Finance Book of the Year

Panic: The Betrayal of Capitalism by Wall Street and Washington  by Andrew Redleaf and Richard Vigilante, is a giant of a book, but its title is very misleading. The book is not at all about how Wall Street and Washington "betrayed" capitalism. It's about how the vast majority of investors, politicians, and bureaucrats fail to understand how markets really work. Most of what we learned about modern portfolio theory has blinded us to some key insights which the authors share. I've been immersed in markets for over 30 years, and I can't remember the last time I read a book or article that made me rethink so many of my deeply-held beliefs.

Are you one of the many that believe in the Efficient Market Hypothesis? In the Capital Asset Pricing Model? Do you agree that, in general, the more risk you assume the greater your reward should be? Do you believe that portfolio diversification is key to managing risk? Do you think that highly liquid markets are by nature efficient? Well, think again. Read the book and discover what you have been missing.

Here are some choice sound bites from the book: "Risk is not the foundation of profit but its most dreaded enemy." "Profit is the payment earned by the exercise of judgment to reduce the risk of an enterprise in an economical way." "Investors are paid for being right, not for the possibility of being wrong." "Diversification is always and everywhere a confession of ignorance." "The preference for public financial markets over all other markets creates a preference for weak ownership over strong." "Both the mortgage crisis and the crash are best understood as the result of government policies that pushed trillions of dollars in assets out of the hands of relatively strong owners and into the hands of weak owners." "The dream of market efficiency and the dream of socialist efficiency are the same dream ... both yearn for capitalism without capitalists." "Free economic markets are especially good at rewarding the creative and productive use of capital ... yet no matter how free the market, it is the men not the market who do the creating."

In addition to offering numerous and seemingly paradoxical insights into markets and investing, the book does a great job of explaining how the financial crisis of 2008 came about and how, with the help of hugely misguided government intervention, it eventually led to a global recession. In my professional career I have spent hundreds of hours trying to explain derivatives to colleagues, professionals, and executives, so I was amazed to see what a good job the book does of making extremely complex securities understandable to just about anyone.

The authors' prescriptions for making things better include: less government regulation, not more; less reliance on securitization, structured finance, and portfolio diversification; more respect for entrepreneurs and savers; a rejection of "too big to fail;" and the elimination of "agencies" such as Freddie and Fannie. I hasten to note that the authors are bipartisan critics, heaping plenty of scorn on the "crony capitalists" that inhabit both Republican and Democratic administrations.

All investors can benefit tremendously from this book, but it should be required reading for all politicians and bureaucrats. That's because the more the government tries to shield us from risk and uncertainty, the worse things become. Rarely have I seen anyone do such a good job of explaining why that is so.

HT: Ashby Foote, who not only recommended, but kindly sent me a copy of the book