Humble Ye Finance! Our entire risk education must be changed or DOOM!
Aristotle and Plato both knew he who controls the educational system controls the society. Finance professors and risk managers still teach students that human events occur in normal distributions. They teach that through the past we can predict the future with great accuracy. Students are taught mathematical tools such as linear analysis, correlation and beta to analyze the past and plot the future. Many phenomena can be predicted via normal distributions but NOT human interactions.
Often financial experts visualize risk or events a sign wave, reasonable normal and predictable. Events get worse, things get better, prices (phenomena) fluctuate about their mean and always revert towards it.
One of the massive fallacies of normal event distributions is the mitigated chances of extreme events. Before this year one could have asked what was the probability of our major financial system crashing? What were the chances of the major investment banks with the most brilliant financial professionals in the world going under? What were the chances of real estate crashing, globally? (The second fallacy of normal distribution is that extreme events are more severe then could possibly be predicted often to the order of thousands or millions greater then a normal observation)
What is ironic is blindness and faith that the highly unlikely can not happen only serves hasten them and make these extreme events more probable and worse. Take the billions of credit derivative swaps that were written on sub prime debt.
Sub prime means that the borrower could not afford the mortgage. These loans were only made because it was assumed that housing prices would continue to go up 10% a year into infinity. The loans then would eventually be re-financed and every one would be happy. The invester got paid. Hard working people who could not afford nice houses would now have one. This was win-. However it was inevitable that there would be a correction, people can only afford housing up to a certain portion of their wages. Finance professionals are taught linear analysis or other mathematical tools of a similar brand that pre-suppose that the future will behave like the past.
We must humble ourselves and realize we can not predict complicated phenomena such as stock price, earnings, geo-politics, heck even the weather! The mind may be master of the world but not the future.
Lehman brothers had the largest bankruptcy in history with 640 billion in debt. In their hubris they sought to leverage up to 40x and greater. Long Term Capital had in excess of 100x leverage! In their minds they could borrow and invest safely. They could know. If one can know the truth about something and know the truth about a system, then you can predict the future of that system. If a finance guy can know the future then he can make money, he can make a lot of money. So investment banks thinking they could know and control leveraged up magnifying their gains. In the end they did not know the truth and were crushed.
Let me state that their gambles were good for a long time and printed money. However, their understanding of financial phenomena was a very close approximation, but not the real thing. As they made more and more money they leveraged more and more and made an other linear mistake: because we never lost big before, we wont lose big in the future. We know what we are doing.
Before this week truth was: of course Lehman, Bear Sterns and Merrel can leverage 40x, they are brilliant, they have statistics and risk managers that can protect them. But they were unable to predict extreme events such as the real-estate crash. Now we look at a company with 40x leverage and think they are insane. Today Goldman has 20x leverage. Are they insane, have hubris or brilliant?
There needs to be a complete revolution in risk management. Something needs to happen like "efficient market theory". It is our lack of understanding of risk when it comes to human events that lead to this financial catastrophe. Even in statistics it is normal to throw out "outliers". One extreme event can destroy an entire portfolio or company. It is unknown how this works. There needs to be more studies of extreme events, not normalcy.
Again, the major reason why we are having the worse financial crisis since the great depression is because major players thought they understood the nature of risk and extreme events, that they could predict and know the future thus giving them the confidence to massively leverage. Until the idea of control is broken then we will not learn from our mistake.
Often financial experts visualize risk or events a sign wave, reasonable normal and predictable. Events get worse, things get better, prices (phenomena) fluctuate about their mean and always revert towards it.
One of the massive fallacies of normal event distributions is the mitigated chances of extreme events. Before this year one could have asked what was the probability of our major financial system crashing? What were the chances of the major investment banks with the most brilliant financial professionals in the world going under? What were the chances of real estate crashing, globally? (The second fallacy of normal distribution is that extreme events are more severe then could possibly be predicted often to the order of thousands or millions greater then a normal observation)
What is ironic is blindness and faith that the highly unlikely can not happen only serves hasten them and make these extreme events more probable and worse. Take the billions of credit derivative swaps that were written on sub prime debt.
Sub prime means that the borrower could not afford the mortgage. These loans were only made because it was assumed that housing prices would continue to go up 10% a year into infinity. The loans then would eventually be re-financed and every one would be happy. The invester got paid. Hard working people who could not afford nice houses would now have one. This was win-. However it was inevitable that there would be a correction, people can only afford housing up to a certain portion of their wages. Finance professionals are taught linear analysis or other mathematical tools of a similar brand that pre-suppose that the future will behave like the past.
We must humble ourselves and realize we can not predict complicated phenomena such as stock price, earnings, geo-politics, heck even the weather! The mind may be master of the world but not the future.
Lehman brothers had the largest bankruptcy in history with 640 billion in debt. In their hubris they sought to leverage up to 40x and greater. Long Term Capital had in excess of 100x leverage! In their minds they could borrow and invest safely. They could know. If one can know the truth about something and know the truth about a system, then you can predict the future of that system. If a finance guy can know the future then he can make money, he can make a lot of money. So investment banks thinking they could know and control leveraged up magnifying their gains. In the end they did not know the truth and were crushed.
Let me state that their gambles were good for a long time and printed money. However, their understanding of financial phenomena was a very close approximation, but not the real thing. As they made more and more money they leveraged more and more and made an other linear mistake: because we never lost big before, we wont lose big in the future. We know what we are doing.
Before this week truth was: of course Lehman, Bear Sterns and Merrel can leverage 40x, they are brilliant, they have statistics and risk managers that can protect them. But they were unable to predict extreme events such as the real-estate crash. Now we look at a company with 40x leverage and think they are insane. Today Goldman has 20x leverage. Are they insane, have hubris or brilliant?
There needs to be a complete revolution in risk management. Something needs to happen like "efficient market theory". It is our lack of understanding of risk when it comes to human events that lead to this financial catastrophe. Even in statistics it is normal to throw out "outliers". One extreme event can destroy an entire portfolio or company. It is unknown how this works. There needs to be more studies of extreme events, not normalcy.
Again, the major reason why we are having the worse financial crisis since the great depression is because major players thought they understood the nature of risk and extreme events, that they could predict and know the future thus giving them the confidence to massively leverage. Until the idea of control is broken then we will not learn from our mistake.
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