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Risk Management with the Wrong Risk

Posted Jan 14 2009 7:47pm

This article in the NYT is so well-done and so closely related to my work on stochastic processes that I have to put it up.

Check out the NYT on Risk Mismanagement.

Nassim Taleb and I, among many others, have a lot of issues with the model everyone uses these days. Value at risk is just one of many applications of the wrong probability model. The Capital Asset Pricing Model is equally at fault. Its arbitrage arguments are correct, but the probability model is wrong.

Notice how the article describes Nassim as fit and trim; a product of his EF lifestyle wherein he adopted kurtosis as the basis for resetting his metabolism.

Even more interesting is the way everyone reacted to the failure of Long Term Capital Management and the current failures described in the article of the prevailing model. Those who used the model embraced it even more strongly in the face of its clear refutation.

This is the same phenomenon one sees in cults. When the cult leader predicts the End of the World and it doesn’t happen the members group together in strong denial and more deeply defend the failed model. This is found in the research on cults and other deeply held beliefs and is seen as a defensive form of confirmation bias. The event is interpreted not as a failure but as a confirmation.

Does Global Warming sound similar?

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