Before you trade, read. There are plenty of gurus and must-read sources. Here are just a few important books to whet your appetite. Remember: knowledge is power – in markets too. If you read nothing else, at least read these:
The importance of fundamentals
Trading in complex derivatives without possessing a thorough understanding of underlying fundamentals can be likened to trying to run before having learnt to walk.
For all the attractions of modern technology, conferring greater data, analysis and speed, there is still a clear need for investors and traders to possess at least some degree of awareness of underlying economical fundamentals and financial history.
When all other forms of analysis and interpretation of market events fail, some bright spark somewhere will urge that we focus on the fundamentals.
As the owners of fast food retailer KFC in the UK recently found out, having an improved system on paper is worthless if the tills are closed and there is no cash coming in because the new supplier has literally failed to deliver.
It is with this in mind that we would encourage capital.com customers to consider a number of key texts that have helped shape the landscape in which they operate today and enable a return to it should the world as we know it come to an end and need to be rebooted.
This will never happen? Don’t rush to be quite so sure. No one who has read the short story Nightfall by the science fiction maestro Isaac Asimov and taken its cataclysmic civilisation-destroying lesson to heart will ever commit completely to the Cloud. Fundamentals remain important.
Book 1. Passport to Profits
One of the world’s best known institutional investors is Mark Mobius, often described as the king of emerging market funds. His book Passport to Profits (subtitled a guide to global investing) was published almost two decades ago but it is still packed with sound, relevant fundamental investment advice.
Passport to Profits does what it says on the cover. It gives aspiring investors, whether private or professional, the benefit of hands-on experience to balance the risks and rewards of global investing.
Mark Mobius, occasionally referred to affectionately as The Bald Eagle, shows the reader how to view investing abroad, how to devise a global investment strategy and the pros and cons of buying directly into a company’s stocks or indirectly via a mutual fund.
As an added bonus, the book (written with the help of New York-born journalist and speaker Stephen Fenichell) is also an enjoyable read in its own right.
It is packed with mantras that communicate the lessons learnt through hands-on experience. Your best protection is diversification. Long-term planning pays.
The time of maximum pessimism is the best time to buy (it might be useful to know that this is a sanitised version of the original Templeton mantra: the best time to buy is when there is blood on the streets).
The time of maximum optimism is the best time to sell. If you can see the light at the end of the tunnel, it’s too late to buy (or sell).
The book stresses the importance of being contrary. As summarised by Sir John Templeton, founder of the investment house that still bears his name: If you buy the same securities as other people, you’ll get the same results as other people.
Or, as he says in another quotation attributed to him: To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude but pays the greatest rewards.
Mobius tells the cautionary tale of how his sister-in-law bought into one of his firm’s global emerging market funds, saying that her timing was ‘a trifle iffy, in that she bought at the height of the 1993 emerging markets boom, because everyone else did.
That boom was followed by the great 1994 emerging markets bust. He writes of how he begged her not to lose faith and to take advantage of the ‘marvellous discounts at which she could now buy more shares in my falling fund’.
She listened to him and bought low and sold high. Buy stocks whose prices are going down, not up, is his advice. Brought up to date, this could apply as easily to Bitcoin and other cryptocurrencies as it did to emerging markets in the early 1990s.
A market collapse lays the foundation for the next boom, as it says on the cover of the comic book version of the Mobius life story, published by Pan Rolling Inc.
Book 2. Real-Time Risk
The development of technology is changing the way we live and work every day, notes the blurb on the inside cover of Real-Time Risk (what investors should know about fintech, high-frequency trading and flash crashes).
Written by quantitative portfolio manager Irene Aldridge and market microstructure analyst Steve Krawciw, it was published by financial education specialist Wiley towards the end of 2017.
Development and change have created a double-edged sword in the financial markets, say the authors. Today’s investors are more informed and have more access to a broader range of investments than ever before, but they are also exposed to unprecedented risk at a moment’s notice.
Real-Time Risk sets how to show all kinds of investors how to benefit fully from the data-rich insight and opportunities that cutting-edge technology offers, while protecting assets from an always-on market.
The authors clearly see their mission as being to position investors for success in the new reality of growing wealth by enabling them to:
- Explore the blatant and not-so-blatant ways that high frequency trading impacts upon their investments
- See why market infrastructure is no longer just for execution traders and market-makers and how long-only strategies suffer by ignoring it
- Develop a balanced, data-driven perspective on global markets to make more informed investment decisions
The authors pose a number of questions to readers, including the following. Do you wonder why the markets have changed so much? Where is it all heading? How will it affect you? Do you remember Bloomberg terminals?
Do you know that allocating to stocks favoured by high-frequency traders will improve a long-term buy-and-hold strategy? Do you understand how regulation will limit or expand you options tomorrow?
Have you ever missed opportunities in the market because you felt you were disrupted?
Is your company oblivious to changes in innovation? The unfortunate truth, they state, is that many established firms are completely unprepared for the fast train of innovation currently passing them by.
Buried away towards the end of the book is a passage that could have been written for users of Capital.com, the importance to investors of minimising volatility, if not in absolute terms then in terms of volatility related to investment returns.
Minimising volatility is a challenging task, the authors concede. In a nutshell, investors need to take three steps.
- Identify the conditions that result in high volatility.
- Correctly predict when the conditions identified in step one are about to occur in the near future
- Select an action for managing this volatility. This could include trimming riskier portfolio holdings, or counterbalancing the offending instruments with offsetting or protective financial instruments, such as futures or options.
In short, Real-Time Risk is identifying simple and effective tools for well informed investors.
Book 3. A Practical Guide to Risk Management
Thomas S Coleman’s highly technical but very readable A Practical Guide to Risk Management has appeared in these columns previously, as a small part of an extended article on the broad subject of hedging risk. But it bears repeated examination and further elaboration.
For him, managing risk is not minimising risk but rather managing the trade-off between risk and return. He says that good risk management allows the following possibilities:
- Same return with lower risk
- Higher return with the same risk
Generally the result will be a mix of higher return and lower risk.
Coleman, now a lecturer and executive director at the Center for Economic Policy at University of Chicago Harris School of Public Policy, adds that the ultimate goal of risk management is to build a robust yet flexible organisation and set of processes to respond to and withstand unanticipated events.
Managing risk for crises, tail events or disasters requires the combining of all types of market risk, credit risk, operational risk, liquidity risks and others.
Generally, Coleman notes, crises or disasters result from the confluence of multiple events and causes. He cites as examples the collapses of Barings, the bank, in 1890 and in 1995 and the Société Générale trading loss in January 2008.
He might equally have pointed to The Royal Bank of Scotland and Lehman Brothers later in 2008.
In explaining what can be a very complex subject, he compares the worlds of risk management in skiing (in particular avalanche risk) with financial risk management. This makes it much easier for the private investor to understand the concepts and practices that are routinely involved in risk management.
A common problem for new skiers, for example, is ignorance of the risks they are taking. There is a clear parallel with tyro investors, except for the asymmetry of payoffs. The penalty for a mistake in financial markets is losing one's money, or job.
The penalty for a mistake in avalanche territory is injury, perhaps even death. But the upside reward in financial markets can be high enough to create incentive problems and so pave the way for overleveraging, investing badly and crashing.
Other topics that Thomas S Coleman addresses and which investors might care to brief themselves on include:
- Methods for estimating volatility and value at risk (VaR)
- Comparison of parametric, historical simulation and Monte Carlo approaches
- Techniques and tools for tail events
- Alternative distributional assumptions
- Extreme value theory
- Analysing risk
- Triangle addition
- Correlation and risk reduction potential
- Triangle addition and risk reduction potential
- Best hedge
- Replicating portfolio
- Risk reporting
- Varieties of credit risk
- Credit risk modelling
- Dependence, correlation, asymmetry and skewing
- Actuarial versus equivalent Martingale (risk-neutral) pricing
- Uses and limitations of quantitative techniques
Book 4. Financial Risk Management for Dummies
The Wiley Dummies brand of publications includes Financial Risk Management for Dummies, written by risk manager Aaron Brown of AQR Capital Management and first published in 2016.
It is impossible to summarise the worth of this volume in just a few hundred words, other than to say that it is a must-have for any investor who wants to be seen as a bona fide investor rather than a gambler.
The first chapter, Living with Risk, looks at understanding the scope of risk, measuring risk, calculating risk, working with financial risk, managing financial risk, working in financial institutions and communicating risk.
Not many financial textbooks will use a quote from the Scottish poet Robert Burns in their opening paragraph. This one does. Aaron Brown translates the best laid plans of mice and men lines as a warning that careful plans can come to nothing.
The thought that Robert Burns might have been somehow subconsciously warning that asset prices can go down as well as up, and that past performance is no guarantor of future performance, is a notion that even this experienced market observer would never have considered.
The second chapter, Understanding Risk Models, has the sub-headings:
- Comparing frequentism and Bayesianism
- Counting frequency
- Betting with Bayes
- Analysing roulette
- Beating roulette
- Comparing to quantitative modellers
- Getting Scientific with Risk
- Going Thermodynamic
- Trading in uncertainty
- Playing with game theory
The Speaking Greek chapter explains alpha, beta, gamma, delta, rho, theta and vega. A must-have book that ends with lists of 10 great risk managers in history from displaced Jewish mathematician Abraham Wald to China’s Zu Chongzhi.
The 10 great risk books that follow range from A Demon of our own Design, by Richard Backstaber to The Foundations of Statistics by Leonard J Savage.
Book 5 Money: The Unauthorised Biography
Moving beyond the mere textbook and into the territory of the history of money, Felix Martin takes the reader on a hugely enjoyable journey starting, almost literally, with the stone age. Or, rather, a stone age.
Ever heard of the Pacific island of Yap, an idyllic sub-tropical paradise nestled in a tiny archipelago nine degrees north of the equator and more than 300 miles from its nearest neighbour?
Yap’s place in monetary history, if not the history of humankind, derives from its status as what Martin calls ‘the island of stone money’. Yap, he writes, had one of the more interesting and unusual monetary systems in history.
The economy of Yap, he continues, could hardly be called developed. The market extended to only three products, fish, coconuts and sea cucumber. There was no other exchangeable commodity to speak of. No agriculture. Few arts and crafts.
Yet Yap had a highly developed system of money. Its coinage consisted of fei, which are large, solid, thick stone wheels ranging in diameter from a foot to 12 feet, having in the centre a hole varying in size with the diameter of the stone, for a pole to be inserted to transport the wheel.
The value of the coins depended on their size, but even their disappearance did not affect their value. The richest family had the biggest stone, which had lain under the sea for two to three generations after a shipwreck.
The family who owned the fei retained the same purchasing power as if it were propped up against their house in the usual Yap manner. Try telling that to a modern bank when trying to rustle up money to pay bills and see how you fare.
Another episode tells how the Roman emperor Tiberius caused a credit crunch when he decided to enforce a long-ignored rule that had been introduced by Julius Caesar. The effect of this was to drastically reduce the money supply and cut the price of property as rich families sold real estate to get their hands on cash.
“With Rome in the grip of a credit crunch, the emperor was forced to implement a massive bailout,” writes Martin. “The Imperial treasury refinanced the overextended lenders with a 100-million sesterces programme of three-year, interest-free loans against security of deliberately overvalued real estate,” he adds.
That sounds eerily similar to how the European Central Bank solved its more recent liquidity issues in the wake of the Great Financial Crisis and illustrates how human behaviour can remain unchanged even while technology advances.
This is perhaps something that investors should bear in mind in a world apparently in utter thrall to algorithms, high-frequency traders and driverless cars. There is a reason why the A in AI stands for artificial.
Artificial might be quicker. Artificial might be cheaper. Artificial might even be safer. But despite everything, some people still maintain that real beats artificial. Each and every time.