I was always interested in economics. However until a few years ago I never really studied finance. Since I decided to change that, I have learnt finance from reading good and bad books, online courses, newspapers, blog posts and online forums and by executing trades. This post sums up and prioritizes the roadmap I recommend taking to learn about finance. Having a deep understanding of macroeconomics is not necessary to learn about finance, even less if you are only looking to manage your own money. However, I highly recommend that you invest some time to understand the basic foundations of how the economy works.
Andrew Lo, an MIT economist, said that while physics has three laws that explain 99% of the phenomena, finance has 99 laws that explain only 3%. Not only do we not fully understand how the economy works but also there is an endless debate on how it should function. Everyone has values and an ideology even if they don’t tell you. You should keep that in mind while studying economics. In this roadmap I try to recommend the tools easily available and that are a part of the current economic thought.
If you have any comment, question or critique you can find me https://twitter.com/federicocarrone.
How the economic machine works
Ray Dalio, founder of the biggest hedge fund in the world, created this 30 minute video called How the Economic machine works. In this video he shares his template to understand how the the economy works. What is taught in this video is simple but really important. Don’t just watch it, study it.
Dalio’s video connects many concepts like transactions, market, central bank, monetary policy, fiscal policy, debt, collateral, credit, interest rate, inflation, deflation, productivity, economic cycles, deleveraging, recession and depression. If you don’t know what any of these words means or if you have doubts search them. In most cases Investopedia will have simple and more begginner friendly definitions than Wikipedia. Also in general at the end of each article you can view useful examples and related concepts that it are useful to check.
Some time ago I saw an interview with an old priest that has dedicated his life to keeping the Latin language alive. The interviewer asked him: “Why are you so good at Latin?”. The priest answered: “Do you see where I am sitting on? My butt. You sit on your butt and study Latin as long as I have. You’ll be a master too”. So the general idea is that it takes time master something, but anybody can do it. My biggest recommendation to learn more about economics and finance is to get a subscription for the Financial Times and The Economist. Read the Financial Times every day, specially the Markets and Opinions sections. Read the weekly Economist magazine, especially the Finance and Economics section. It’s like working out, after some time you will see big changes but you won’t be able to see them by doing short-term comparisons. Learning and reading about the financial and economic situation of different countries of the world can be overwhelming at the beginning. Geopolitics is closely related to economics. These three Youtube channels are great for making sense of what you read: Caspian Report and VisualPolitik, Geography Now. Geography Now is almost exclusively about geography but it is great to watch when you are reading news about a part of the world you don’t know much about. Caspian Report is the most profound of the three and tries to explain the deep structural reasons for what happens in the world. VisualPolitik doesn’t go as deep in the analysis as Caspian Report and has a noticeable political agenda but it is useful too.
My recommendation is that you avoid at all costs watching TV channels like CNBC or any newspaper that focus only on daily news. We live in a world without flavor, dominated by clickbait news and post-truth politics. Deep, slow to digest, opinionated analyses are hard to come by. I prefer to read anything that makes me think even if it is written by somebody that thinks or has opposite values to mine.
Macroeconomic courses and books (optional)
To better learn the concepts that where mentioned by Ray Dalio’s video you should follow Khan’s Academy Macroeconomics course.
I am not a big fan of textbooks since I find them way too schematic, but if you want to advance in the subject you will need to read one. Mankiw’s Principles of Economics or Krugman’s Macroeconomy are the most basic. Blanchard’s Macroeconomics is a little bit more advanced. I am giving many options since you will probably find one of the three books at your library. Keep in mind that studying one of this textbooks is not needed to advance in studying finance. In addition, I don’t agree with their model of the economy but it is good to know how most economist think.
Learn basic finance to invest your own money
The first thing I recommend that you do is to follow Nobel prize Robert Shiller’s Financial Markets course. The course covers stocks, bonds, dividends, markets, brokers, exchanges, bubbles and basic financial market history. He explains things in a simple and concise way. With this course you will get a basic understanding of what finance is.
The next step on your journey should be to get some practical experience. The best way to do this is to open a brokerage account to invest some of your own money. Fees and safety should be the main considerations when choosing which broker to use. Also your nationality and where you live are big factors when choosing a broker. I had good experiences with Interactive Brokers, Saxo Bank and DEGIRO. Robinhood is a new player that you should check out too.
After opening your brokerage account you should decide what you want to invest in. The first book I recommend reading is A Wealth of Common Sense. It is a very good book that explains how to create a simple framework to decide how to invest for the long term. A more dry and profound book to read that is pretty similar to the previous one is A Random Walk Down Wall Street. It is an excellent critique to the so-called technical analysis and it sums up the different investigations that have shown that humans are not rational investors. It is a good book that demonstrates that for the retail investors the best thing to do is to put their money in passive, low-fee investment vehicles instead of paying a money manager that charges a lot and doesn’t even deliver market returns. My biggest issue with the book it is that it adheres way too strongly to the Efficient Market Hypothesis (EMH). Eugene Fama, another Nobel prize and one of the most important EMH adherents, said that “In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value”. That means that in general there is no free money laying around or that getting above-average returns is really difficult. That is correct especially for the retail and individual investor. However as you will see in the advanced part of this roadmap I recommend books that are critical of this theory.
Two great books that explain more complex investment strategies are Global Asset Allocation and Global Value. The Global Asset Allocation shows how diversifying your portfolio outside bonds and stocks can be useful. Global Value Allocation shows how investing in countries that are cheap, measured by fundamentals like the Price/Earnings ratio, gets your great returns in the long run.
With Shiller’s course and these four books plus your broker account you should be perfectly able to invest your money in an intelligent way.
Financial theory and derivatives
At the beginning, learning about futures, swaps, options or derivatives can be overwhelming. Before stepping into more technical grounds I recommend that you read about the history of hedge funds with their successes and failures to understand what they did and how. More Money Than God: Hedge Funds and the Making of A New Elite by Mallaby does just that. A quote from the book:
Although Weymar looked to his teachers for help in refining his mathematical and computing skills, he was unimpressed by their efficient-market theories. “I thought random walk was bullshit,” he said later. “The whole idea that an individual can’t make serious money with a competitive edge over the rest of the market is wacko.”
As you can see, this book goes in the opposite direction than A Random Walk Down Wall Street. The success of the main protagonists depends on finding market inefficiencies, they are not believers in efficient market hypothesis. Thanks to a hedge fund called Quantopian that provides data, a development platform and education, you can write your own investment algorithms and backtest them to find this type of small market inefficiencies. Their free lectures are a great resource that you should follow if you know how to code in Python and if you have some knowledge in probability and statistics. They will introduce you to futures, the Capital Asset Pricing Model, alpha and beta, factors, means reversion, pairs trading and long-short strategies.
After following these lectures it is time to move on into learning about options. Options are difficult because you are leveraged, they react non-linearly to volatility changes, time plays a huge factor in their pricing and their payoff function can be convex or concave (if you don’t understand what these words mean don’t worry). You can be right about your bet but still lose money and the other way around. They are a counter-intuitive beast. You can create a strategy with options that looses money 99% of the time and still make enough money on the 1% case to recover everything that was lost and more. There are two books I have used to understand options. The first book I have read is Options, Futures and Other Derivatives by John Hul. It is a textbook that explains all the moving parts of a trade that involves derivatives. A good thing about the book is that is has quite a few exercises after each chapter so that you can double-check you really understood what you have read. Since it was difficult for me to grasp everything I have read from Hul’s book, I decided to read a second book called Option Volatility & Pricing: Advanced Trading Strategies and Techniques that was written by Natenberg. The tone of the book felt like it was written by a practitioner. It was easier to digest. Hul’s book seemed a little bit more advance and I think it is better to read Natenberg book first and Hul’s book afterwards.
After learning the theory you should do some paper trading and real trading with options and futures before moving on. Now it is time to switch from the technical side of things to learning more about the history of financial theory and its critics. The Misbehavior of Markets: A Fractal View of Financial Turbulence by Mandelbrot is a book that summarizes the history of modern financial theory. After that, it shows that modern financial theory doesn’t take into account big market moves that happen more frequently that what the theory predicts. At the end of the book Mandelbrot proposes other ways of modelling financial markets. I found the critique more interesting than the proposal.
Antifragile by Taleb is a book that summarizes many ideas that Taleb wrote in Fooled by Randomness and The Black Swan. Similar to what Mandelbrot wrote, Taleb proposes that unpredictable events are far more frequent and influential than most models take into account. Therefore, we should build anything, including our financial strategies, in a manner that benefits from chaos rather than try to avoid it.
After learning about the tools at your disposal and the dangers involved in trading with options it is time to learn how to really trade volatility. Trading Volatility by Bennett, Volatility Trading by Euan Sinclair, Volatility Smile by Emanuel Derman and Dynamic Hedging by Nassim Taleb are the best books in the area. I have only studied the first two. The last two are more complex and I have only done superficially and rapid lecture.
At some point you need to learn more about financial accounting. Aswath Damodaran has a great course about companies valuation that I recommend that you follow
The modern monetary system can not be separated from the financial markets. This was deeply visible in the last financial crisis. It is important to understand how the banking and monetary system works from a practical point of view. Mehrling’s course is a great introduction to this.
At last, probability and statistics are the best tools we have to assess an work with risk. Thinks Stats and Probabilistic Programming & Bayesian Methods for Hackers are the best practical books I can recommend to quickly learn probability and statistics. If you want to start the trip that goes down the rabbit hole I recommend that you do Statistics with R Specialization by Duke.