Ben Warwick, Editor
Book Review
Reviewed by Jon Ford, CFP®
I cracked this book following the Journal of Financial Planning Symposium and FPA's annual conference in San Diego—I was inspired! I felt up to the challenge of The Handbook of Risk, knowing that I would cover old ground but also break new.
I expected to meet old friends like the efficient frontier, eigenvalues, leptokurtic distributions, Jensen's alpha, Black-Scholes, Monte Carlo, Taylor series, and time diversification. But strange concepts also loomed large: forensic accounting, ambiguity aversion, chaos related to long-term forecasts, downside semivariance, and the exponential GARCH (a.k.a. EGARCH) model. I was in for a bit of a stretch and eager to begin.
Coincidently many of presentations at the FPA conference were attempts to make operational the early research and attitudinal findings presented in this book. Investment and investing risk seems to be on everybody's minds and it is refreshing to see researchers and analysts beginning to develop a body of knowledge that can be extended into our financial planning practice.
The book itself is divided into three parts:
1. The nature of risk
2. Measuring risk
3. The investment manager's viewpoint
Each of the 18 chapters is a reprint from a book, such as "The Failure of Invariance" from Peter Bernstein's Against the Gods, a journal article reprint, such as "A New Paradigm for Portfolio Risk" from The Journal of Portfolio Management, or an original work, such as Brian Cornell's chapter, "Hedge Fund Risk."
Prepare to be challenged. Managing an investment portfolio is essentially about selecting and assembling a set of risks into a coherent whole. Most of us identify investment risk, at least in part, with volatility measured as standard deviation over varying time periods. But readers are left with the notion that volatility is nothing more than predictability. Part 1 redefines risk in terms of the likelihood of loss as it is perceived by the portfolio owner—that is, the possibility of loss or injury. To discuss portfolio risk with real clients means to superimpose projected cash flow from investment conversions onto the time period for essential payments.
The value of reframing risk in terms of client perceptions rather than an investment's statistical character was clearly very helpful; further, there were mind-bending challenges to many of our commonly held practice truths. For example, many of us talk with clients about time diversification (risk reduction related to the passage of time). Chapter 12 explains why investors hold to that belief even though it's wrong. The authors also give a good whacking to mean variance optimization and CAPM, which I found refreshing as MVO seemed a bit surreal in my practice even though I gave it a good try for a few years because I thought I should.
Although the book comes at it from many risk dimensions—fundamental, phenomenological, statistical—it stays true to its course. It provides under one cover some of the seminal work on the topic of investment risk. As investment professionals we know that mastery of this topic is essential to being in a position to avoid the failures and anguish that surface from investment disappointments. This is a very good book; it has the added benefit of preparing the reader for FPA conferences for years to come as we wrestle with reducing risk in our clients' lives.
Jon Ford, CFP®, is president of CF Financial Planning Solutions, Inc. in Cedar Falls, Iowa.
Wiley Finance
www.wileyfinance.com
$79.95 (hardcover: 274 pages)
2003
