Book review:A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innov
I highly recommend this book. It is written by a guy who has worked on Wall Street for years and has been a professor at either Harvard or MIT (I can’t remember which), worked for the big banks, the trading houses and prime brokerages, and hedge funds (i.e. he has been around the block). It is an interesting collection of stories tied together with a point that he tries to make and real life examples for the things you hear about a lot (esp. in the last two months with The Bear and all). He was there for all the major events the crash caused by portfolio insurance in 1987, some of the earliest uses of statistical arbitrage, problems cause by fixed income relative value trades and the currency issues in the late 90s (He was at Salomon Bros when they were basically killed and had a front row seat for the LTCM deal), the tech bubble, and the era of corporate scandal. One thing that is important to remember is that this is not a text book or a book on how to invest (although I personally believe that you can learn more from understanding the stuff in a book like this and learning how capital markets work than you can from reading books on investing since 90% + of them are complete crap).
One of the best things about this book is tied in with the one negative I can see to it. The author starts out with pointing out the fact that over the last 50 years the volatility of the world’s economy (i.e. Main Street) has been cut in half, yet over those same years the volatility of financial markets has increased by 50%. This in spite of the creation tons of complex financial instruments that are ostensively meant to decrease risk. He then puts forth the theory that these products in combination with high amounts of leverage are having the opposite effect (i.e. increasing risk) hence the title “demon of our own design”. I don’t see how in light of the events so far in 2008 and the events ten years earlier anyone can argue this point. He goes off to make his point with lots of example, and lots of stories as described above. The problem is the stories sometimes get so involved that they meander away for the point of the book (some of them seem irrelevant , although interesting none the less). Basically the book seems to be stuck somewhere in-between a memoir and a thesis paper and therefore is not as effective as it could have been if it was one or the other. I personally did not mind this, but I could see how some people could make this legitimate critique.
Note: While you don’t need to have a phd. From MIT or for that matter even a BS in finance or economics to understand this book (I don’t have any of those). It will require some basic background knowledge on economics and financial markets.
If you enjoy this book I also recommend When Genius Failed: The Rise and Fall of Long-Term Capital Management which is about the LTCM crises in 1998.