Ever heard of Nassim Nicholas Taleb? Most people haven’t. But his perspective on rare and improbable events goes a long way towards making the current financial crisis understandable. Two of his books deal with the assumptions made in financial risk models and the inadequacies that are inherently part of these models.
These books came back to mind when I opened up an article online called ‘Risk Mismanagement‘ published on the 2nd of January 2009 in the NY Times.
This article (all 10 pages of it) discusses risk management on Wall Street and the blinders that people had on regarding risk. People become reliant on risk measures that couldn’t deal with the possibility of a crisis like we’re facing. Taleb has been speaking out loudly about these risk measures for years. Take a look at Taleb’s home page which makes it clear how much he enjoys watching what’s going on. “My major hobby is teasing people who take themselves & the quality of their knowledge too seriously & those who don’t have the courage to sometimes say: I don’t know….” he says right at the beginning.
Taleb is fond of saying that he has made money only 3 times in his life, during the 1987 crash, during the bursting of the tech bubble, and now. In fact, he’s made millions on these events.
If nothing else, the events now going on in the financial markets should make people listen to Taleb more closely. However, we shouldn’t just listen to him about financial matters. The phenomenon of ‘The Black Swan’ applies to anything and we might just find out to our misery that there’s a Black Swan waiting for us somewhere else.
For example, have you read about the recent swarms of earthquakes beneath Yellowstone National Park? This has ‘just the facts’, but for those who don’t see the significance, read the US News & World Report’s story. Still asking why this is important, you can get more of the history of the Yellowstone Supervolcano with other references from Wikipedia. The essential point here is that on average the supervolcano has been erupting roughly every 600,000 years and the last eruption was 640,000 years ago. Even at that, it’s a highly improbable event, very unlikely to occur in our lifetime. Another Black Swan!
The real problem with risk models and risk assessments is that we believe the numbers and don’t think critically about what they really mean and how applicable they are. Wall street fell in love with a risk number that expanded until everyone used it, but they failed to use judgment to interpret it. Worse, many of the decisions makers didn’t really understand it anyway and just took it as a reliable measure of their risk exposure. It wasn’t.
Academicians who teach risk management always talk about the limitations. The ‘Quants’, people steeped in the mathematics of risk management are willing to admit that it isn’t perfect. So why did everyone not see problems on the horizon? Why did people keep saying there’s no problem? Why has the unlikely event nearly destroyed us? Read Taleb, it’s interesting stuff, but expect heavy going.
Black Swans exist in many places, but we never see them coming and don’t prepare for them. On wall street, this has led to a melt down we’re just starting to feel. Where else will we find a highly improbable event occurring that will affect us all?