Saturday, December 06, 2008

Risk

I just heard a man - well, a financial 'expert' - say something like, 'If you do not understand risk, do not invest in the stock market.' Ahem, well, excuse me. Let us be clear - over the past twenty years no 'expert', no financial journalist, no broker, no politician, no trader and, above all, not a single banker has shown the slightest understanding of risk. Of all the astounding revelations that have emerged from this crisis, none is more staggering that the continued deployment by the banks of a mathematical system called Value at Risk. This involves some very sophisticated mathematics designed to console. Some grand fromage at Goldmans or wherever would daily be told that his 'value at risk' was x, he would smile and calmy spend the day drinking camomile tea and thinking he was a master of the universe. But VAR is nothing more than the bell curve in a fancy suit. The bell curve is useless in assessing complex system. Almost everybody outside the financial system has known this for years. But people in the City were too stupid and too impatient to read academic papers and they sat back with their VAR report thinking everything would happen inside the bell curve and anything that didn't couldn't possibly matter. What real statisticians and scientists know and what should be the lesson that sinks in from this crisis - but it won't - is that catastrophe will happen, it will happen sooner than you think and its impact will be worse than you expect. Get used to it, guys - but you won't.

7 comments:

  1. Who the Gods wish to destroy, first they make mad, I am afraid the human need for certainty is too strong.

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  2. "and its impact will be worse than you expect"

    Most experts say this will be like the 80s crash and nowhere near like the 30s. Yet I just watched a video of that Black Swan guy who says it will be much worse than the 30s crash. Personally, from a purely gut feeling, I think we're entering terrifying new territory.

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  3. But why, if this was widely known about VaR, at least outside the financial community, did no one pointshout about during the past 20 years? Or did someone (other than Nassim, implicitly, in The Black Swan lasy year)?

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  4. "Pointshout about" sounds good though, Frank, very evocative. It's either an animated warning or a 1950s dance craze.

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