A professional acquaintance recently recommended that I read William Poundstone’s Fortune’s Formula, which he told me Bill Gross (famed PIMCO investor) proclaimed one of the greatest investment books in recent memory. In fact-checking such a promotion, I was unable to find confirmation. However, as a random aside totally unrelated to the book itself, I did come across Gross’ December 2006 investment outlook piece, which both gives a shout-out to the book as well as provides a nice commentary on risk, leverage and distortions of reality that dotted the investment landscape prior to the onset of the credit crunch in late summer 2007. In railing against the prevailing conventional wisdom, Gross’ observations turned out to be quite prescient:
under the new world assumption of today’s low volatility and narrow asset risk spreads…there is a maximum leverage point…beyond which returns can be maintained only with increasing and significant expectations of financial loss. We estimate that the maximum alpha an average hedge fund can generate in today’s marketplace utilizing a broad array of financial assets which average a 50 basis point risk premium, displayed in Chart 2, is 200 basis points. Any attempt to go further by levering up an already…levered portfolio increasingly risks significant and in some cases, total loss of principal… I have a strong sense that the ability to lever any or all asset returns via increasing leverage is reaching a climax and therefore, that CPDO, corporate credit spreads, and more importantly, sophomoric assumptions of future assets returns in all markets may require some future compromise.
One of the graphs incorporated into the article illustrates nicely the paradigm shift between new world and old world perceptions of risk and reward.
Now, back to the book itself. I must admit that I am of two minds when it comes to judgment. On the one hand, I identified greatly with the subject matter, most of which was presented in an engaging and easily digestible manner. The NY Times described it as perhaps “…the world’s first history book, gambling primer, mathematics text, economics manual, personal finance guide and joke book in a single volume.” All topics that are generally right up my alley.
