Seeing Tomorrow: Rewriting the Rules of Risk

This book establishes a strong foundation in risk management. It leans substantially on decision theory and behavioral economics. Its main concept is "regret." Regret is downside risk. We can insure against that downside risk by buying a Put option. Even if we deal in illiquid markets where such options are not available, it is still key to calculate the economic value of regret or of that Put option (if it were to exist). Similarly, the upside of a transaction is equivalent to buying a Call option. Mr. Dembo comes up with this equation: Upside - Lambda(Regret). Lambda captures your risk tolerance. If your risk tolerance is high, Lambda will be small. The inverse is true too. With this straightforward model, the authors can explain a whole lot of economic incentives with a behavioral component. For instance, you can easily explain why most people would not mind playing roulette with just a dollar bill. But, the same people would not play with $100 dollar bills. In effect, most people would rather take on a bad risk (with poor odds) on a small scale, than take on a better risk (better odds) on a larger scale.

Ron S. Dembo and Andrew Freeman explain how to weigh the basic elements of risk management - time horizon, scenarios, risk measure and benchmarks. They write in a direct style to appeal to the general reader, and they include numerous charts and tables to illustrate their basic principles and examples. While their mathematical reasoning may be difficult for less expert readers, it is an essential element of the book, since creating mathematical models is at the heart of risk management. With this caveat, we from getAbstract recommend this well-researched book to executives who make corporate decisions and to serious investors.

Dembo and Freeman approach risk from a very fundamental point of view, going back to the psychology of decision making. In their mark-to-future framework, decisions are evaluated by their expected value across multiple possible scenarios and risk has a different meaning for each decision maker, according to their expected Upside and Regret. For all those exposed to concepts such as Value-at-Risk, this will help put things in perspective.

Dembo's book covers an often misunderstood concept and that is risk tolerance. He approaches risk tolerance from a new perspective, although one most financial professionals would recognize from their experience. Dembo has put it into words and form. He clarifies many misconceptions. Along with Charles Ellis' "Investment Policy" and Donald Trone's "Management of Investment Decisions" this completes the "must have" trilogy. Robert Levitt, CFP, CFA, Levitt Novakoff & Co., L.L.C.