James Rickards on Modeling of Financial RisksToday's edition of the Washington Post contains an excellent article by James Rickards, one-time general counsel of Long-Term Capital Management and currently a consultant on national security and capital markets. Rickards explains why the models Wall Street has been using to assess the risk of their portfolios are fundamentally flawed.
Central to Rickards' discussion of risk modeling is the concept of complexity:
Both natural and man-made systems are full of the kind of complexity in which minute changes at the start result in divergent and unpredictable outcomes. These systems are sometimes referred to as "chaotic," but that's a misnomer; chaos theory permits an understanding of dynamic processes. Chaotic systems can be steered toward more regular behavior by affecting a small number of variables. But beyond chaos lies complexity that truly is unpredictable and connot be modeled with even the most powerful computers. Capital markets are an example of such complex dynamic systems.The article is short and is well worth reading in its entirety.
Labels: Risk management