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The Perils of Simplifying Risk To a Single Number
A few weeks back we discussed the perspective that the economic meltdown could be viewed as a global computer crash. In the NYTimes magazine, Joe Nocera writes in much more depth about one aspect of the over-reliance on computer models in the ongoing unpleasantness: the use of a single number to assess risk. Reader theodp writes: "Relying on Value at Risk (VaR) and other mathematical models to manage risk was a no-brainer for the Wall Street crowd, at least until it became obvious that the risks taken by the largest banks and investment firms were so excessive and foolhardy that they threatened to bring down the financial system itself. Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future. Reliance on models created a 'false sense of security among senior managers and watchdogs,' argues Nassim Nicholas Taleb, who likens VaR to 'an air bag that works all the time, except when you have a car accident.'"
http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all
The problem with using a single number is simple: It is easily gamed and there's lots of incentive to do so.
So people will sell you worthless junk that technically has a high number rating because if you're relying on the number you'll pay them for their worthless junk.
Fanatically anti-fanatical
Tell me the meaningful service the stock market provides
1) the stock market makes it possible to invest in companies at fractional rates, allowing capital to flow from small pools (you and me) to companies who seek investment capital. Without the stock market, only large investors could invest in companies, which would make it more difficult for enterpreneurs to raise funds.
2) The stock market provides liquidity for those investors who have new information about companies, and therefore want to get rid of their investment. The market makes it possible to sell. Again, this makes people more willing to provide investment funds, because of the existance of an exit strategy/mechanism.
This does not change the fact that most of the participants are lying thieving bastards, and that regulation is needed. That said, though, stock markets are an essential mechanism for the distribution of saved wealth to productive uses for that wealth, and are close to as important as money itself for allowing the economies of the world to function.
I was taught to respect my elders. The trouble is, it's getting harder and harder to find some.
I disagree, accurate information is required for the market to choose the most efficient price/product.
"In the long run we're all dead" Keynes famously said; and in that case it means that, sure, if we wait long enough, people will stop trusting liars and crooks and they will be weeded out, but by that time damage will have been done, and the market will not have functioned optimally in the mean time.
Risk, in financial terms, is a measure of the variability of returns, i.e. the standard deviation of the returns. A well-diversified portfolio generally reduces the variability due to the individual risks of investments being uncorrelated. Harry Markowitz, the father of portfolio theory, pointed out that these quants all assumed that a basket of mortgages is highly uncorrelated and thus well diversified. However, in a broad real estate downturn, they all become very highly correlated. Therefore, if your standard deviation WAS 10%, it suddenly becomes 50% or more, which rapidly changes your VaR from a handful of millions to several billion overnight. VaR, being an oversimplification, didn't take that into account and all the big investment firms suddenly had billions of dollars at risk and billions of dollars of losses without realizing it. It's simply a matter of garbage-in, garbage-out, something my Portfolio Analysis prof drilled into our head and hopefully gets drilled into the heads of Wall Street CEOs.
Standardized, regulated exchanges usually come about when a market already existed before, but it would be desirable to have a more transparent, reliable market clearinghouse. With stocks, people invented shares long before anyone opened an actual stock-exchange: you write out a contract on paper agreeing that, in return for $x, so-and-so now owns 1 share of your company, and you have a contract somewhere specifying how many total shares there are, when/if new shares can be issued, etc. It's basically what happens when you try to expand a small partnership to more than a few people and bring in investors.
Once you get enough of these fractional-ownership certificates floating around, each with slightly different rules, and disputes start arising about who owns what and what that means, the logical next step is to agree on some relatively standardized method of fractional ownership, and a central clearinghouse to trade the certificates. Which is what stock markets are.
On the other hand, moving that sort of business to stock markets also increases the number of market participants and frequency of transactions by reducing entry and transaction costs---it's impossible, for example, to "day-trade" paper stock certificates in person directly with their owners thousands of times per day. That has positive and negative effects---positive in that it increases available capital and gives retail investors more parity of access compared to large investors, and negative in that it makes the whole system more volatile and sensitive to chaotic-systems effects.
10 PRINT CHR$(205.5+RND(1)); : GOTO 10
It is. I work in a similar vein of the industry as Taleb (derivatives trading, but at a bank). he is the guy who says we are undervaluing the chance of a crash every day of every year and once in a while, he strikes it big. he is the guy who plays the same strategy every day and says "told ya so" when it finally pays off. he's not a fool, but it's a self fulfilling prophecy if you believe in a cyclical market so it's hard to put much weight behind him.
But, it's a cheap strategy to do in derivatives. You don't require much cash and since you are buying optionality, margin calls have a hard limit so it's less uncertain(to the downside) than other strategies.
But he is right about VAR. it's not something that is hard for anyone to tell you who has worked at a bank. I can remember 2 distinct times where my main job was to find out how to reduce our var without reducing our actual market risks (in order to free up risk capital so we could take bigger bets) and it will be my job again in a few days as everyone starts repositioning for the new year.
We have to do it in earnest because management always looks to the recent past to guess at your exposure to the future and generally, the models that VAR uses are far weaker than any modern pricing models or risk models because they are much harder to implement. the volatility of the last 18 months will cause/ is causing everyone's VAR to spike (even when carrying far less real risk) therefore adding to the massive de-leveraging management is requiring of everyone. this means over the next few months, one of the primary jobs of every trader will be obscuring the risks his portfolio is taking in order to take bigger risks (yeah, those incentives are still the same).
now you may call me a pariah but after working in this industry for a relatively short period of time, I've come to realize that is all there is in it. this is how business is done, how it was done, and how it will be done. As shareholders continue to keep their boards in place, we are obviously doing exactly what a majority of our shareholders expect of us and that is our overarching mandate (and yes, I am not an investor in any of the banks anymore, even my own, because I realize to be a successful banker you are paid by shareholders to screw shareholders).