Clever Geek Handbook
25 January 2026

Guide to Hedge Funds

Recommendation

This brief handbook offers a concise, highly readable introduction to the controversial subject of hedge funds. Philip Coggan demystifies these complex, generally unregulated investment vehicles. He identifies the major hedge-fund investment styles, lists some of the most important hedge funds and explains how they work. He elucidates some of the darker corners of the hedge-fund world, providing one of the most comprehensible accounts yet written of its risks and regulatory challenges. BooksInShort recommends this book to readers who have a basic acquaintance with the language and concepts of finance and investment, and who seek an unbiased, objective introduction to hedge funds.

Take-Aways

  • Hedge-fund managers have become a focus of fascination and even horror.
  • The label “hedge fund” covers many investment styles and is difficult to define.
  • Hedge funds share some characteristics: extraordinarily high compensation for managers, very high risk, greater than expected leverage and a focus on absolute return.
  • Hedge-fund regulation and supervision have been rather lax in the United States.
  • Continental Europeans, especially Germans, have called for tighter regulation of hedge funds, but Britain and the U.S. have preferred a laissez-faire approach.
  • Studies suggest that hedge-fund managers do produce returns even in bad markets, but investors may not get what they pay for, since managers keep so much of the earnings.
  • Activist investors buy corporate equity and push management changes to increase value.
  • The hedge-fund industry is changing as it matures. Some managers are seeking permanent capital; others have diversified into tamer financial activities.
  • The devastating consequences of the subprime mortgage crisis suggest that hedge funds’ future growth may not be as impressive as their past growth.
  • Clearly, the hedge-fund industry has serious work to do on risk control.

Summary

The Hedge-Fund World

Hedge-fund managers are Wall Street’s new public paradigm: the money manipulators who take home the big profits. Mostly male, the managers of hedge funds have proven their power to change the value of currencies, rattle company managers, crash markets and make enormous amounts of money while doing so. Twenty-five hedge-fund managers shared $14 billion in total compensation in 2006, and the three most highly compensated earned $1 billion or more apiece. Moreover, they make that much even though they turn away investment money. The best hedge-fund managers are quite selective about whose money they manage. Indeed, having money with one of the funds at that level is a status symbol that confers bragging rights.

“Those...who run the funds have the power to bring down currencies, unseat company executives, send markets into meltdown and, in the process, accumulate vast amounts of wealth.”

Hedge funds have grown more important in the financial system while they have taken on functions that used to belong exclusively to banks, insurance companies, pension funds, mutual funds and so forth. Yet, most hedge-fund managers have a casual, sartorial style that seems out of keeping with their eminence, and that is much more laid-back than the power-suited bankers of the 1980s. Unlike the old “Masters of the Universe” about whom novelist Tom Wolfe wrote in Bonfire of the Vanities, the new breed shuns the heart of Manhattan and prefers to situate its offices in such tranquil suburbs as Greenwich, Connecticut.

“The industry is gradually becoming mainstream. But this is still a weird and wonderful world, with lots of different creatures being dubbed hedge funds, even though they have strikingly different characteristics.”

In the public mind, at least in Great Britain, the face of hedge funds is George Soros, who “broke the Bank of England” in 1992. In the United States, the public may be more apt to recognize the name of Long-Term Capital Management, the fund whose roster of Nobel laureates was unable to prevent it from nearly crashing the entire global financial system in the late 1990s. However, few people outside of the financial industry know much about hedge funds, and even fewer know who manages them. This is partly by design. Most hedge-fund managers shy away from publicity for good reason: in 2003, kidnappers nabbed one of them.

Hedge-Fund Basics

Hedge funds are difficult to define. The category has a startling variety of investment styles, instruments, strategies, fee schemes and other characteristics. Yet, these generalities apply:

  • Hedge funds tend to be private, that is, shares do not trade publicly.
  • They tend to be illiquid – investors are not free to take out capital at will.
  • They tend to be exempt from many of the regulations and taxes imposed on other investment vehicles.
  • They tend to be flexible and to speculate in a wide variety of instruments.
  • They tend to use leverage, that is, to borrow in order to boost returns.
  • Their managers tend to be extremely well paid. They reap sometimes outlandish amounts, even when they don’t succeed. These fees are quite controversial.
“Hedge fund techniques are here for good, even if the industry itself changes out of all recognition – and 2007’s bad publicity will probably slow its growth.”

Hedge funds are riskier than many other investments. Among the risks:

  • Leverage magnifies gains but it also multiplies losses. Some hedge funds were virtually wiped out in 2007, that is, their investors lost most or all of the capital they invested because of speculation in mortgage-backed securities.
  • Exemption from regulation means that fraud may be easier to perpetrate in hedge funds. In fact, some hedge-fund managers have lied, or misrepresented profits or investments.
  • Illiquidity ties investors to the fund, meaning that getting money out in bad times can be difficult.
  • Hedge-fund managers charge high fees, sometimes more than high enough to absorb any excess return an investor may have expected; you may not get what you pay for in some cases.
  • Hedge funds are not transparent, and their opacity makes it difficult for investors to know where funds are invested. And again, leverage makes this opacity even riskier.
“Hedge fund fees are high enough to raise questions about whether they make more money for themselves than for their clients.”

One scholar referred to hedge funds as “the Galapagos Islands of finance,” meaning that intense competition among managers leads to rapid, multifaceted evolution and an astonishing proliferation of innovation. Investors flock to hedge-fund managers who have good reputations, but caveat emptor – a sterling reputation gives no real assurance that the manager will succeed.

“Traditionally, activists were seen as a force in the American market, but they have been moving their attention to Europe. This helps explain why they have been the subject of controversy; in continental Europe, shareholders have traditionally been seen

Some investors may seek hedge funds to diversify their portfolios. Because hedges can make money whether the market is rising or falling, they have generally logged good records. However, unlike conventional money managers, hedge-fund managers do not define success in terms of beating a market index. If an index falls, and the conventional managers’ customers do not lose as much as the index did, they may call that a success. However, the investors still lost money. By contrast, hedge-fund managers look to absolute returns. Losing money is failure – period!

“The danger for funds-of-funds may lie in excessive risk aversion.”

Hedge-fund managers make money in falling markets by selling short. Their ability to sell short easily is important to their success, but it is also fuel for controversy. Corporate managers detest it when investors sell their stocks short because that is, in effect, a vote against their management. The short seller bets that a stock’s price is going to fall, borrows shares and sells them now, planning to buy them back later at the lower price and return them to the lender. Short selling serves a valuable economic function. For instance, it helps deflate bubbles and manias. Short selling whispers words of skeptical reason into a market’s euphoric ears. So, hedge funds’ short selling is not shady or immoral, but it is risky – as are many hedge-fund investment strategies.

How Hedge Funds Make Money

In 1990, only 600 hedge funds were active; in 2000, that rose to some 10,000. Hedge funds took in about $65 billion in fees in 2005, and likely more in subsequent years. Traditionally, hedge investors have been rich, but in recent years, even pension funds have bought hedge investments.

“It certainly seems hard to claim, at first sight, that hedge funds earn rewards commensurate with their contribution to society.”

Hedge funds break into four broad categories, each with numerous subcategories:

1. Equity or Stock Market Funds

These funds include:

  • Long-short – Long-short managers buy some stocks and sell others short, hoping to make money when their long positions go up and their short positions go down.
  • Market neutral – This is a subgenre of long-short investing in which the manager attempts to neutralize the portfolio against the market’s up-or-down moves, and make money on the relationship between securities instead of on their directional moves.
  • Short selling – Short funds do not take long positions; they rely only on short selling.

2. Arbitrage Funds

These funds attempt to profit from mispriced securities. Generally, the managers bet on a theoretical relationship between prices. When a price moves out of the theoretically correct alignment, they invest expecting it to move back. The main types of arbitrage investing are:

  • Convertible – Some bond covenants allow investors to exchange the debt for equity at a certain price. Hedge fund managers analyze these convertible securities as a combination of a bond and an option, and speculate on the underlying price relationships.
  • Statistical arbitrage – Statistical arbitrageurs, who are practitioners of an intensely quantitative discipline, look for patterns in security prices.
  • Fixed-income arbitrage – These investors try to profit from inefficiencies in bond pricing. This was the strategy of the Long-Term Capital Management (LTCM) hedge fund, which failed due to flawed models and insufficient capital.

3. Directional Funds

These types of funds invest in trends:

  • Global macro – Global macro investing has faded in popularity in recent years, partly because it takes a great deal of investors’ faith that a hedge-fund manager will predict the future correctly. George Soros, Julian Robertson and Michael Steinhardt were famous in the early 1990s for their success with this strategy. George Soros, for example, became notorious for allegedly forcing the British pound out of the European exchange rate mechanism in 1992.
  • Managed futures and commodity trading advisors – As the names imply, these funds invest in futures and commodities. Although not, strictly speaking, hedge funds, they do take enormous risks and earn enormous returns. Moreover, some of the best-known hedge-fund managers started out in this sector.

4. Event-driven funds

These funds invest in specific situations. For example:

  • Distressed debt – These funds buy the debts of entities that have fallen on hard times, betting that in the rush to get out of these situations, the owners of that debt are willing to sell at lower prices than the entities’ true prospects justify.
  • Merger arbitrage – Investors bet on the results of acquisitions and mergers.
  • Activist investors – Investors push management changes that increase value.

Hedge Funds: the Good, the Bad and the Future

Hedge-fund regulation has been a contentious subject. Generally speaking, the British and the Americans have favored a free-market approach while continental Europeans, especially the Germans, have called for binding rules. Until recently, the relative absence of hedge-fund scandals in Britain and the U.S. has given strong support to the case for self-regulation. However, recent events in the mortgage market, especially the chaos involving investments in subprime mortgages, may have changed that.

“Academic studies come thick and fast but they seem to agree on one conclusion: Hedge funds do produce alpha [earnings in a down market]. The question is how much of that alpha is kept by the managers.”

To many it seems that hedge fund managers are paid disproportionately to their value to society. It is difficult, they say, to argue that the task of managing a hedge fund is more socially valuable than that of teaching children or healing the sick. Moreover, hedge funds seem remarkably risky. Although champions of hedge funds point to the sophisticated risk-control policies of at least some funds, the subprime market crisis led many to believe that hedge-fund investing has had a deleterious effect on the financial system. These issues came to the fore:

  • Flawed models – Hedge-fund managers tend to have studied at similar schools, so they look at the same data and draw similar conclusions. Because they have the same ideas about what it takes to build a good financial model, instances have occurred in which all their models failed in similar ways simultaneously, leading to the kind of coordinated movement that destabilizes markets.
  • Structured investments – Hedge-fund managers invested heavily in mortgage-backed securities and other sophisticated security structures under the illusion that they had thoroughly analyzed this strategy and understood what they were doing. Events left little doubt that they had, in fact, misunderstood the risks.
  • Carry trade – Managers borrowed in low-interest-rate currencies and invested in high-interest-rate currencies. Over the long term, the carry trade should be unworkable. Indeed hedge-fund managers tend to be on the same side of the same trades, raising the question of just what customer they could sell to in the event of problems.
“Hedge funds are not so much an industry, or an asset class, as a structure.”

Two things are clear about hedge funds: They do seem to generate above-market returns and managers keep a disproportionate share of those returns. However, hedge-fund returns are not dispersed in a normal distribution. They are, according to some research, somewhat skewed to losses and somewhat more than normally vulnerable to extreme events.

“At the risk of being pretentious, you could almost say that hedge funds are a state of mind.”

That said, hedge funds have been remarkably popular among investors in recent years. Some of the more successful American hedge funds have evolved into diversified financial-services holding companies. Predicting what hedge funds will become in the future is difficult. Some evidence indicates that the industry may be consolidating and perhaps growing tamer. Some fund managers are striving to reduce risk and increase transparency. Hedge-fund managers have also been seeking permanent capital so they can insulate themselves against market instability and short-term turbulence. However, an industry notorious for high fees may have difficulty justifying those fees if it is not bearing risk.

About the Author

Philip Coggan writes the “Buttonwood” column for The Economist, where he is also capital-markets editor.

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Guide to Hedge Funds

Book Guide to Hedge Funds

Profile Books,
 


25 January 2026

The Age of Turbulence

Recommendation

In the wake of the 2008 global financial crisis, it’s easy to forget that former US Federal Reserve chairman Alan Greenspan presided over a tumultuous economic period that was both “irrationally exuberant” (these are his own words) and painfully transformative. His autobiography predates the crisis – even the later edition’s 2008 epilogue precedes the Lehman Brothers bankruptcy – so any current reader will likely view Greenspan’s career through that crystal. Yet his thorough, expansive history of US politics and economics from the end of World War II to the turn of the 21st century, including his private thoughts on working with six US presidents, is a compelling illumination of how the nation evolved. His command of economic history, facts and figures is impressive, but he is much more than a numbers nerd: He grew up a fatherless only child, once made a living playing saxophone in jazz bands and married a famous television journalist, none of which kept him from being at one time “the second-most powerful man in the world” and its “most powerful banker.” While the book’s first half engagingly reveals Greenspan’s personal journey, the second half – his meditations on global issues – bogs down in plodding econospeak. Nonetheless, BooksInShort warmly recommends this instructive personal and national saga to those interested in economic history and contemporary issues.

Take-Aways

  • Alan Greenspan grew up in New York City, a fatherless only child whose passions were baseball, music and Morse code.
  • He had no plans to attend college; instead, he toured with bands as a saxophone player.
  • Fascination with numbers led him to study economics; he entered the field of econometrics just as businesses began using statistical modeling and forecasting.
  • His friendship with free market proponent Ayn Rand formed his intellectual character.
  • Greenspan began in government in 1967, as a Richard Nixon campaign volunteer. Gerald Ford made him head of the Council of Economic Advisers in 1974.
  • Greenspan became Fed chairman in 1987 and always upheld the Fed’s independence.
  • In a speech in 1996, he characterized America’s soaring markets as “irrationally exuberant,” a term that became synonymous with the 1990s.
  • Greenspan believes that a competitive marketplace, solid legal and property rights, and sound policies are the key components assuring a nation’s continuing prosperity.
  • Deficits and borrowing are natural outcomes of growth and economic progress.
  • Since “global warming is real and man-made,” the world needs better energy policies.

Summary

Numbers Driven

Alan Greenspan was born in 1926 in Manhattan, where his divorced mother raised him amid her large, lower-middle-class Jewish family. As a boy, he delighted in memorizing baseball statistics, train schedules and telegraph codes. Scouring the beaches of Queens for coins during the Depression led to his lifelong habit of walking with his eyes cast down. His absent father appeared in his life only sporadically.

“Economics appealed to me from the start: I was enthralled by supply and demand curves, the idea of market equilibrium and the evolution of international trade.”

Greenspan was a middling student, though he excelled in mathematics. He developed a love for music in his youth, diligently practicing first the clarinet and then the tenor saxophone. He never intended to go to college; in 1943, he fully expected the armed services to draft him, but a medical discharge precluded military service. He made a living as a musician, touring the US with big-band orchestras and jazz groups. He eventually attended Juilliard, where he studied piano and composition and played saxophone alongside his classmate, Stan Getz.

“Economists cannot avoid being students of human nature.”

Greenspan read business books in his spare time and prepared his fellow musician’s income taxes. Finding that his passion for numbers never left him, he enrolled in New York University in 1945 to pursue degrees in finance and economics. He immersed himself in the works of free market economists.

“There’s an inherent conflict between the Fed’s statutory long-term focus and the short-term needs of most politicians with constituents to please.”

After college, he went to work in the up-and-coming field of econometrics, where he obsessively pored over statistics and wrote articles for publication. Major companies were beginning to see the planning benefits of financial forecasting and economic models, so Greenspan’s talents were in high demand.

An Intellectual Education

Greenspan worked on research projects for manufacturers, particularly in the steel industry, and for government, where he contributed to Pentagon defense programs. In 1953, he and William Wallace Townsend formed an economic research and econometric modeling company, Townsend-Greenspan.

“The Fed’s job during a stock market panic is to ward off financial paralysis – a chaotic state in which businesses and banks stop making...payments they owe each other and the economy grinds to a halt.”

In his personal life, Greenspan ended a brief first marriage. He also joined the Collective, a group of intellectuals under the leadership of Fountainhead author Ayn Rand, a Russian émigrée who espoused free-market “objectivism,” a strident belief in individual achievement and laissez-faire capitalism. Rand informed Greenspan’s thinking on subjects beyond economics. He explains, “I was intellectually limited until I met her.” She attended his 1974 swearing-in as head of President Gerald Ford’s Council of Economic Advisers. Greenspan and Rand remained close friends until her death in 1982.

“Economics Meets Politics”

In 1967, Greenspan volunteered as an adviser to Richard Nixon’s presidential campaign. Nixon impressed him as “thoughtful,” “intense” and “factually oriented,” but Greenspan was so taken aback by the candidate’s profanity-riddled rants that he turned down a position in his administration. He continued to serve on government committees and, in 1974, overcame his objections to Nixon’s economic policies and agreed to chair the Council of Economic Advisers. Yet by the time Congress approved his appointment, Nixon had resigned in the wake of the Watergate scandal, so Greenspan served under Ford.

“In the late ’90s, the economy was so strong that I used to...say to myself, ‘Remember, this is temporary. This is not the way the world is supposed to work’.”

Though both Nixon and Ford were Republicans, Greenspan disagreed with both about the wage and price controls they set up to tackle crippling inflation. Greenspan used his facility with economic modeling and his network of contacts within business and industry to fine-tune the national metrics the US used to gauge output, business inventories and company orders. With better information, Greenspan improved his team’s ability to predict outcomes and to advise Ford about economic action.

Out of Office and Then Back Again

When Democrat Jimmy Carter became president, Greenspan returned to New York and his firm, which his senior staff had been managing ably. Rejoining the private sector allowed Greenspan to join corporate boards. He continued to indulge his early morning habit of reading and writing in the bathtub (this became a lot easier when he discovered waterproof pens). He also dated journalist Barbara Walters, who introduced him to the world of media and celebrity.

Presidents Richard Nixon and Bill Clinton “were by far the smartest presidents I’ve worked with.”

When Republican Ronald Reagan became president, he asked Greenspan to lead the effort to shore up Social Security. In 1987, Greenspan agreed to succeed Paul Volcker as chairman of the US Federal Reserve Board. His first big test came 69 days later on Black Monday, October 19, 1987, when the market fell 508 points, an unprecedented one-day drop. He and his team scrambled to provide liquidity to roiling markets and to soothe nervous banks and investors.

“I was saddened...when I discovered that [President George H.W. Bush] blamed me for his loss. ‘I reappointed him and he disappointed me,’ he told a television interviewer.”

The Fed continued its policy of monetary control via interest rate management to maintain stability in the economy. While it could operate apart from political pressure, the Fed – and Greenspan personally – often felt the heat, particularly during Republican George H.W. Bush’s administration. Worried about growing deficits and mounting debt, Greenspan advised Bush to address these issues while the economy was still robust. But Bush, who famously promised “Read my lips: no new taxes,” resisted the need to raise revenue and cut spending. He objected to the Fed’s interest rate increases and blamed Greenspan for his loss to Democrat Bill Clinton.

“Irrational Exuberance”

Greenspan enjoyed a solid rapport with Clinton, “a risk taker...not content with the status quo,” and found him intelligent and economically astute. Resisting political pressures to tax and spend, Clinton revamped government expenditures, creating the biggest budget surpluses since 1948. The Fed, increasingly working with econometric data, forecasting models and interest rate manipulations, engineered a “soft landing” in 1995 for an overheating economy. By then, dot-coms were booming, and markets took off; the Dow Jones Industrial Average blew past 4,000, 5,000 and 6,000 by October 1996.

“What attracted me to [President Ronald Reagan] was the clarity of his conservatism.”

Greenspan’s analysis first focused on productivity growth as the impetus for soaring economic activity, but as the Dow kept climbing, he struggled to encapsulate onrushing events. In December 1996, he coined the term “irrational exuberance” to capture the puzzling phenomenon of continually rising asset prices. And, in 1997, long-time bachelor Greenspan married well-known TV journalist Andrea Mitchell.

“My biggest frustration remained [President George W. Bush’s] unwillingness to wield his veto against out-of-control spending.”

The new century caught the US at a propitious moment. Surging productivity from technology and investment meant economic good times. The disputed 2000 election ushered in Republican George W. Bush’s administration, which took a proprietary interest in financial matters to enact campaign-promised tax cuts. The problem – a good one to have – was how to manage the predicted unprecedented surplus of more than $500 billion due by 2006. Investing such immense surplus assets would be nearly impossible in most US and global markets. Greenspan “came to a stark realization that chronic surpluses could be almost as destabilizing as chronic deficits.”

“Talking to Ayn Rand was like starting a game of chess thinking I was good and suddenly finding myself in checkmate.”

Politicians pushed for tax cuts, while Greenspan and others cautioned that the government should first extinguish the national debt and then assure the continuation of Social Security. He agreed with Treasury Secretary Paul O’Neill that tax cuts were in order, but only after covering the debt and Social Security. Both men endorsed the idea of “triggers,” like expenditure caps, that would halt spending and spur tax reductions if projected surpluses didn’t happen. But Congress and the president ignored their counsel and in 2001 approved “an across-the-board cut” of $1.35 trillion.

“I’m not threatened by a powerful woman; in fact, I’m now married to one. The most boring activity I could imagine was going out with a vacuous date – something I learned the hard way...as a bachelor.”

Almost immediately, officials had to revise surplus projections downward, as stock market weakness as well as a slowing economy resulted in reduced tax revenues. In the year 2002, the deficit was $158 billion, despite the 2001 surplus of $127 billion. With Bush’s tax cuts and his 2003 Medicare revisions paying for prescription drugs, reduced tax revenue sealed the surplus’s fate: “Red ink was back to stay.” Yet Bush added to defense budgets, war spending and farm subsidies and approving every spending bill, a behavior “without modern historical precedent.”

Out of the Firing Line

In 2006, Greenspan retired from the Fed. As an informed observer, he offers the following:

  • “Economic growth” – The components assuring a nation’s continuing prosperity are, amongst others, a competitive marketplace – in domestic commerce and in international trade – respected legal and property rights, and high-quality policy makers and policies. Capitalism demands its participants to demonstrate character and trust, since “government regulation cannot substitute for individual integrity.”
  • “Modes of capitalism” – Socialism can’t provide capitalism’s economic well-being and growth, yet debate continues on what forms of capitalism are best. Each nation makes its own decision about the balance between building “material wealth” and addressing social services stresses; “regrettably, economic growth cannot produce lasting contentment.”
  • “The choices that await China” – Chinese leaders have recognized that a centrally planned economy limited China’s progress, both materially and politically. “Without the political safety valve of the democratic process,” their challenge will be to align their political system with the free market principles that most Chinese have embraced.
  • “The tigers and the elephant” – The rise of the Asian tigers ( including Taiwan, Korea, Singapore, Indonesia and Malaysia) shows the economic power of that region. Yet each nation’s market reforms are based on its unique circumstances. For example, India’s challenging duality symbolizes “the productiveness of market capitalism and the stagnation of socialism.”
  • “Russia’s sharp elbows” – While Russia has been imposing the rule of law, its authoritarianism continues in politics and culture. It must shift its economy away from reliance on oil and gas or risk falling victim to “Dutch disease,” whereby in-demand natural-resource exports lift a currency, making the rest of an economy uncompetitive.
  • “Latin America and populism” – Capitalism vies with a persistent “economic populism” that comes from a legacy of colonialism. Following crises throughout the region, some countries, including Brazil and Mexico, have recently achieved stability.
  • “Current accounts and debt” – Deficits and borrowing are natural outcomes of growth and economic progress. If the economy stays strong, debt should not pose a problem; it should allow continuing growth and prosperity.
  • “Globalization and regulation” – As globalization makes increasing income inequities evident, social stresses will result. Regulators should constantly revisit their rules to ensure that they remain relevant to changing market practices.
  • The inflation “conundrum” – Technology, globalization and monetary policies may be responsible for unusually low inflation throughout most economies.
  • “Education and income inequality” – Wealth increasingly is concentrated into fewer hands, while middle-class people no longer can rely on good-paying manufacturing jobs. To prepare people for new positions by teaching them new skills, the US will need to implement education reform, along with prudent immigration policies.
  • “The world retires” – But “can it afford to?” A falling birth rate and an aging population will put pressure on social programs in an unprecedented way. Benefit cuts are inevitable, so people will need to work longer and save more for retirement.
  • “Corporate governance” – Corporate scandals, outsized executive pay and other abuses have focused attention on this area. Capitalism demands that shareholders must hold executives responsible for their actions. Yet government should have no role in legislating compensation for workers or executives.
  • “The long-term energy squeeze” – Because “there can be very little doubt that global warming is real and man-made,” the world needs better energy policies, but any policy should hew to market dictates rather than government-imposed rules. A gasoline tax would help dampen petroleum use, an important step in reducing the US’s vulnerability to events in the oil-producing Middle East.

About the Author

Alan Greenspan served as chairman of the Federal Reserve Board from 1987 to 2006. He now heads Greenspan Associates, an economic consulting firm.

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The Age of Turbulence

Book The Age of Turbulence

Adventures in a New World

Allen Lane,
 


25 January 2026

Sources of Power

Recommendation

In this original, honest and sometimes amusing book Gary Klein studied expert decision makers, such as firefighters, soldiers and chess masters, who operate under highly challenging conditions. He shares his early assumptions about how they made decisions, but his research reveals that his initial theories were wrong. He has learned what good decision making requires and shares that expertise in tightly focused chapters rich with examples. BooksInShort recommends this book to anyone interested in decision making, and especially to those who make high-stakes determinations under dynamic conditions: leaders, strategists, futurists, investors and businesspeople.

Take-Aways

  • Experts don’t rely on analytical, academic decision-making processes.
  • Skilled decision makers use accumulated expertise to read situations, create possible solutions and act immediately.
  • “Intuition” helps decision makers see crucial patterns in a situation.
  • Experienced decision makers visualize possible solutions with focused “mental simulation.”
  • Experts identify context-specific “leverage points” to improvise solutions.
  • Successful problem solving moves through a repeating cycle, not a linear path.
  • “Experts see the world differently.”
  • Stories and metaphors help problem solvers organize and frame challenges.
  • Successful teams share expertise, practices and a social network while communicating intentions on a deeper level.
  • People who lack expertise and can’t predict others’ behavior make poor decisions.

Summary

“Decisions and Models of Decision Making”

Most people make decisions badly. However, firefighters, military leaders and chess masters, for instance, make critical decisions under extreme pressure every day. If they are wrong, the least they can lose is a career-defining game: the most is someone’s life. These experts reach their decisions in “high stakes,” time-pressured situations. They must act despite scarce information, ambiguous objectives and ill-defined methods. Often they must “juggle complex goals,” recognize relationships and perceive differences while immersed in dynamic circumstances that change second by second. Yet these experts routinely make good decisions. How are they able to think through the issues, choose among options and direct their will while avoiding the paralysis of self-doubt?

“Intuition depends on the use of experience to recognize key patterns that indicate the dynamics of the situation.”

They eschew the “rational choice strategy” taught in many business schools. In that model, you identify and evaluate your options, weigh different aspects, produce ratings and choose the alternative that scores the most points. But decision-making pros don’t use any aspect of this model. When asked, many experts couldn’t remember making decisions or even considering alternatives. Their know-how allowed them to read a situation quickly – even immediately – to identify patterns and act. They determined and pursued fresh options in the midst of application. They generated alternatives only when their first actions failed.

“The distinctions between problem solving and decision making blur in natural settings.”

Studying experts’ processes leads to a different model of decision making: the “recognition-primed decision model” (RPD). This model generates solutions immediately, based on the practiced recognition of a situation’s patterns. Decision makers project these solutions forward in their imaginations and test them by visualization, “not by formal analysis and comparison.” This model doesn’t necessarily generate the best response; it quickly chooses the “first workable option,” which is the preferred option under time pressure. The RPD model emphasizes action. It depends on experience, so rookie decision makers may need to employ “analytical methods.” People can learn to use RPD by exercising “deliberate practice,” accumulating experience, getting feedback and “reviewing prior experiences” to deepen their skills.

Where Decision Makers Get Their Power

People who make difficult decisions regularly draw on many “sources of power,” including “intuition,” “mental simulation” and the use of “leverage points.”

“Experts see the world differently. They see things the rest of us cannot. Often experts do not realize that the rest of us are unable to detect what seems obvious to them.”

Decision makers using intuition call on a depth of expertise that distinguishes “key patterns” to diagnose a situation. Intuition sometimes seems like a “sixth sense” urging immediate action, as when a veteran firefighter leads his team out of the flames just before a building collapses. Intuition can be a tool, enabling you to anticipate what will happen next. To increase intuition, deepen your “experience base.”

“The biggest danger of using mental simulations is that you can imagine any contradictory evidence away.”

To employ mental simulation, visualize a situation and project it into the future “through several transitions.” Good decision makers include three factors in their simulations and project them through no more than six steps. If they must involve more factors or stages, experts group them to work with a smaller number.

“We are impressed when someone with expertise...knows...what to do in a difficult situation; we are also impressed when someone invents a new procedure on the spot.”

Use simulations to understand what has happened or what might occur. Identify the parameters of your simulation: where you will start and end, and what drives change. Create an “action sequence” and run the simulation. Review it for completeness, applicability and coherence. Simulations are useful but dangerous in that “you can imagine any contradictory evidence away” by selecting the facts you prefer for your simulation. Instead, consciously seek alternative explanations. Help planners find the flaws in their forecasts by asking them to project their strategies forward, imagine their plans falling apart and diagnose the factors causing failure.

“The past and the future are part of experts’ experiences. They grow out of the ability to run mental simulations.”

Mental simulation isn’t easy, but it can help you develop “situation awareness” that can lead you to reach decisions in circumstances where traditional analytical methods don’t apply. Generating simulations during a situation will help you quickly prioritize clues, highlighting an advantage of the RPD model: Users act to solve a problem almost immediately. Contrast this methodology with the traditional rational choice strategy, which calls for weighing alternatives one at a time. That contemplative approach works better in organizational contexts in which you face defined goals and the need to justify your decisions, or in situations where conflict may arise over your choices and where you have the option to seek the best overall alternative.

“Cognitive task analysis is the description of the expertise needed to perform complex tasks.”

Experienced decision makers identify leverage points where their efforts will produce the greatest return. These points are analogous to handholds in rock climbing: No rule tells you how to find them. Instead, handholds (and leverage points) shift according to “the conditions of the climb and the climber.” High-level decision makers seek leverage points in practices as varied as chess, new product development or international policies. You’re more likely to find leverage points in fields in which you are an expert.

Decision Making and Problem Solving

Academicians discuss decision making and problem solving separately, but the distinction collapses “in natural settings.” Reviewing one stage of a problem at a time is a linear approach. However, identifying leverage points – whether positive ones, which help you, or negative ones, which others might use against you and which you must guard against – showcases the “nonlinear aspects” of problem solving. Skilled innovators construct working solutions by looking at a problem from different perspectives and trying a number of attacks. They work in a cycle: They first identify the issue, which sets the search for an answer in motion. Then they “represent the problem,” an exercise which can range from framing the issue broadly to proposing a specific diagnosis. From there, they harness leverage points to “generate a course of action” and evaluate the results. They may identify a new problem, or use what they’ve learned to represent the problem in a new way.

“Metaphor does more than adorn our thinking. It structures our thinking

Acknowledging the processes involved in this cyclical, context-dependent approach grounds innovation in reality. Focus on defining your goals, examining the situation, creating simulations, and so on. Applying this nonlinear process can strengthen planning. Too often, people develop plans in great detail, even as the situation diverges from their starting point, making their efforts both futile and wasteful. Realize that it is easy to make plans too complex, too specific and too rigid. Replace such plans with simpler, more “modular” strategies that allow you to try one step at a time and check your results against reality.

How Experts Think and Train Others to Think

True experts see the world differently. Their accumulated experience allows them to detect patterns and details that novices miss, and to notice “anomalies.” They don’t just see the events in front of them. They see the larger picture in order to link current events with past causes and future effects. Experts shift their “time horizon” appropriately. When necessary, they focus on the moment, but they have the ability – based on their “mental model of the task” – to look ahead to anticipate future needs more accurately. They see how situations unfold, not just on the surface, but also in their underlying functions and principles. They recognize opportunities for action and moments for improvisation, while taking their own capacities into account. They develop an awareness of their own limitations by analyzing their performance, tracking instances when they lose “the big picture,” and using the lessons of their poor performance to improve their future actions.

“Whenever we make a request – ask for an errand or give a command – we need the person to read our mind.”

You can apply these practices to train people in your organization. Start by identifying their “sources of expertise.” Who knows what and how did they learn it? Next, “assay the knowledge” by analyzing the tasks these experts engage in to see precisely what is involved. This leads to the third step, in which you “extract the knowledge,” and the fourth, in which you “codify” it, making tacit know-how explicit so you can organize it into routines that nonexperts can follow.

“The cognition of a team can be inferred from three sources: the team’s behavior, the contents of the team’s collective consciousness and the team’s preconscious.”

Storytelling offers a way to organize concepts into meaningful patterns. Stories explain and create relationships. They place “agents” in a situation in which they must solve a problem, explain their tools and tactics, and indicate their “intentions.” Stories touch on “causality” and “context,” and often highlight “surprises” that the problem solvers encounter along the way. Combining these factors in story form helps people learn and teaches them lessons. Stories often appear in politics – all good conspiracy theories start with a good story – and in the justice system, where the better story often wins the case. Stories also apply in business and innovation. For example, “AT&T’s best software programmers” worked their progress reports into narratives to guide their actions, and then reworked them into better stories as they learned more. Prompt the experts you know to tell and retell their stories to extract their knowledge. Such accounts are the verbal equivalents of mental simulations.

“Experts...see inside their own thought processes – the process of metacognition, which means thinking about thinking.”

In a related fashion, people use “analogues and metaphors” to frame how they think about choices. For instance, you approach a political issue differently if you perceive it as a casual conversation rather than as a meaningful struggle. Metaphors also help people generate new solutions. For example, Steve Wozniak and Steve Jobs borrowed the metaphor of a desktop in organizing the Macintosh computer interface. Metaphor often resides at the core of equipment design. You can use “analogical reasoning” to deal with a poorly defined problem. Analogies can “function like experiments” by relating disparate causal factors to each other. Analogies also can help predict what might happen in new situations; the most fitting analogue serves as the finest predictor.

“Poor outcomes are different from poor decisions. The best decisions possible given the knowledge available can still turn out unhappily.”

Frequently, people cooperate to solve problems, either in a brief, spontaneous fashion, or as part of a team’s mission. When you work with someone else and you communicate a dilemma, you present an expectation that often goes unrecognized: You essentially are asking someone else to read your mind. That is to say, when you ask someone to do something, he or she has to correctly divine the intention behind your words. This always is challenging, but it is particularly difficult during decision making or problem solving, when both intention and circumstance may be shifting and unclear. To work around this dilemma, you and your listeners must extend yourselves. Consciously state your intent and ask about theirs. Be explicit in team settings. State your overall goals for the task, then clarify its specific objectives. Outline the steps in your action plan and the reasoning behind it. Indicate what decisions the team has to make, what obstacles it might encounter and what constraints could hold it back.

“People become problem solvers when they...create a new course of action, improvise, notice difficulties way in advance, or figure out what is causing a difficulty.”

Communicating these factors will help you build a “team mind.” However, the best collective entities share other traits as well. Teams such as US Forest Service firefighters work well together because they practice enough to keep sharp. They function in stable groups that collaborate for extended periods and promote from within. They form a cohesive social network, or even several networks, within their service and with other organizations. Successful teams share “practices and routines,” and develop a consistent team identity. Their “competencies” and their group identity feed (and are fed by) the team’s cognitive and metacognitive abilities: These teams think together and reflect jointly on how well they function. By contrast, members of poorly performing teams don’t communicate their intent well, they change rosters too often and too quickly, and they lack the trust born of consistent social interaction.

The Sources of Poor Decisions

Experts once believed that bad decisions derive from bias and faulty thinking, but the reality is more complicated. Stress factors can contribute to weak decisions. For instance, time pressures can force you to act with less information, noise can capture your attention and blind you to situational cues, and stress itself can weaken your working memory. Uncertainty can erode your decision-making ability. If you can’t gather information or recognize the patterns in a situation, doubt can freeze you. People make poor decisions when they can’t properly assess an issue that constantly changes, they “have to predict human behavior,” or they can’t get enough repeated experience to build their skills. Similarly, when circumstances offer little useful feedback or when time horizons are extended, bad decisions may result. “Making public policy” and raising children are but two examples in which most of these instances apply.

About the Author

Gary Klein, founder of Klein Associates, Inc., is the author of The Power of Intuition and the co-author of The Working Mind.

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Sources of Power

Book Sources of Power

How People Make Decisions

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