Investing in the Modern Age.

Roberts, Helen

Investing in the Modern Age by Rachel E. S. Ziemba and William T. Ziemba, Hackensack, NJ: World Scientific Publishing, 2013.

Rachel E. S. Ziemba and William T. Ziemba had front-row seats for the financial markets in the tumultuous years 2007-2012 in North America and Europe. Investment professionals and those who aspire to become them will find here analyses that bring context to market phenomena from the perspective of quantitative finance. This means that financial market returns, amounts invested and diversification strategies, predictions of returns, and measures of risk are key. Events can appear suddenly and require immediate response. The Ziembas effectively utilize as-events-were-unfolding analyses and provide additional helpful context. Augmented by supporting information, definitions, and descriptions in the preface and beginning chapters, the authors translate many of the wild and crazy events of the recent past into breezy and readable prose. This book is based on reports previously published in Willmott Magazine columns with the addition of context, definitions and explanations of industry terms. This is very helpful for students and other readers who may be less familiar with financial industry jargon. Acronyms and industry terms are not always explained, however, so some may want to have an investment web site handy. Members of the general public may find the math and charts a barrier, but the Ziembas provide sufficient descriptions to make their points clear. Investment insights, a positive tone, and an overall spirit of checking investment strategies with data pervade the book. Quantitative finance has a reputation for heavy mathematical calculations. While data, charts, and equations play their part, they are well-chosen for making the authors' points even if the reader might be fuzzy on the math. This broadens the potential audience.

The collection is organized into seven major themes that open a window into the financial industry relevant to a wider audience than just investment professionals. Don't skip the Preface, which is more like an introductory chapter to the book. The Preface gives a bird's eye view of how the whole book holds together, a quick overview of financial disasters and financial investors' errors over the last 20 years, and a focus on one possible recipe for disaster: over betting. With the insight that traditional mean-variance analysis measures of risk are not sufficient for diversification during, for example, market crashes, the Ziembas demonstrate how investors fail to diversify enough, describe the incentives in both directions, unpack rewards and dangers, and analyze results of a range of potential outcomes. Linked markets mean that assets that, in average times move relatively independently, may correlate in turbulent times. Crisis scenarios may be widely ignored ex ante, even viewed as impossible. The probability of a particular scenario may in fact be small, but not zero. In a crisis, that difference can be critical. Then the failure to diversify over even these low-probability scenarios (they call this over betting) means too little diversification at the time it is most needed: when disaster hits. A position diversified according to the usual experience is not diversified enough. In crisis, previous measurements of correlation may be wrong if they are based only on available past history. A position is instead exposed "to a series of related risks in seemingly uncorrelated assets classes" (p. xiv). Besides the analysis, the book's discussion gives a mild taste of how those in the industry use data and convince colleagues.

The first six themes illuminate the financial markets. The first theme defines their approach--to structure investments to get as close as possible to a sure bet where the worst outcome possible is to break even (arbitrage). Chapter 1 explains how to construct an arbitrage in a specific horse race (2009 Breeders' Cup Classic $5 million race in Santa Anita). Did it work out? Read it and see. Chapters 2 and 3 introduce and describe behavioral biases and rival investor camps.

Theme 2, the longest at 10 chapters and over 100 pages, describes and analyzes behavior, including typical mistakes and strategies, of funds: index funds, hedge funds, pension funds, and other investment funds with the goal of beating average market returns. It's not easy, and it can be complicated!

Themes 3, 4, and 5 are focused on what is and is not predictable in markets: seasonal effects, violent market moves, and stock market crashes, with catchy titles like "Sell in May and Go Away and the Effect of the Fed" (Chapter 17), or "What Signals Worked and What Did Not" (Chapters 2325), or "How to Lose Money in Derivatives and Examples of Those Who Did" (Chapter 26).

Theme 6 is titled "Bubbles and Debt," but might also be called "Investing Around the World," which is actually the title of Chapter 35. Theme 6 also includes a set of prescriptions for improving the U.S. originally written in 2011 but updated after the 2012 election.

Theme 7 is for the sports and entertainment guys and those who love them--application of these techniques to sports markets: betting on football (NFL) and horse racing. The Dr Z (et al.) systems looked at racetrack betting as if it were investing in a financial market rather than betting on a race and then searched for "mispriced" place and show bets as if they were violations of efficient market pricing. Buyer beware--these opportunities expire quickly.

The book is chock full of examples for a course in quantitative finance. Its conversational tone and references to specific recent events would enliven the equations and calculations and demonstrate how practitioners work. Behavioral economics courses, especially those focusing on behavioral finance, can use selected chapters to identify investor and market biases. Economic historians and financial markets historians will see forces identified not only to explain the financial crises, but also, in the chapters on portfolio choices, to minimize losses across all future possible paths.

There are always quibbles, of course. Some of the illustrations and charts are small enough that the fonts approach the unreadable without a magnifying glass. While the colors in graphs and pictures are attractive, occasionally the colors, especially reds, disappear. Unexplained acronyms are sometimes misleading. For example, Chapter 2 discusses uses of the FED model and charges of its lack of evidence without directly defining it. Is FED an acronym or do they mean the Federal Reserve, familiarly-shortened to "the Fed"? (The Federal Reserve Chairman, Allen Greenspan, used a comparison of U.S. Treasury note yields to stock market yields in 1997, which became known as the Fed Model.) Chapter 2 defines Ziemba's model for suggesting asset allocation and predictions of potential investment opportunities (Bond Stock Earnings Yield Differential, or BSEYD) and mentions that some forms are equivalent to the FED model, but never defines the Fed Model. The chapter finishes with a very accessible and helpful critical discussion of the best potential use of the BSEYD model and its usefulness in predicting market crashes.

Financial analysts' models combined with ex-post analysis--these give the flavor of Investing in the Modern Age. To use this book for your own investing portfolio, you would need access to the financial databases for the prices and math and computing power to calculate the indicators, but also realizing that if you know these relationships, others do also and may have already arbitraged away their advantages. But we have the enjoyment of the Ziembas' tales.

Helen Roberts

Clincial Professor of Economics

Director, Center for Economic Education

University of Illinois, Chicago