This NYT article states that the mathematical models used to determine risk on different investments/securities failed to consider how humans would use those models, which contributed to the crisis in a big way. The article goes on to talk about credit-default swaps, securities, and derivatives but (partly because I'm not a big finance person and I wouldn't know a derivative if it bit me) I just found a couple of points in the article interesting:
1. The article says that financial models couldn't keep up with the rapid pace of technological growth and financial innovation. And apparently neither could humans, for as they continued to chase after the potential profits to be found in such innovation, they disregarded or underestimated the possible risk.
2. What the models say and what the analysts say can be very different. A model can predict one thing, but if an analyst says the probability of it is very low, investors may be more inclined to agree with the more optimistic analysts.
3. "Complexity, transparency, liquidity, and leverage" are risks and factors not easily captured in a mathematical model. And it's not like humans can be counted on to adhere to the laws of mathematics in everday life.
4. In regards to financial regulation, it should be like "fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law."
What interested me was the notion that despite people's best efforts to predict risk and map out the financial market, ultimately it all comes down to how humans use the information. Models may assume humans act rationally, but as in this case, it seems like people's use of new financial instruments outpaced the calculated warnings of the model, and the way we acted was not all that rational.
1 comment:
Bea, I completely agree with you on this. It is interesting how people think they can use logical methods to predict the future without counting in the effects of using such tools.
If one person could predict that one thing is going to happen, it is obvious he is not the only one who has the capability to come up with that prediction. And who knows if 1000 or 10000 persons has already thought of the same thing. The problem here is people think they are acting ahead of everybody while in fact they're not earlier than anyone.
Bottom line, hope for the best but always plan for the worst, people!
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