« Bed, Bath & Beyond's Q3 Earnings | Main | Wallstrip Unstripped »

I just got around to reading Joe Nocera’s recent article on the life and death of risk management, and the titanically overrated blowhard Nassim Nicholas Taleb. The media tends to like these “Big Think” articles as it feeds into the Malcolm Gladwell-style of bring Big Ideas to the masses. Gladwell, in fact, was one of the first to highlight Taleb a few years ago in the New Yorker.

If you’re not familiar with Taleb, he has one idea and one idea alone. Actually, it’s not even his idea. The man who really impresses me Benoit Mandelbrot. Anyway, the idea is that stock returns don’t follow the normal distribution (the bell curve). That’s it—that’s the Big Think idea.

Here’s the deal: If stocks don’t follow a bell curve, then a lot of the ways we measure risk are flawed. For Taleb, of course, it’s much more than that. His idea (meaning Mandelbrot’s) is really an impossible to comprehend discourse on the human soul. In short, everyone else is a moron and only Taleb gets it.

He highlighted his idea in his two awful books, Fooled by Randomness and the Black Swan. I’ve actually read both books and I’m curious how many people who bought the books have actually read them. My hunch is that these could be part of the great unread books of the world. The reason is that the books are so bad that they’re barely literate. Taleb goes on and on about how he’s such an aesthete living in a world of philistines, yet he can’t write a single coherent page. Now expand that 400 pages. If people knew just how tedious these books are, I doubt they would receive so much praise.

Taleb and others now claim that Value at Risk, or VaR, played a large role in the credit mess. Sorry, that simply isn’t the case. Risk models are perfectly fine to use as long as you’re aware of the limitations. Every financial ratio or metric is like that. Just because it has some flaw is no reason to blame the movement of the economy on the misuse of math. Nocera points out that once Goldman Sachs saw problems with their VaR numbers, they adjusted. No big deal and Goldman is still in business today. Nocera quote one risk manager, “VaR is a peacetime statistic.” Exactly.

Here’s an excerpt from the article:

“VaR was inevitable,” Gregg Berman of RiskMetrics said when I went to see him a few days later. He didn’t sound like an intellectual charlatan. His explanation of the utility of VaR — and its limitations — made a certain undeniable sense. He did, however, sound like somebody who was completely taken aback by the amount of blame placed on risk modeling since the financial crisis began.

“Obviously, we are big proponents of risk models,” he said. “But a computer does not do risk modeling. People do it. And people got overzealous and they stopped being careful. They took on too much leverage. And whether they had models that missed that, or they weren’t paying enough attention, I don’t know. But I do think that this was much more a failure of management than of risk management. I think blaming models for this would be very unfortunate because you are placing blame on a mathematical equation. You can’t blame math,” he added with some exasperation.

Here’s another good snippet:

And yet, instead of dismissing VaR as worthless, most of the experts I talked to defended it. The issue, it seemed to me, was less what VaR did and did not do, but how you thought about it. Taleb says that because VaR didn’t measure the 1 percent, it was worse than useless — it was downright harmful. But most of the risk experts said there was a great deal to be said for being able to manage risk 99 percent of the time, however imperfectly, even though it meant you couldn’t account for the last 1 percent.

Howard has more. As usual, he's bang on.

Posted by edelfenbein at January 7, 2009 4:43 PM