Panic

There is a perfect betting strategy that lets the gambler always make money even against house odds. It goes like this: start with a minimum bet. If you win, take your winnings and start the process over. If you lose, double your bet (so if the minimum is $1, you've lost $1 and are now betting $2). If you win, start over; if you lose, double (so now you've lost $3 and are betting $4). Each time you win, you pocket the $1 win and start over with the minimum bet. Eventually, even though the string of bets may be very long, you'll win, and as soon as you win you've made $1.

This is called the Martingale betting strategy, and it was known in the 18th century. You'll notice the casinos are still in business. So what's the catch? Boundary conditions.

Martingale only works if the gambler is unbounded in time and bets. In other words, you have to be able to keep playing until you win. If at any point you have to stop playing in the middle of a losing streak, you lose, potentially a quite substantial amount of money (much more than you've made $1 at a time). Even worse, Martingale only works if you have unbounded wealth. You have to double the bet on each loss, and long losing streaks are more common than people intuitively expect. Bet doubling also leads to high amounts of money much faster than people intuitively expect. In practice, Martingale is impossible because no one has enough money to follow its rules in all cases (even if casinos didn't, for other reasons, have maximum bets). But, and this is key, observe that Martingale can appear to work, quietly but slowly, for some period of time before suddenly failing catastrophically.

Panic is a collection of essays and news articles about four recent financial panics: the Black Monday stock market crash of 1987, the collapse of Long Term Capital Management in 1998 (with some discussion of the Asian and Russian financial crises that preceded it), the dot.com bubble burst in 2001, and the collapse of the housing market in 2007. With the exception of the dot.com bubble (more on that below), each of these panics, as presented in this book, appear rooted in financial trading strategies that resemble Martingale in their short-term effectiveness with long-term hidden risk. But, in financial markets, the problem can be even worse than with Martingale.

Martingale is applied to games that are purely random, which means mathematical rules govern how much information about their behavior you get over time. In other words, because the games are governed by random chance without psychology reinforcing runs, Martingale is likely to blow up soon enough that the lesson will probably be expensive but not devastating. Financial markets, on the other hand, have a substantial human factor. One of the thoughts that arose while reading Panic is that the human factor seems likely to both extend the "normal" periods, where one trades off wins and losses without any long streaks, and the "panic." In other words, if one added human psychology to the sorts of games one would try to use Martingale on, I think it would be more likely that one could see days or weeks (or years) without a streak of more than three or four wins or losses, followed by a streak of 100 straight losses. This is even more dangerous and devastating for Martingale than what one gets through random chance, and for any other strategy that ignores long-term boundary risk for short-term profit.

Panic is edited by Michael Lewis, author of such books as Liar's Poker, and is divided into four sections, one for each panic. Each section starts with an introduction by Lewis, followed by news articles from before the panic (to set the tone of the time) and during the panic. It then concludes with longer, more thoughtful essays written months or years after the fact. Most of the articles are taken from newspapers or news magazines such as The Economist, but there are a few excerpts from books as well. Everything here, except for Lewis's section introductions, was previously published.

I think Lewis is one of the best financial journalists currently writing. He's both insightful and entertaining, and is extremely good at communicating information while telling stories. Unsurprisingly, I found his contributions to the book the best part. Readers of his books may be mildly annoyed at the excerpts from Liar's Poker and The New New Thing, but the rest of his writings (another five articles) are rescued from newspaper archive oblivion. Particular highlights for me were "How the Eggheads Cracked," which takes a detailed look at Long-Term Capital Management's actual tactics and trading positions and where they took their losses (not in highly speculative areas, as people often conclude), and "In Defense of the Boom," which is Lewis's defense of the dot.com bubble.

One thing that Panic made clear to me is how the dot.com bust was not the same as the other panics discussed here. Unlike the first two panics (which mostly involved excessive exuberance in financial instruments that were artifacts of the financial system rather than representations of underlying value), the dot.com boom actually built things. Many of the companies were on poor footing and collapsed, but the ones that survived (Google and Amazon, for example) did legitimately change the world, and the investment that boomed and then collapsed was investment known throughout to have a high risk (mostly venture capital and stock IPOs). Lewis makes those points, but he also makes another that I hadn't thought about: while most of the bubbles involved money flowing towards people who were already rich, and many of the crashes (particularly the mortgage bubble) involved significant damage to the finances of average people, the dot.com bubble was mostly the other way around. Venture capitalists and Wall Street investors poured millions of dollars into startups that paid salary out to ordinary people. Those who did make it rich tended to be more middle-class, technical people. It's a refreshing reversal of how panics normally work.

Apart from Lewis's articles, only Dave Barry's hilarious essay on getting rich from real estate stood out for me, but there's a lot of competent, interesting writing here and nothing I thought was pointless. All of the included essays are short and to the point, being mostly taken from media where concision is required, which keeps the collection moving and held my interest. The weakest section is the coverage of the mortgage crisis; since the book went to press in 2008, the latest article dates from January of that year and much of the fallout and later analysis is missing. This unfortunately also means that Lewis's own exceptional essays on the mortgage crisis from late 2008 and 2009 aren't present. But I suppose that's why one buys The Big Short.

There are a few new facts and tidbits of analysis here, but I think the main feature of Panic is the chance to present existing knowledge about separate incidents in a format that encourages comparison between all four recent panics. It was not until reading this book that I really internalized Taleb's argument from The Black Swan about systemic risk. I'd understood the general point, but the specific examples and analysis made it easier to see that common thread. As with the Martingale strategy, people tend to miss or discount boundary conditions, but rare events can swamp all other effects.

This is not a particularly optimistic book, but it has an appealing style of intellectual curiosity that I recognize from Lewis's other writing. Lewis doesn't think that we'll ever do anything effective to prevent these sorts of panics and may instead have to adjust to their permanent presence as part of the modern financial landscape. I personally tend more towards Taleb's viewpoint that this is unsustainable. But whichever side of that debate one comes down on, this is good food for thought, and at times is highly entertaining. Recommended if you like reading the analysis articles in the business section of the newspaper, although not recommended as highly as Lewis's own books.

Rating: 7 out of 10

Reviewed: 2010-10-23