Sunday, March 24, 2013

Red-blooded Risk - not your ordinary risk book


Aaron Brown, the author of Red-Blooded Risk: The Secret History of Wall Street, is not your ordinary risk manager. He is  an expert poker player, trader, and academic who knows a thing or two about how to manage the real risk in a portfolio. This is not your ordinary risk book but a history of risk management, the musings of the author, an academic march through some of the important history and concepts behind risk management interspersed with cartoons. If you want a simple book with a well defined outline, this is not the place. However, Brown has some of the most interesting things to say about risk management that I have seen in print.

Brown thinks of risk through play within a game. Knowing the game helps tell you baout the risks thatc an be taken and how they can be measured. He also makes a strong distinction between frequentism and bayesian analysis. A problem that can be counted can use fundamental probabilities to measure risk, but most of the problems we face are hard to count and have limited data so we have to develop some priors on how to answer the question. Thus, you need a bayesian point of view. More importantly, you have understand how to bet and what to wager in order to be a good at managing risk. Measurement is one thing, but interesting what it means to wager and how to size these correctly is critical. Knowing the pay-off is critical if you want to bet.

Brown discuses his key seven principles of risk management:
1. Risk duality - the idea that you have to understand and exploit the unexpected;
2. Valuable Boundary - it is necessary to set risk boundaries;
3. Risk Ignition - if you set the right level of risk taking you will be able to grow returns exponentially, the Kelly criteria;
4. Money - money is not the only way to measure or should be thought of when measuring risk;
5. Evolution- there is natural selection when taking risk because we have different utility or sensitivity to risk;
6. superposition - some things and activities cannot be measured with money;
7. Game theory - we are playing games against others.

This is not an easy book. brown discusses a lot of important philosophical topics on risk with a flair of story-telling. It is a good read but requires some very careful thought.



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