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The Perils of Simplifying Risk To a Single Number

kdawson posted more than 5 years ago | from the black-swan-rising dept.

Math 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.'"

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Gladwell's "Blowing Up" (4, Interesting)

gambit3 (463693) | more than 5 years ago | (#26328839)

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 [gladwell.com]

Re:Gladwell's "Blowing Up" (1)

commodore64_love (1445365) | more than 5 years ago | (#26329205)

Cool. I like free.

Also BusinessWeek* has a good article about the same phenomenon. In summary it says: "Economists are looking for a magic equation that will explain everything, similar to how F=ma explains sublight phenomena in physics. The problem is that while physics deals with things, economics deals with human beings, and human beings are emotional, irrational, and hard to explain with simple math."

*
* It's the issue about Silicon Valley's dying days, and a picture of a destroyed computer.

Liberal economics, Adam Smith, etc (4, Insightful)

Nicolas MONNET (4727) | more than 5 years ago | (#26329377)

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.

Re:Liberal economics, Adam Smith, etc (1)

yuriyg (926419) | more than 5 years ago | (#26329705)

"Liberal economics" doesn't assume that individuals would make rational decisions. Financial publications often state that in the short time frame markets are chaotic environments. Instead, the assumption is that the market as a whole would choose most efficient price/product/service in the long run.

Re:Liberal economics, Adam Smith, etc (2, Insightful)

homer_s (799572) | more than 5 years ago | (#26329845)

- 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.

Or maybe, the assumptions are:

- that individuals make decisions which are more rational than if someone else makes it for them
- that they have access to better information

Re:Liberal economics, Adam Smith, etc (3, Funny)

ultranova (717540) | more than 5 years ago | (#26330227)

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"

But if we could repeal the physical regulations, so the three black holes would be free to contract amongst themselves how they wish to move without being burdened by nanny physics, we would have that solution !

Re:Gladwell's "Blowing Up" (1)

Hordeking (1237940) | more than 5 years ago | (#26330071)

explain everything, similar to how F=ma explains sublight phenomena in physics.

Only when velocities stay well below the speed of light or masses stay around planet-sized (smaller, actually, since the Earth has enough mass to frame-drag space).

Re:Gladwell's "Blowing Up" (1)

cryptoguy (876410) | more than 5 years ago | (#26329821)

For an EXCELLENT article about this, read Malcolm Gladwell's "Blowing up", which you can find online for free:/p>

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

Quote from the article:

If anything completely out of the ordinary happens to the stock market, if some random event sends a jolt through all of Wall Street and pushes G.M. to, say, twenty dollars, Nassim Taleb will not end up in a dowdy apartment in Athens. He will be rich.

So, does anybody know whether Taleb is rich now?

Re:Gladwell's "Blowing Up" (2, Insightful)

MightyYar (622222) | more than 5 years ago | (#26329973)

So, does anybody know whether Taleb is rich now?

According to Wikipedia:

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the Financial crisis of 2007â"2008, a crisis which he attributed to the failure of statistical methods in finance [17][18]. According to Bloomberg, his Black Swan Protocol earned investors half a billion dollars. Taleb's financial success coupled with his earlier predictions have seen him catapulted to prominence. He has appeared on numerous magazine covers and television shows to discuss his views

Re:Gladwell's "Blowing Up" (1)

commodore64_love (1445365) | more than 5 years ago | (#26329857)

>>>Malcolm Gladwell's "Blowing up" - http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm [gladwell.com]

I just finished reading this article. You know what it reminds me of? Farming. Day-after-day you have to go through the pain of tilling the soil, spreading the seed, fertilizing, sometimes watering. You put in the sweat and labor in the hopes that you will get several acres worth of leafy vegetables. And if you don't - if the crop fails - then you try again during the second year. And the third year. And so on.

Empirica's strategy seems to follow the same pattern: lots of daily pain and loss, in the hopes of someday having a good harvest. How many years can a farmer... er, stock investor continue in that fashion until he bankrupts himself? It's a great strategy so long as the "harvest" comes in and saves your butt.

Re:Gladwell's "Blowing Up" (2, Informative)

Paul Rose (771894) | more than 5 years ago | (#26329987)

Highly recommend book "When Genius Failed"
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]

post VaR : (0)

Anonymous Coward | more than 5 years ago | (#26328841)

1 (?!)

Here's a single number: (-1, Troll)

Anonymous Coward | more than 5 years ago | (#26328845)

100%. That's the chance that kevin dawson's stories suck.

the answer to everything... (0)

Anonymous Coward | more than 5 years ago | (#26328847)

42 ;)

Re:the answer to everything... (1)

EdIII (1114411) | more than 5 years ago | (#26328927)

The answer to everything is 42 ;)

It's not that the answer was wrong, it was that the question is retarded. If you think about that for a moment it's not even offtopic :)

Re:the answer to everything... (1)

morgan_greywolf (835522) | more than 5 years ago | (#26329073)

Exactly. But this is what happens -- we want what I call a 'McWorld'. What I mean by that is that we seem to want to put some monkey behind a computer, have them enter a few pieces of information, and spit out a simple answer. No brains, no real skills -- just need someone who can fog a mirror. When you boil everything down to fully-automatic, all-I-need-is-a-mirror-fogger-in-the-seat type of McWorld like that, you get the same results you get at McDonald's -- it works 'good enough' for many, but almost certainly isn't the 'best' product for anybody.

First post! (-1, Troll)

dword (735428) | more than 5 years ago | (#26328849)

1

(risking my karma)

Re:First post! (0, Offtopic)

sammyF70 (1154563) | more than 5 years ago | (#26328861)

you just had a car accident and the airbag didn't blow up

Re:First post! (0, Offtopic)

morgan_greywolf (835522) | more than 5 years ago | (#26329177)

Ummmm...shouldn't that be 0 then?

VaR - just the wrong number for the job (0)

Anonymous Coward | more than 5 years ago | (#26328869)

The problem isn't so much reducing risk to a single number -- it's the risk of reducing it to the wrong single number. Put simply, VaR (as measured and used by most banks) tells you how bad it will get 2 or 3 times a year. Great -- it's a fantastic measure for management to have. But to use it (as regulators did, and managers were seduced to), as a proxy for how bad it would get once every thirty years was nonsense -- that simply wasn't what it was measuring.

Re:VaR - just the wrong number for the job (2, Insightful)

jlf278 (1022347) | more than 5 years ago | (#26329433)

No, the problem was reducing to a single number, you yourself say that just looking at 95% VaR (2 to 3 times occurence daily over one year) is not enough. You're right they need to consider 95% and 99% VaR, among other levels of risk tolerance...and I know many firms do and have been. I believe the bigger problem was the faulty assumptions in calculating VaR, primarily assuming a standard distribution bell curve. Many portfolios do not have symmetric profit. Also, when prices start to soar or plummet, volatility increases. Furthermore, a random walk doesn't correctly articulate the complex actions of market participants (prone to fear, marriage to a position, etc.) and IMO underestimates the outer reaches of the bell curve. According to this flawed modeling, it wasn't a once in 30 year event being ignored, it was a once in 30 million year event. Obviously it is extremely probable that was an incorrect estimation of the risk, but it wasn't an error of only looking at 95% VaR.

Re:VaR - just the wrong number for the job (3, Insightful)

ClassMyAss (976281) | more than 5 years ago | (#26329815)

FTA, and I think this really gets to the heart of the problem (it's talking about the execs and regulators that didn't really understand what the numbers they were looking at meant):

There was everyone, really, who, over time, forgot that the VaR number was only meant to describe what happened 99 percent of the time. That $50 million wasn't just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time.

Single page version. (1)

khasim (1285) | more than 5 years ago | (#26328889)

Math? (3, Insightful)

EdIII (1114411) | more than 5 years ago | (#26328899)

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.

Hmmmm. Math or "subjective degrees of belief about the uncertain future".

I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel. Seems my supposition is being proven correct more and more each day.

Until recently, it was the smaller guys in the stock market that were getting screwed and the whole system kept the thievery down to a manageable level. Now from the largest, to smallest, they all seem to be getting destroyed, American in ruins, and the previously rich and powerful with outstretched hands at the Feds.

Of course maybe that is too cynical, but I always saw the stock market as rigged from the beginning. What do I know though? :)

Re:Math? (4, Insightful)

Chapter80 (926879) | more than 5 years ago | (#26329077)

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.

Re:Math? (0)

wellingj (1030460) | more than 5 years ago | (#26329141)

I think we can look at it another way. The systemic fail we are looking at comes from the belief that lots of money can be made with out manufacturing anything. Sure services can be sold as well but that equals someones time. 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. So... I agree they are lying, thieving, immoral, unethical, and greedy f'ing bastards. I just wish they would make something of value instead of distract us from the real economic problem, which is that the US doesn't produce as much value as it consumes.

Re:Math? (3, Insightful)

Kjella (173770) | more than 5 years ago | (#26329403)

Tell me the meaningful service the stock market provides

The ability to let me put my money into companies and products I think will be successful without making complex arrangements? Certainly, the stock market is taking on a life of its own but speculation happens with physical goods too. The alternative to publicly traded companies which implies a stock market is either privately traded companies or no trading at all, and I can't see any of those being better.

Re:Math? (1)

Ed Avis (5917) | more than 5 years ago | (#26329471)

The systemic fail we are looking at comes from the belief that lots of money can be made with out manufacturing anything.

I expect most Slashdot readers, if they have a job or make money, do it without producing anything physical.

Re:Math? (2, Informative)

vlm (69642) | more than 5 years ago | (#26329517)

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:Math? (5, Informative)

Alpha830RulZ (939527) | more than 5 years ago | (#26330061)

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? (1)

commodore64_love (1445365) | more than 5 years ago | (#26329371)

You are correct.

I bought SPY stock when the market was down around 7500, and now the market's above 9000, so doing some quick math...... I increased my money from $50000 to $60000 (approximately). In a few more years if the market returns to its 13000 level, my stock will have a value close to $90000.

That's certainly better than what I would earn in a simple-interest account in the bank (~$58,000) during the same timespan.

Re:Math? (4, Interesting)

El Torico (732160) | more than 5 years ago | (#26329163)

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.

Re:Math? (2)

Tanktalus (794810) | more than 5 years ago | (#26329551)

Aha. What you want is for everyone to join /. so we can hand out appropriate karma. ;-)

Re:Math? (2, Insightful)

commodore64_love (1445365) | more than 5 years ago | (#26329295)

>>>I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel.
>>>

We're discussing corporations and businessmen, not governments and politicians. Oh wait; they are the same thing. (shrug). Too bad there's still so many gullible citizens out there who believe corporations or governments are trustworthy. If only there was a way to make people more skeptical about the lies spilling from businessmen' and politicians' mouths.

If you flee to the Democrats, they hate corporations but love government. No good. If you flee to the Republicans, they hate government but love corporations. That's no good either. If only there were a party that hated both, since both corporations And governments are untrustworthy institutions. That's a party I could stand behind.
.

I will say one positive thing about corporations. They can't reach into your wallet. Bill Gates may have a stranglehold on the personal computer, but he still can't access my wallet. (Thank God.) I haven't handed Mr. Gates any money since I bought Windows XP in 2002. My Congressman on the other hand - he rifles through my wallet as if it was his own personal treasury - grabbing whatever he desires to take. So that makes corporations the lesser of two evils (imho).

Re:Math? (1)

russotto (537200) | more than 5 years ago | (#26329405)

My Congressman on the other hand - he rifles through my wallet as if it was his own personal treasury - grabbing whatever he desires to take. So that makes corporations the lesser of two evils (imho).

Short term. But in the medium and long terms (which have already arrived), the corporations just use the hand of government to reach into your pocket.

Re:Math? (1)

domatic (1128127) | more than 5 years ago | (#26329655)

My favorite is government forms delivered as Office documents or government services that insist on IE.

Re:Math? (1)

ShieldW0lf (601553) | more than 5 years ago | (#26329415)

It has to do with accountability, and stated ideals and responsibilities.

When the government screws the people, you can at least point at them and say "That's not right, you're not supposed to do that, and we're going to hold you to higher standards. We have that right."

When a corporation screws the people, they're just doing what "they're supposed to do". They have no higher standards to be held to.

That's the freedom we brought to the USSR. The people still get screwed, but the leadership is free of the requirement to even make it seem like they're looking out for the people, and can flaunt the arbitrary manner in which they wield their power with impunity.

That's freedom, western style.

Re:Math? (1)

Chris Mattern (191822) | more than 5 years ago | (#26329665)

When the government screws the people, you can at least point at them and say "That's not right, you're not supposed to do that, and we're going to hold you to higher standards. We have that right."

And then you can enjoy the sweet, sweet sound of their derisive laughter.

When a corporation screws the people, they're just doing what "they're supposed to do". They have no higher standards to be held to.

And then you can decide not to give them any more of your money. That's not an option with a government.

Re:Math? (0)

Anonymous Coward | more than 5 years ago | (#26329709)

greedy fucking bastards that were ready to bend you over for a nickel

How about a new model of free market based on emotion and belief? Investment should be done on the basis of which ideas you believe in, not on basis of maximum profit. An example: Bono investing Palm. The goal of maximizing profit suggest a fixed size opportunity and market which do not correlate well with observable reality.
  New and high risk ideas could actually have more change to be invested in.

Re:Math? (1)

UnknowingFool (672806) | more than 5 years ago | (#26329811)

I think one of the underlying problems was simple greed. For decades, how companies were viewed by Wall Street was their profitability. Over time, it became about growth. The problem with this slight change is growth in mature markets is hard, especially during downturns.

Take for example, Apple. Apple has made gads of money on the iPod. At some point everyone in the world will have one. Now they either have to find another market or Wall Street will punish them. It won't matter if they still make money. All Wall Street cares is if they keep making more each time. Such a system encourages companies and people to abuse them.

Taleb goes much farther than that (-1)

Anonymous Coward | more than 5 years ago | (#26328905)

He basically claims that VaR and much of current microeconomics is fatally flawed. And sadly, I can only agree. I have spent enough time studying science (engineering, PhD in mechanics, among other credentials), and when I finally got interested in economics, I have immediately been flabbergasted by the sheer amount of garbage that microeconomics is. Don't get me started on the hypotheses behind the "general equilibrium" theory, they are simply ludicrous. And then, most mathematics behind this crap seems to be done by poorly skilled undergraduates. How long did it take them to come up with such obvious things as the Lipsey-Lancaster theorem (simple application of Lagrange multipliers) which basically brings down the whole optimality thing? Not to mention Nash, Debreu-Sonnenschein-Mantel, etc.?
And these are the people driving our financial system!
Please wait while I'm gone throwing up...

Re:Taleb goes much farther than that (1)

wisty (1335733) | more than 5 years ago | (#26329043)

There is a guy called Steve Keen who more or less predicted the collapse using an ODE system. When he presented his findings (some time ago) he claims that the economists in the crowd thought that a 6 variable ODE was so complicated that he had to have made a mistake.

Re:Taleb goes much farther than that (1, Interesting)

Futile Rhetoric (1105323) | more than 5 years ago | (#26329123)

So Mr. Mathematically-savvy Man, why don't you go ahead and transform economics for the better? I'm sure there are many more "obvious" things out there to come up with.

VaR is a pretty decent risk measure on a micro scale. The real problem with it is that VaR constraints tend to make banks less diversified, introducing systemic risk. When things go sour, banks are forced to sell off similar assets, and because all of the banks tend to hold assets with similar risk, markets fluctuate all the more.

It is telling that a broad index of hedge funds is better resistant against risk than an index of banks.

Re:Taleb goes much farther than that (2, Insightful)

jeffasselin (566598) | more than 5 years ago | (#26329927)

Economics is not a science.

Science is the application of the scientific method. When's the last time you saw an economist perform an experiment where only one variable was at play?

Re:Taleb goes much farther than that (0)

Anonymous Coward | more than 5 years ago | (#26329357)

I think there should be a 10 year moratorium on the invocation of the central limit theorem in financial mathematics.

These jackasses assume that everything vaguely bell shaped is a normal distribution and then fall to pieces when it turns out that the real distribution has fatter tails.

perils of believing in the corepirate nazi mantra (0)

Anonymous Coward | more than 5 years ago | (#26328913)

the odds are stacked way against US. we note that without a legitimate replacement, folks greed/fear/ego based ?thinking? sends then right back to the scene of the crime for some additional punishment. better days ahead.

Self-referential? (4, Insightful)

aeinome (672135) | more than 5 years ago | (#26328915)

So what's the VaR of using VaR? :)

Simplifying decisions (0)

Anonymous Coward | more than 5 years ago | (#26328933)

Simplifying risk to a single number is as dangerous as simplifying a decision to buy or sell to a single boolean value.

It's something that has to be done at some point regardless of how the risk is estimated and how all the information is used to make the final decision.

A bit more to the topic: One just has to find the correct numbers and use them well for decision making. It will be more reliable than hand waving and can actually be analyzed.

Re:Simplifying decisions (1)

Chrisq (894406) | more than 5 years ago | (#26328979)

Simplifying risk to a single number is as dangerous as simplifying a decision to buy or sell to a single boolean value.

false ;-)

Re:Simplifying decisions (1)

jank1887 (815982) | more than 5 years ago | (#26329571)

"Simplifying risk to a single number" oh, by the way, what's the current terror level?

"42" has always worked for me (0)

Anonymous Coward | more than 5 years ago | (#26328939)

Some people enjoy "69", but "42" has always been a lifesaver throughout the last 30 years...as long as I have a towel. Hmm... I thinking the "69" people also may want to have a towel as well.

Not an Either/Or Situation (1)

financialguy (680124) | more than 5 years ago | (#26328953)

First, don't forget that Taleb is selling something. Very smart guy, but he wants to make a good living too.

VaR isn't something I'd want to be without, but you clearly can't depend on models alone when your assumptions are uncertain. That's what the whole mess with CDOs and such comes down to- bad assumptions.

With the mortgage-backed market (e.g. sub-prime), the assumption was that N number of borrowers would default in X period of time. If they had the models would've been fine, but in reality they didn't, and the basis for the assumptions was horribly incorrect. Why those assumptions were incorrect is another story.

Re:Not an Either/Or Situation (1)

Anonymous Coward | more than 5 years ago | (#26329103)

Why those assumptions were incorrect is another story.

They didn't take into account that sub-prime loans were increasingly being used by "investors" to buy their third, fourth and so on rental or flipping unit. Once the market turned, people weren't defaulting on one house at a time, they were defaulting on three or four.

The "next wave" is still ongoing: with unemployment rising, the prime default rate has tripled. Responsible people who bought houses within their means are finding their means have gone and aren't coming back.

Re:Not an Either/Or Situation (1)

OwnedByTwoCats (124103) | more than 5 years ago | (#26330065)

One of the problems is that some managers evaluated traders' performances by only looking at a single number. And that number covered results in 99 buckets, and left the contents of the last bucket uncounted.

It's trivial to set up a game that pays off modestly 999 times out of 1000, but that last one wipes out all of your losses tenfold. And the Value At Risk metric, by design, doesn't show that one out of a thousand loss. The trader posts the modest profit 99.9% of the time. Every work day for four years. Then the designed-in "black swan" losses arrive. The trader has four years of bonuses, so he's not too bad off.

Re:Not an Either/Or Situation (3, Funny)

Paul Rose (771894) | more than 5 years ago | (#26330247)

Commonly used analogy in derivative trading: "Picking up nickels in front of a steamroller" (sometimes bulldozer).
Modest returns, low rate of failure, but really messy when you do fail...

I don't think that the problem is a single number (2, Insightful)

Chrisq (894406) | more than 5 years ago | (#26328971)

I don't think that the problem is a single number it is connectivity. 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%. The thing is if one loses that much then the markets may lose confidence meaning the others go down too - they are not independent probabilities.

Re:I don't think that the problem is a single numb (0)

Anonymous Coward | more than 5 years ago | (#26329175)

Yes, no kidding. As flawed as some of these models are they definitely do not treat all investments as independent.

One of the best features of a VaR model is to offset positions against each other. As an incredibly simple example lets say that after a day a of trading one prop desk has a long ibm position and another prop desk has an equally sized short ibm position. Its important to understand that those two positions effectively cancel each other, and your VaR from them is $0.

This concept gets much, much more complicated when dealing with derivatives and relations across asset classes.

Re:I don't think that the problem is a single numb (0)

Anonymous Coward | more than 5 years ago | (#26329935)

OK. And can you give us a single number of the risk of simplifying to a single number?

Re: I don't think (4, Interesting)

Hemogoblin (982564) | more than 5 years ago | (#26330091)

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.

RE: (0)

Anonymous Coward | more than 5 years ago | (#26328975)

Garbage in - Garbage out, much of the input data to the VaR was questionable.

The (bigger) peril of assuming only 1 risk (2, Informative)

petes_PoV (912422) | more than 5 years ago | (#26328985)

Money is all about numbers, so quantifying "risk" in numerical terms is not only valid, but to be encouraged. You wouldn't bet on a horse if the odds were quoted as "almost impossible", "very unlikely" etc. You'd want to know what possible return you'd get for your bet and roughly what would be the chances of winning.

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.

We discussed (5, Insightful)

Hognoxious (631665) | more than 5 years ago | (#26328989)

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.

Welcome to the Age of Bayes (3, Interesting)

radtea (464814) | more than 5 years ago | (#26329031)

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.

Why is anyone still making this distinction, as we now know that the only self-consistent numerical representation of risk follows directly from our subjective degrees of belief about the uncertain future? Furthermore, we have known this for over a generation... isn't it about time that the knowledge start filtering into the popular discourse?

While Bayesian methods are not always all that useful for practical problems (I use them on occasion in my work) the conceptual foundations and deeper understanding of the nature of plausible reasoning and its relation to probability theory needs to be more widely understood.

One of the big take-home messages from the Bayesian revolution is that probability theory is nothing but quantification of what we do subjectively, insofar as our subjective impressions are self-consistent, so the only people who are still debating quantitative vs subjective approaches as such are people who do not understand the question.

Re:Welcome to the Age of Bayes (5, Insightful)

Hoplite3 (671379) | more than 5 years ago | (#26329199)

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.

Air bag (1)

Thanshin (1188877) | more than 5 years ago | (#26329067)

An air bag that works all the time, except when you have a car accident.

A question for the powerful minds of /.

How is the risk of driving with that airbag in your car compared to a normal one?

- Greater.
- Smaller.
- Exactly identical.
- Unknown until you open the box.

Re:Air bag (1)

Lord Bitman (95493) | more than 5 years ago | (#26329395)

We know from random statistics of crashes involving cars which are supposedly equipped with airbags capable of deploying during an accident that a high percentage of all "untested airbag readiness" (UAR from here on) cars actually do have airbags. The risk of these not deploying is low.

Meanwhile, however magically, we know that car X's airbag will _not_ work in an accident. The risk in driving that car is high.

If X is also a UAR car, the risk is identical.
If X is known to be defective, the risk is greater.
If X is known, however magically, to not be defective, the risk is higher.

Unless you're an infant in the front seat.

Minmaxing ftw! (5, Insightful)

Opportunist (166417) | more than 5 years ago | (#26329091)

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?

Re:Minmaxing ftw! (2, Insightful)

Aladrin (926209) | more than 5 years ago | (#26329275)

I've started to play D&D a few times, but the groups I was in didn't seem to care about the rules at all and viewed my interest in the rules as bad... We never got past making a character, and I tried a few times.

So I'm serious when I ask: Why is that kind of person bad? Aren't they having fun within the rules? Don't the make the adventure more exciting instead of less? They take a system that is pretty predictable and stretch it to the limits.

As for 'rules lawyers', which you didn't mention, aren't they just keeping the gameplay fair? I mean, if there's rules, they're meant to be obeyed.

As for 'playing the system' of the stock market... I'm surprised nobody thought it could happen. Even if they aren't a gamer, surely they've seen the same activities in the workplace or even their own house. Everything runs like this because there's always someone who wants something.

Re:Minmaxing ftw! (1)

Opportunist (166417) | more than 5 years ago | (#26329545)

Well, bad. It ain't bad if everyone's doing it and everyone's having fun. It is bad if some people actually want to play by the rules, for various reason (because they think the rules help making things fun for everyone, for example, or because they know the game falls apart if rules are simply ignored, unless people don't give a rat's behind about the game at all and just wanna "gank shit") or if they're not being told that the rules are out the window. Because it's kinda frustrating to try to play by the rules only to see that everyone who ignores them gets away with it and is actually also more successful.

Who said roleplaying can't be like real life?

Re:Minmaxing ftw! (1, Informative)

Anonymous Coward | more than 5 years ago | (#26329585)

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.

Re:Minmaxing ftw! (1)

hibiki_r (649814) | more than 5 years ago | (#26329803)

If you don't like a game built around a lot of rules to be min-maxed, you play one of many other RPGs that stay far away from the D&D family, and are light on rules precisely to avoid this very issue.

In D&Ds case, the reason min-maxers are bad is because they turn a cooperative game into a competitive game: If your character is not tuned and theirs is, yours actions become less relevant, and eventually you don't feel like you are playing.

In the stock market today, a big problem is that many people aren't playing with their own money: They've been entrusted with money because they are supposedly experts. In the end, the fall they take once they go too far is losing their job, not their life savings. Same thing with corporate managers, that will be rehired by their buddies in other companies if they drive their corporation into the ground.

Re:Minmaxing ftw! (2, Insightful)

khallow (566160) | more than 5 years ago | (#26329833)

As for 'playing the system' of the stock market... I'm surprised nobody thought it could happen.

Guess you haven't been paying attention then. A lot of the rules of the market (for example, insider trading, mark to market accounting, bank reserves, etc) exist because of these well known impulses. When things go bad, the self-serving routinely express bewilderment, employing the "nobody thought it could happen" defense. Almost never is this statement true.

Re:Minmaxing ftw! (2, Funny)

sugarman (33437) | more than 5 years ago | (#26329931)

Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?

Perhaps because those in the "roleplayer" and "policy wonk" sets have almost no-overlap?

While I'm all for using simulations in systems work, thinking the econ crisis is similar to the time your party killed an Ancient Red Dragon and then bought Greyhawk with the loot probably isn't too helpful.

Re:Minmaxing ftw! (1)

jeffasselin (566598) | more than 5 years ago | (#26329957)

Your comment is strangely relevant and I wish I had mod points.

Distributions and correlations. (0)

Anonymous Coward | more than 5 years ago | (#26329105)

Value at Risk (VaR) is simply business/finance jargon for quantiles of a probability distribution, heaavily promoted by JP Morgan since the 1980s and widely adapted by financial and non-financial institutions alike. It's usually the 95 or 99 percentile of the value of some portfolio per day/week/month/year.

Now there is a lot of criticism about using wrong distributions (usually assumed Normal/Gaussian). Economists have known this for a very long time: pretty much anybody who as studied the subject knows most financial returns are not Gaussian. Even in an undergraduate course I had to calculate VaRs with thick tailed and asymmetric distributions. I'm not sure if this is done in practice in big firms though. The amount data to estimate the statistics are typically far bigger than in class assignments, and assuming Gaussianity makes the calculations very easy.

I think BTW that it's more sensible to recognize that variances and correlations are changing over time, and use proper dynamic models to account for that, rather than simply replacing the Gaussian with a thick tailed skewed distribution.

Re:Distributions and correlations. (1)

mugurel (1424497) | more than 5 years ago | (#26329179)

That makes sense. Other than that, I think they are just facing the bias/variance trade-off http://en.wikipedia.org/wiki/Overfitting_(machine_learning) [wikipedia.org] . If you want your model to be better at predicting particular unlikely events, it will come at the cost of an overall loss of prediction accuracy.

Re:Distributions and correlations. (0)

Anonymous Coward | more than 5 years ago | (#26329389)

No, no no no NO! This has nothing to do with overfitting - overfitting happens when you have too many degrees of freedom for the data that you're fitting. This was an instance where there was no data to fit, so instead you need to either produce a detailed model based on other data that you do have, or add a significant fudge factor. Neither was done, and that's where we are now...

My work consists almost completely of setting odds on events, formerly of the financial sort and more recently for sports. And you run into this type of thing all the time, where you have to put odds on an event that's pretty much never been observed before, nor has anything like it. The only thing you can do is try to break the "impossible" event into a string of sub-events that are slightly more tractable, handle the correlations between those, look for any shred of constancy and pick apart what would make it vary, etc., etc. It's a real fucking pain in the ass to do, as you would expect. Far more difficult than properly predicting more normal events, where you actually have some data to work with (the data can then become the model, and in many cases you don't even need to know what the data is that you're looking at).

Detailed external modeling was not performed in this situation (and it's unlikely that anyone could envision all the potential catastrophe situations, by the way, so this is neither a stupidity nor unexpected). Where this really went wrong was that the managers who don't understand the prediction process and its limitations saw these magical VaR numbers that had helped them sail the smooth waters so well for all these years, and started relying too heavily - almost exclusively, even - on them, thinking that they accounted for all the risk that they faced. They stopped adding in the "Shit happens" premium that you should always tack on since you know you can't account for all the shit that happens.

A "Shit happens" factor imposed by an external entity (one that has no financial stake in allowing people to take on more risk than is "safe," judged by some conservative measure) is the only realistic way this could have been avoided - anyone that claims they could have put meaningful odds on a financial meltdown of this sort is flat out lying, it involved far too many factors, one of which is the faulty prediction of the risk of financial meltdown, which would have been lessened had someone achieved a reasonable model of its risk, which would have invalidated the model and caused a re-modeling of the risk, and so on.

Re:Distributions and correlations. (1)

WaZiX (766733) | more than 5 years ago | (#26329399)

Now there is a lot of criticism about using wrong distributions (usually assumed Normal/Gaussian). Economists have known this for a very long time: pretty much anybody who as studied the subject knows most financial returns are not Gaussian.

That's why the capital requirements are set to 3 times VaR (10 days, 99%), of course this is only takes the "fat tails" problem into account.

To be frank, every risk manager (and regulator) has known that the VaR figures were arbitrary since the start, but you have to set the capital requirements somewhere... and that somewhere will ALWAYS be arbitrary because indeed, correlations and risk will always be dynamic...

The biggest criticism you could make to banks are not that they use VaR models (or Estimated Shortfall), but how BAD THEIR MODELS WERE. Before the end of 2007, almost no bank reported exceptions to their VaR calculations... And not even did they not report exceptions, they never even got close to their VaR... When you understand that, on average, this VaR should be exceeded on average 3 times a year... but it never (well almost, it happened 3 times for the whole industry in 3 years if i remember correctly) happened! Now you could say that they were too careful, but no, they included fees into their returns... effectively hiding their risk exposure to the regulator.

But even if their VaR models had been realistic, they still did not take liquidity risk into account, and the massive leveraging that took place increased that liquidity risk to unsustainable levels... (exactly like LTCM)

It's simpler than that (5, Interesting)

joss (1346) | more than 5 years ago | (#26329127)

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 (5, Insightful)

u38cg (607297) | more than 5 years ago | (#26329185)

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:It's simpler than that (2, Insightful)

WaZiX (766733) | more than 5 years ago | (#26329421)

Well, it's not so much that they wanted to minimize their risk of being fired as they wanted to maximize their bonuses... But your argument stands nonetheless...

Re:It's simpler than that (3, Insightful)

vlm (69642) | more than 5 years ago | (#26329429)

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.

The key is not so much making a high ROI, as it was the separation of risk from transaction fees. My local bank would loan to anyone, as they immediately sold the loan and pocketed a transaction fee. They couldn't care less if any payments were made. Very few people realize how "investment"-type companies like banks turned into little more than a commissioned salesforce. And commissioned salespeople only make money on transaction volume, not long term return on investment.

Re:It's simpler than that (2, Insightful)

scamper_22 (1073470) | more than 5 years ago | (#26329851)

Not quite. Risk models are important. However, at some point comes a very subjective view of how much is at stake with that risk. Let us call this resiliancy.

This is really what most of the western world is missing. Resiliancy.
Resiliancy is an attitude more than just a number. This is really what Taleb talks about with the black swan.
Before, they only knew of white swans. So if someone came up to you and made you a bet that there were only white swans, you would take it. Almost as if someone made a bet with you regarding pigs flying. You would take that bet. However, what happens when you find the black swan, which they did in australia... suddenly if you had made the bet, it could be disastrous.

Even if an action has 99% upside, and only 1% downside, you MUST consider what if that 1% occurs. It is a recognition of the complexity of the world we live in.

Since this is slashdot, it's like coding. It is resiliant to over allocate memory just for resiliancy sake. Maybe I only need an array of 30. Yet, I will allocate an array of 32... just for some safety even if I 'KNOW' it will never get to that point. You sacrifice some optimization for some resiliancy.

I would almost venture to say, most of the western world is operating completely on extreme theory. There is no resiliancy built into the system.

We bet on 'innovation economy' because we don't want to reduce our standard of living to where we are our own farm/textitle/manufacturers.
We bet on housing prices always going up (even though population growth is stabilizing/declining... see Japan/Germany/Italy...).
We bet on providing complete welfare from cradle to grave, giving up on the resiliancy of the family support structure.

The bad thing with all these is the downside risk is extreme... almost catastrophic.

Open Source Risk Modeling (4, Interesting)

Doofus (43075) | more than 5 years ago | (#26329147)

Far down in the depths of the article, the author points out that JPMorgan open-sourced their risk modeling methodology, which popularized the VaR (Value at Risk) approach used by most of the big financial firms:

What caused VaR to catapult above the risk systems being developed by JPMorgan competitors was what the firm did next: it gave VaR away. In 1993, Guldimann made risk the theme of the firm's annual client conference. Many of the clients were so impressed with the JPMorgan approach that they asked if they could purchase the underlying system. JPMorgan decided it didn't want to get into that business, but proceeded instead to form a small group, RiskMetrics, that would teach the concept to anyone who wanted to learn it, while also posting it on the Internet so that other risk experts could make suggestions to improve it. As Guldimann wrote years later, "Many wondered what the bank was trying to accomplish by giving away 'proprietary' methodologies and lots of data, but not selling any products or services." He continued, "It popularized a methodology and made it a market standard, and it enhanced the image of JPMorgan."

Climate Models (0, Offtopic)

jamesl (106902) | more than 5 years ago | (#26329171)

And then there are the computer models that predict climate. As a single number. Temperature of the atmosphere. For the next 100 years. Scary?

Re:Climate Models (1)

ddstreet (49825) | more than 5 years ago | (#26329323)

Average temperature predictions scary? Only to you.

Re:Climate Models (1)

radtea (464814) | more than 5 years ago | (#26330233)

Average temperature predictions scary?

Only to anyone who understands that temperature is an intensive thermodynamic quantity and therefore cannot be meaningfully averaged in an inhomogeneous medium such as the atmosphere. It is a bit scary to see a meaningless number continually used as the basis for a massive power grab.

Atmospheric heat content can be averaged, if we had a clue what it was, and a surrogate average temperature generated from that. As near as I can tell all global temperature records of note are dry-bulb temperatures which are, by themselves, thermodynamically useless for this sort of averaging.

Global OCEAN temperatures are rising, and that should be a matter of concern because that is a clear indicator of increasing ocean heat content, but as I said, it is a bit scary to see people who believe absolutely in their own righteousness base their arguments on a literally meaningless number.

And the point about complex models failing is very well taken. The climate system is far more complex and we have far less information about it than the financial system, and anyone relying on computer models for their beliefs about climate systems ought to be willing to invest everything they own based computer models of the financial system.

Any takers?

Re:Climate Models (1)

sshir (623215) | more than 5 years ago | (#26330093)

That's "climate", not "weather".

Weather is chaotic - meaning 2-3 weeks prediction tops. Climate is too, but horizon is much further away.

Hell, solar system itself is chaotic, meaning you cannot predict positions of planets very far into the future. But thousands of years - no problem.

It's the bonuses, stupid (2, Insightful)

tomhath (637240) | more than 5 years ago | (#26329319)

Objective or subjective models don't mean anything to people who only care about short-term performance. Whether the investment is good or bad in the long term doesn't matter to an investment manager who stands to get a seven figure bonus based on the current year's numbers. So what if the company fails next year? Not his problem.

Re:It's the bonuses, stupid (1)

justinlee37 (993373) | more than 5 years ago | (#26329387)

That certainly had something to do with it, but there were a great deal of contributing factors, particularly depending on which effects of the credit meltdown you are concentrating on (bank insolvency, the decline in value of subprime mortgage assets, the decline in value of residential real estate, etc). For example (and this plays into your point) when primary lenders were distributing mortgage-backed securities to secondary lenders (other banks who would buy mortgages packaged together), they were able to pass the risk of lending the money onto another bank. This doesn't just mean that the people didn't care about the performance of their bank in order to fatten their paychecks; they were so interested in fattening their paychecks that they ingeniously passed all of their commission-incentive dodgy loans onto OTHER banks, where they would damage the performance there!

In other words, don't try to boil it down to a single issue. You just can't.

American Bandstand (1)

vjmurphy (190266) | more than 5 years ago | (#26329457)

If it works for Dick Clark, it works for me.

"I give Bank of America a 77, because of their assets and because I can really dance to it. "

There are many factors (1)

atherton2 (728611) | more than 5 years ago | (#26329521)

Yes giving out so much in bonuses made people focus on short term gains, rather than stable returns, some models were wrong, and hundreds of other factors. One factor that I think is over looked in this is the number of times the computer programs/ algorithms etc were ignored. I have heard off friends working in the industry that computer models that favoured a less risky lower return approach were binned or ignore. Unwelcome risk reports were made to disappear. It was not computers or mathematicians that are to blame here. It is the people who thought they were smarter than the rest of us. Those who thought it would never end, well all things come to an end, and the sick thing is these are the ones who made the millions and left everyone else in the S***.

Catch 22 of Lending (0)

Anonymous Coward | more than 5 years ago | (#26329531)

Anyone sane enough to borrow money wouldnt ask.
Anyone asking isnt sane enough to use borrowed money.

Its been the lending policy for years, and I am sure it will continue this way in the future. They continually throw offers to borrow money at my wife who has excellent credit, and enough money in the bank to not need what they are offering.

So, how much risk is it? (1)

wurble (1430179) | more than 5 years ago | (#26329617)

So, could you summarize, in a number, how risky it is to use a single number to represent risk?

The Problem of Using a Number (3, Informative)

tbannist (230135) | more than 5 years ago | (#26329697)

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:The Problem of Using a Number (4, Insightful)

giafly (926567) | more than 5 years ago | (#26329879)

The problem with using a single number is simple: It is easily gamed and there's lots of incentive to do so

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.

Taleb doesn't know everything (4, Interesting)

Kupfernigk (1190345) | more than 5 years ago | (#26329897)

Taleb is very arrogant. But he still cannot see beyond his limited perspective as a quant. He is right in arguing that the fundamental error in the model was to assume that the binomial distribution works for everything, but there also seems to have been a "conservation" error - assuming that risk scaled linearly with the axes. Any statistician with experience knows that reliance can only be placed on the outliers of a distribution when there is enough data around those outliers.

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.

Model accuracy wasn't the only problem (5, Interesting)

EdwinFreed (1084059) | more than 5 years ago | (#26330041)

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.

Two things, make that three (1)

LatencyKills (1213908) | more than 5 years ago | (#26330057)

"The purpose of computing is not numbers, but insight" - Hamming
"Simulations are like political prisoners, either can be tortured to tell you what you want to hear." - Unknown

But beyond the clever idea that we shouldn't all become mindless drones to our simulations if we don't understand the underlying principles that went into them is the problem that, at least in the financial world, risk and reward became disconnected, mortgage brokers being the perfect example. Mortgage brokers don't get paid unless they sell a mortgage. Their income depended not on the soundness of the mortgages they sold, but merely on the number regardless of how small a chance there was of the mortgagee managing to support the payments. Every time this bad debt got sold someone made a commission, so it was repackaged and resold dozens and dozens of times.

Also, when people talk about all the money the banks lost on this bad debt, it's not like it went up in smoke. That money went somewhere. Some people made phenomenal killings in the bad debt market.
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  • quote
  • ecode

"ecode" can be used for code snippets, for example:

<ecode>    while(1) { do_something(); } </ecode>