The Perils of Simplifying Risk To a Single Number 286
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.'"
Second attempt. (Score:5, Informative)
http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all [nytimes.com]
The (bigger) peril of assuming only 1 risk (Score:3, Informative)
The problem in the financial world is one of thinking there's a single factor called "risk". In fact there are many, interlinked factors: The risk the business will go bust is one - however from that sprout a whole range of subsidiary risks: from losing all your investment to getting back 95% of it.
Similarly with mortgage risk and any other type of investment. What the financial markets need is a better understanding of the causal links between risks and to price the returns on investments accordingly.
That will be a *big* job, and one that will take years or decades to iron the bugs out of.
Re:Math? (Score:3, Informative)
Tell me the meaningful service the stock market provides and I'll listen, but I'm hard pressed to find the value in their service.
For the corporations, the ability to raise money for higher risk capital purchases than banks (were) willing to tolerate. For the short term investors, seemingly infinite liquidity compared to almost any other form of investment. For the long term investors, while the baby boomers are pouring money in, its a great ponzi scheme, at least until the baby boomers start pouring money out on a net basis.
Play a couple games of "railroad tycoon deluxe" or "RRT2" or whatever, and get back to us. There's a game genre that needs new releases.
Re:Minmaxing ftw! (Score:1, Informative)
I personally believe that a healthy interest in rulesets is a good thing, and dislike the kind of group you describe. However, the classical "munchkin" or "rules lawyer", though I believe the term is overapplied, attempts to form extreme interpretations of the rules.
For example, in a game in which no rule exists for damage to carried equipment (common in "light" game systems, but often such rules are incomplete even in more comprehensive systems), a rules lawyer might argue that an important document on ordinary paper should be retrievable in good condition after the person carrying it suffers a direct hit from a mortar or incendiary tank shell. A game with penalties for shooting or being shot while running, but with no explicit rules for when one can be considered to have started or stopped running, may have a player argue that their character runs, slows to a walk just long enough to perform their attacks for a round, then starts running again. These holes are legitimate weaknesses in the game, but they seek to exploit them rather than fix them.
Perhaps a better (if different) example of a rules lawyer is a clever approach to ambiguous wording. Remember Time Walk in older Magic: The Gathering sets, which said "Opponent loses next turn", and how you can get a meaning that is altogether not synonymous with "Opponent misses next turn" out of it?
A truly classical munchkin will often outright cheat, but the term usually carries a connotation of being willing to abandon playing a role for in-game power. Consider a character with a Pacifist flaw (giving some other benefit), such that the character can only fight in self-defense, being played in an extremely provocative manner and with a liberal definition of "self-defense". There are also holes (which are legitimate flaws) that a classical munchkin will exploit that do obviously absurd things, like deal infinite damage.
The Problem of Using a Number (Score:4, Informative)
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.
Re:Gladwell's "Blowing Up" (Score:2, Informative)
About the "rise and fall" of Long Term Capital Management -- based on the massive 1998 failure of a hedge fund based on mathematical risk models and included a Nobel prize winner among its directors.
ISBN-10: 0375758259
ISBN-13: 978-0375758256
Amazon link: http://www.amazon.com/When-Genius-Failed-Long-Term-Management/dp/0375758259/ref=sr_1_1?ie=UTF8&s=books&qid=1231168194&sr=1-1 [amazon.com]
Also see wikipedia writeup: http://en.wikipedia.org/wiki/LTCM [wikipedia.org]
Re:Math? (Score:5, Informative)
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.
Re:Math? (Score:3, Informative)
Tell me the meaningful service the stock market provides and I'll listen, but I'm hard pressed to find the value in their service.
The real service the stock market (or any other commodity or derivative market) provides is the transfer of risk. The market allows hedgers to minimize their exposure to risk by selling it to speculators who are willing to accept it in exchange for the potential returns. Every other function of the market is secondary to that.
The market is simply the most efficient method of risk transfer we have found. The only alternatives are to either not allow the transfer of risk at all, which would practically destroy the modern economy; or to socialize economic risk and make the government the only shareholder in all businesses.
In the long run we're all dead (Score:4, Informative)
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.
VaR = GIGO (Score:4, Informative)
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.
Depends how you use it.. (Score:3, Informative)
The problem with VAR is not the measure itself, which is assuredly useful if one understands the limitations.
The problem is that once any risk measure (that is say, 95%+ 'reliable') becomes institutionalized as the gold standard, catastrophic failure of the financial system is inevitable (at least according to the general black swan theory).
Why? Because any firm that doesn't optimize profit against the risk criteria is going to have a lower P/R, and will lose capital to firms who are more 'efficient' at investing as long as things are 'normal'. This will result in the firm either folding, or being acquired.
If the firm does optimize to the risk criteria however, they stick a ton of risk into the tails of the risk distribution, which isn't measured, and so they'll get taken out when the black swan hits (ie. a rare event occurs, and all that hidden risk smacks them upside the head).
(and yes, I know this is a very simplified explanation).
it's also an *increase* in regulation (Score:4, Informative)
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.
Re:Gladwell's "Blowing Up" (Score:5, Informative)
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).
Re:Model accuracy wasn't the only problem (Score:3, Informative)
It's even worse than that. A coworker of mine used to work for a company that made models for mortgage banks. Some of the banks started balking that the models were showing something bad was happening, so they demanded the models be changed. Instead of saying no, the company responded by giving the banks "knobs" to tweak. This shut them up, but also let them lie to themselves till it was too late.