safeguard your financial prospects when you can’t know what the future will look like?
Upside, Downside is a toolbox to protect yourself from financial risk. Co-authored by a leading financial journalist and a pioneer in the field of risk management who advises the world’s major banks, it gives investors access for the first time to the most advanced risk management strategies available, distilled into three simple rules for managing risk. These rules – Knowing What You Own, Using Multiple Scenarios, and Anticipating Regret – will allow you to take control of your financial future. You can’t banish all the dangers of the world, but Upside, Downside will give you the skills to manage them.
"synopsis" may belong to another edition of this title.
About the Author:
Dr. Ron S. Dembo is the founder and former president of Algorithmics Incorporated, and grew it from a startup to the largest enterprise risk management software company in the world, with offices in fifteen countries and over half of the world’s top banks as clients. He is founder and CEO of 0footprint. He has taught at Yale and MIT, and has published over sixty technical papers on Finance and Mathematical Optimization, and holds a number of patents in computational finance. In 2003 he was among the first fifty people inducted into the Risk Hall of Fame.
Excerpt. © Reprinted by permission. All rights reserved.:
one
the three rules of risk
In 2004, Anthony Richards of London, England, liquidated all his possessions and went to Las Vegas with the proceeds – $135,000, all he had in the world except for the clothes he was wearing. After trading the money in for chips at the Plaza Hotel casino and playing some low-stakes games to warm up, he strode to a roulette table and bet it all on red.
The ball landed on Red 7 and Richards doubled his money. Unlike most big winners, he knew enough to quit while he was ahead. He arrived back in London twice as rich as when he had left.
All of us take risks every day of our lives. When we walk down the sidewalk we ignore the risk that a big truck will go out of control and mow us down. We know this might happen, but the odds are low, so we bet against it. The upside of being able to use the sidewalk offsets the downside of the small likelihood that we might be injured or killed.
To put it another way, most of the risks we take each day are calculated risks. Whether consciously or instinctively, we analyze various future scenarios before we act, to ensure that the odds are in our favour.
Except in our financial lives. Even though our financial security is crucial to our well-being, both present and future, we take risks with our money that we would never take with our personal safety. Often without realizing it, we do the financial equivalent of dashing out into a busy street and into the face of fast-moving traffic.
Obviously, Anthony Richards (not his real name) was taking a wild gamble. But many other people, who consider themselves cautious and responsible and who would never dream of doing what Richards did, also take unreasonable risks with their money, often unknowingly. Take the case, reported in The New York Times, of George Casterline, a longtime employee of Corning Inc., of Corning, N.Y. When, in the 1990s, the value of the Corning stock he owned reached $500,000, he began planning for an early retirement. Then the telecommunications companies that were customers for Corning’s fibre-optic cables suffered severe setbacks. Corning stock went into freefall, dropping from $113 to just over $1, and Casterline had to put his retirement plans on hold.
Thousands of employees like Casterline have taken advantage of plans that encourage workers to buy stock in the companies they work for. Few of them would consider themselves reckless gamblers. But in fact, their financial situations are almost as risky as was that of Anthony Richards when he walked up to the Las Vegas roulette table with his life savings in hand.
What if Casterline, when his Corning holdings hit $500,000, had realistically assessed future scenarios? Here he was with a fortune in the stock of the same company where his human capital (his job) resided. Moreover, this company was dependent on the fate of the volatile telecommunications industry. Was the stock more likely to continue its heady ascent or to fall? Moreover, regardless of the prospects for the stock, was it wise to have one’s entire financial well-being riding on the welfare of just one company, even though that company had been successful in the past? Clearly not. Any objective analysis would have quickly revealed that Casterline’s downside risk was greater than the upside. If he had analyzed his situation in those terms, he could have traded in his Corning stock for a diversified portfolio and continued planning for early retirement.
As for Anthony Richards, his upside was a chance of doubling his money. Instead of $135,000, he would have $270,000. That is a respectable amount but it is not a great fortune, certainly not enough for a thirty-two-year-old to retire on. Not enough, in fact, to change Richards’s life in any significant way. His downside was the strong likelihood of being left penniless. Viewed objectively, the downside vastly outweighed the upside.
But Richards didn’t see it that way, an illustration of the importance that individual psychology plays in investment decisions. An older person who had lived through trying economic circumstances and struggled to accumulate a modest nest egg would not have done what Richards did. But for a young person who has never known hard times and who doesn’t foresee much difficulty in starting over should he lose, the extra $135,000 he will get if he wins is worth more than the regret he will experience if he loses. In other words, in Richards’s case, the upside of his Las Vegas escapade was worth more than the downside.
Traditional risk-return analysis cannot account for such seemingly perverse behaviour. Only when we understand that each investor is different and that the perception of upside and downside varies according to one’s experience, age, and personality can we understand it. Each of us has to take into account our own individual situation – both financial and psychological – when we make investment decisions.
Nobody can predict the future. That is a basic fact of life, but one that seems to elude many investment advisors, managers, and financial gurus. The financial pages of our newspapers are full of predictions, most of which turn out to be wrong. For example, all forty-three forecasts by major institutions for economic growth in Britain in 1999 turned out to be wrong. Yet forecasters continue to forecast, and many otherwise rational people continue to take their forecasts seriously.
As John Kay explained in the Financial Times, there is a steady supply of forecasts “because there is demand: investors and businesses that continue to believe, despite the evidence, that these people really see the future in their crystal balls. Hope continues to triumph over experience, just as it does among the customers of medical quacks and racing tipsters.”
We cannot predict the future because the future is inherently uncertain. The scenario planner recognizes that the future could unfold in many different ways; meanwhile, the forecaster ignores this basic fact of life.
the three rules of risk
In 2004, Anthony Richards of London, England, liquidated all his possessions and went to Las Vegas with the proceeds – $135,000, all he had in the world except for the clothes he was wearing. After trading the money in for chips at the Plaza Hotel casino and playing some low-stakes games to warm up, he strode to a roulette table and bet it all on red.
The ball landed on Red 7 and Richards doubled his money. Unlike most big winners, he knew enough to quit while he was ahead. He arrived back in London twice as rich as when he had left.
All of us take risks every day of our lives. When we walk down the sidewalk we ignore the risk that a big truck will go out of control and mow us down. We know this might happen, but the odds are low, so we bet against it. The upside of being able to use the sidewalk offsets the downside of the small likelihood that we might be injured or killed.
To put it another way, most of the risks we take each day are calculated risks. Whether consciously or instinctively, we analyze various future scenarios before we act, to ensure that the odds are in our favour.
Except in our financial lives. Even though our financial security is crucial to our well-being, both present and future, we take risks with our money that we would never take with our personal safety. Often without realizing it, we do the financial equivalent of dashing out into a busy street and into the face of fast-moving traffic.
Obviously, Anthony Richards (not his real name) was taking a wild gamble. But many other people, who consider themselves cautious and responsible and who would never dream of doing what Richards did, also take unreasonable risks with their money, often unknowingly. Take the case, reported in The New York Times, of George Casterline, a longtime employee of Corning Inc., of Corning, N.Y. When, in the 1990s, the value of the Corning stock he owned reached $500,000, he began planning for an early retirement. Then the telecommunications companies that were customers for Corning’s fibre-optic cables suffered severe setbacks. Corning stock went into freefall, dropping from $113 to just over $1, and Casterline had to put his retirement plans on hold.
Thousands of employees like Casterline have taken advantage of plans that encourage workers to buy stock in the companies they work for. Few of them would consider themselves reckless gamblers. But in fact, their financial situations are almost as risky as was that of Anthony Richards when he walked up to the Las Vegas roulette table with his life savings in hand.
What if Casterline, when his Corning holdings hit $500,000, had realistically assessed future scenarios? Here he was with a fortune in the stock of the same company where his human capital (his job) resided. Moreover, this company was dependent on the fate of the volatile telecommunications industry. Was the stock more likely to continue its heady ascent or to fall? Moreover, regardless of the prospects for the stock, was it wise to have one’s entire financial well-being riding on the welfare of just one company, even though that company had been successful in the past? Clearly not. Any objective analysis would have quickly revealed that Casterline’s downside risk was greater than the upside. If he had analyzed his situation in those terms, he could have traded in his Corning stock for a diversified portfolio and continued planning for early retirement.
As for Anthony Richards, his upside was a chance of doubling his money. Instead of $135,000, he would have $270,000. That is a respectable amount but it is not a great fortune, certainly not enough for a thirty-two-year-old to retire on. Not enough, in fact, to change Richards’s life in any significant way. His downside was the strong likelihood of being left penniless. Viewed objectively, the downside vastly outweighed the upside.
But Richards didn’t see it that way, an illustration of the importance that individual psychology plays in investment decisions. An older person who had lived through trying economic circumstances and struggled to accumulate a modest nest egg would not have done what Richards did. But for a young person who has never known hard times and who doesn’t foresee much difficulty in starting over should he lose, the extra $135,000 he will get if he wins is worth more than the regret he will experience if he loses. In other words, in Richards’s case, the upside of his Las Vegas escapade was worth more than the downside.
Traditional risk-return analysis cannot account for such seemingly perverse behaviour. Only when we understand that each investor is different and that the perception of upside and downside varies according to one’s experience, age, and personality can we understand it. Each of us has to take into account our own individual situation – both financial and psychological – when we make investment decisions.
Nobody can predict the future. That is a basic fact of life, but one that seems to elude many investment advisors, managers, and financial gurus. The financial pages of our newspapers are full of predictions, most of which turn out to be wrong. For example, all forty-three forecasts by major institutions for economic growth in Britain in 1999 turned out to be wrong. Yet forecasters continue to forecast, and many otherwise rational people continue to take their forecasts seriously.
As John Kay explained in the Financial Times, there is a steady supply of forecasts “because there is demand: investors and businesses that continue to believe, despite the evidence, that these people really see the future in their crystal balls. Hope continues to triumph over experience, just as it does among the customers of medical quacks and racing tipsters.”
We cannot predict the future because the future is inherently uncertain. The scenario planner recognizes that the future could unfold in many different ways; meanwhile, the forecaster ignores this basic fact of life.
"About this title" may belong to another edition of this title.
- PublisherDoubleday Canada
- Publication date2006
- ISBN 10 0385661592
- ISBN 13 9780385661591
- BindingHardcover
- Edition number1
- Number of pages224
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