Preface to the Fifth Edition

I
n the past eight years, since the last edition, our industry has continued to change. The
extraordinary bull market of the late 1990s, followed by the bursting of the tech bub-
ble in 2000 seemed to be events that could never be overshadowed, but the subprime
collapse in 2007 proved us wrong. We learned what risk was all about, when money was
pulled from every possible investment at the same time. In many cases, the investments
that were liquidated had no other relationship than having profits that were needed to
cover losses elsewhere. The principles of diversification held true, but we saw the worst-
case scenario, where everything moved in the same way at the same time. It was an event
with a very low probability, but not zero.
During the years that have followed, we would expect much more focus on risk man-
agement, rather than risk measurement. Understanding how to reduce risk before the
fact is much more productive than identifying it afterward. Some hedge funds, following
in the steps of Long-Term Capital Management, have chosen to see this as a rare event,
not likely to be repeated. The rationale for this is that, in order to reduce the chances
of large risk, you must also reduce returns. They see investors as preferring the small
chance of a large loss to the less acceptable assurance of lower profits. I won’t try to
judge the merits of this decision.
On the other hand, we should all understand the best choices for controlling risk.
With that in mind, many of the changes in this edition address risk control, from the indi-
vidual trade level, to the strategy rules, to the portfolio.

COHERENCE

One of the improvements in this edition is the added coherence from one section to
another and from one chapter to another. There will be references, both forward and
backward, showing similarities between many techniques. By incorporating those refer-
ences, some of the duplication has been removed. Considerable effort was made to use
the same notation throughout the book, in hope that it will make the formulas easier to
understand. You will also find that there is a greater attempt to make this material flow
from section to section as a continuous learning process.

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