January 27, 2008
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
*Thomas Tan is a director at InvestorWalk, LLC. Thomas earned an MBA from the Fuqua School of Business at Duke University, and holds the Chartered Financial Analyst (CFA) designation. Mr. Tan also worked as an investment director at Vestopia. For more details about him and his other investment thoughts, please visit www.investorwalk.com.
Value at risk (VaR) financial models are the latest game being played by those on Wall Street who profess to manage risk, a troubling trend detailed superbly by Joe Nocera in a January 2nd New York Times Magazine article, They give bankers a false sense of confidence in their risk control while, in reality, they increase the level of risk for society as a whole.
But Nocera understates the problem. The risk management groups on Wall Street are actually engaging in risk manipulation, risk distortion, and risk amplification — anything but risk management.
Public perception is that Wall Street didn’t do much risk management over the past decade, or perhaps longer, resulting in the profound credit crisis that wiped out many financial firms and left others precariously hanging on. But the problem is not that Wall Street didn’t have people monitoring risk. Almost every firm hired scores of risk managers during the last several years, with some being paid millions of dollars a year. The problem was that the more people they hired and the more VaR financial models they ran, the worse their understanding and assessment of risk became.
Why so? There are two main reasons. First, the structure of VaR models is not based in reality. They place too much faith in the fantasy of mathematical algorithms to explain the behavior of human beings. They assume human behavior can be modeled as accurately as launching a rocket — that we can predict its path and outcome 100% correctly. It’s no coincidence risk managers are often called rocket scientists — they treat people like physical objects. Is human behavior really that predictable? Are risk managers so crazy as to think human beings behave like a mindless, computer predefined rocket? Does human behavior obey math principles or is it the other way around?
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