The Flaws of Finance

With the ever increasing number of black swans hitting the world, there is a rapid increase of critique with regards to different models the financial industry uses in determining risk and how to hedge IT. Must read by James Montier on the subject.

The National Rifle Association is well-known for its slogan “Guns don’t kill people; people kill people.” This sentimenthas a long history and echoes the words of Seneca the Younger that “A sword never kills anybody; it is a tool in the killer’s hand.”

I have often heard fans of  finanancial modelling use a similar line of defence. However, one of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling. He points out that “Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands.

The intelligent supporters of models are always quick to point out that financial models are, of course, an abstraction from reality. Just as physicists can study worlds without frictions, Financial modelers should not be attacked for trying to reduce the complexity of the “real world” into tractable forms. Finance is often said to suffer from Physics Envy. This is generally held to mean that we in finance would love to writeout complex equations and models as do those working in the field of Physics. There are certainly a large number of market participants who would love this outcome. I believe, though, that there is much we could learn from Physics. For instance, you don’t find physicists bettingthat a feather and a brick will hit the ground at the same time in the real world.

Full must read article here.

Chart Wikipedia

h/t Ross