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.'"

Comments

Second attempt.

[khasim]

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all

We discussed

[Hognoxious]

we discussed the perspective that the economic meltdown could be viewed as a global computer crash.

Indeed we did. And I think we came to the consensus that it was a load of bollocks.

Minmaxing ftw!

[Opportunist]

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?

It's simpler than that

[joss]

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.

Re:It's simpler than that

[u38cg]

Mmm. Herd instincts for the lose. But the few financial instituitions that stood against the headwinds are now reaping the rewards. For example, in the UK LTSB is taking over HBOS, despite the fact that HBOS was nearly twice LTSB's size at the height of the boom. The rational players are doing just fine.

Re:Welcome to the Age of Bayes

[Hoplite3]

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.

Model accuracy wasn't the only problem

[EdwinFreed]

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.

Re:Math?

[Alpha830RulZ]

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.