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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.'"
For an EXCELLENT article about this, read Malcolm Gladwell's "Blowing up", which you can find online for free:
http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm
Watch the Teaser Trailer for "The Lightning Thief" Her
http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all
So what's the VaR of using VaR? :)
When you don't have a leg to stand on, don't even get up.
Indeed we did. And I think we came to the consensus that it was a load of bollocks.
Confucius say, "Find worm in apple - bad. Find half a worm - worse."
You're looking at it all wrong! I mean, you may be right (that they are all lying, thieving, immoral, unethical, and greedy f'ing bastards), but there's opportunity in that!
Had you BET on that, you'd be rich right now. You can invest in the potential downfall of many securities. Which, by the way, was what many of the financial companies and hedge funds did.
And I really don't think this is a "if you can't beat them, join them" situation. It's recognition of human nature, and investing with that recognition in mind. You aren't necessarily doing anything illegal or immoral by betting on the downfall of companies. You are wisely investing.
Looking at it that way, many moral, ethical Wall-streeters may have made lots of money on the downside fluctuations in the market, and so your premise that they are *all* thieves must be incorrect.
Is here any roleplayer that does NOT know how using an artificial value to describe "real" problems automatically leads to some people "playing the system" instead of playing the game?
Nobody here ever had a munchkin in his troupe? A powergamer? A minmaxer? Someone who learned the rules and immediately started to look for loopholes, how to play by the rules without actually taking them serious?
Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?
We used to have a Bill of Rights. Now, with the rights gone, all we have left is the bill.
Risk models are largely irrelevant because the only risk anyone in the financial sector is really interested in minimizing is the risk that they will get fired. The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc. Rational market my ass.
http://rareformnewmedia.com/
If the Government becomes a lawbreaker, it breeds contempt for law;
After seeing the rampant fraud committed by the global financial elite, I'm very inclined to agree with you. What we need isn't just a number that quantifies risk, but also a number that quantifies trust.
I would pay for a service that tracks every person involved in business that was ever convicted, under indictment, or subject of a complaint. It should also track which firms employed them and where they are working now. It should also cover which "civil servants" were "on watch" at the time.
In the land of the blind, the one-eyed man is usually crucified.
Beyond the style of model, the trouble in finance is the feedback nature. If a big impressive model is developed to price an asset and all of the big boys buy in and use the model, then the model DOES describe the assets price. Because everyone is making decisions based on the model.
That's all great until reality intervenes. Then you have a bubble.
That sort of model feedback has always made finance seem "iffy" to me.
Use the Firehose to mod down Second Life stories!
Liberal economics -- not liberal politics, quite the opposite most of the time -- explicitly derives its conclusions from three assumptions: that individuals make rational decisions, that they have access to information, and that they are free to buy/sell.
Those are pretty reasonable assumptions, and, when they hold, the conclusions tend to hold.
The difference with physics is that when physicists start saying "assuming that this body is of negligible mass and at non-relativistic speeds" they don't end their exposé with "thus we have a solution to the three body problem for three super massive black holes at 0.999 c"
Social psychology has shown repeated instances where rationality is seriously impaired. For example, social proof can make us all really stupid. And cognitive dissonance is a bitch. What do those words mean? When a million idiots do something stupid, you're very likely to think it's a very good idea, too. And the longer you've been doing something stupid without negative consequences, the less likely you are to stop.
Add to that the fact that those "investment vehicles" were designed to conceal information, specifically financial risk, and right here you have two out of three pillars of classic economic theory missing. Is it any wonder the whole thing went down?
Finally, I wonder if any free marketer / libertarian types actually read any Adam Smith. I remember reading a quizz, which unfortunately I can't find anymore, Marx vs. Smith, in which you were asked to identify whom had written what. Very hard to tell them apart in some cases.
Exactly. And one easy way to game the system is to bet that the authorities will always act to keep markets stable, which you can do by taking risks that would otherwise be stupid. In other words, traders are incentivized to leech off the taxpayer. I'm surprised the crash took so long.
Reduce, reuse, cycle
As an example, suppose that the distribution suggests the chance of losing 50 million dollars is +3 sigma for some measure. The problem is that there is a subtle effect - say panic, herd effect or some interaction of derivative models - which only becomes significant around the 3 sigma mark. The result could be that the exposure at a 4 sigma event is billions of dollars. A proper risk model would need to take this into account
My conclusion based on what I have read so far is that the physicists (in particular) involved in developing quantitative models would have benefited from a lot more exposure to real world experiment. They would then have had more of a clue about the unreliability of data away from the mean, scatter, and the importance of the fact that in physics subtle errors turn out to be signs that the model is wrong - e.g. relativistic effects only become important at a significant fraction of c.
From scarped cliff or quarried stone she cries "A thousand types are gone, I care for nothing, no not one."
A friend of mine is a risk assessment quant who was working at Lehman right up to the point where they declared bankruptcy. I asked him about this article the other day. He said that their models started telling them something was very wrong back in 2007. The problem was that Fuld (the CEO) refused to believe what the models were saying.
The most accurate model in the world won't help if you don't pay atention to the results it produces.
There's also apparently an issue with the classical VaR models depending on transparent pricing, which these real estate instruments lack. So some of the most troublesome assets apparently weren't in the model.
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.
You might think that if you have three investments with a 10% risk of losing £1,000,000 the chances of all three of them losing £1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%.
No, no-one who actually calculates and uses VaR thinks that. Anyone who has done any statistics, like all finance quants, will correctly take into account covariances. The actual problem is the interpretation of the "correct" VaR, and relying on it too heavily.
I'll give you the actual definition of VaR. If you calculate the VaR(10 day, 5%) to be $100,000, this means that there is a 5% chance that the loss on your portfolio over a 10 day period will be larger than $100,000, or that your profit will be larger than $100,000 assuming a symmetric distribution. It's when people think "Oh that's great, we can ONLY lose $100,000" when you have a problem. The actual loss could be ANY value larger than $100,000.
It's hardly a perfect statistic, since there are still many assumptions involved. However, it's still a decent estimator and it's better than making a wild guess based on gut feelings. Despite what most people currently believe, a lot of brainpower has gone into developing financial theories and some stuff is pretty damn good. The financial industry deserves some bashing, but it frustrates me when people spread incorrect information; at least complain about the right things.