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FBI & victim's apathy


Bystanders to this financial crime were many

By Nassim Nicholas Taleb and Pablo Triana

Published: December 7 2008 19:18 | Last updated: December 7 2008 19:18

On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese’s wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese’s rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the “bystander effect”. This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods).

Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes.

Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.

Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

Nassim Nicholas Taleb is a professor of risk engineering at New York University PolyTechnic Institute. He is the author of ‘The Black Swan: The Impact of the Highly Improbable’ (2007). Pablo Triana is a derivatives consultant and author. His new book, ‘Lecturing Birds on Flying’, will be released in spring 2009


The pseudo-science hurting markets

Tuesday Oct 23 2007 13:25


Last August, The Wall Street Journal published a statement by one Matthew Rothman, financial economist, expressing his surprise that financial markets experienced a string of events that "would happen once in 10,000 years". A portrait of Mr Rothman accompanying the article reveals that he is consider­ably younger than 10,000 years; it is therefore fair to assume he is not drawing his inference from his own empirical experience but from some theoretical model that produces the risk of rare events, or what he perceives to be rare events. 

The theories Mr Rothman was using to produce his odds of these events were "Nobel-crowned" methods of the so-called modern portfolio theory designed to compute the risks of financial portfolios. MPT is the foundation of works in economics and finance that several times received the Sveriges Riksbank Prize in Econ­omic Sciences in Memory of Alfred Nobel. The prize was created (and funded) by the Swedish central bank and has been progressively confused with the regular Nobel set up by Alfred Nobel; it is now mislabelled the "Nobel Prize for economics".

MPT produces measures such as "sigmas", "betas", "Sharpe ratios", "correlation", "value at risk", "optimal portfolios" and "capital asset pricing model" that are incompatible with the possibility of those consequential rare events I call "black swans" (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues' accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that "Nobel" prize.

In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of 1987, an event that, if anything, completely demolished the laureates' ideas on portfolio construction. Further, the crash of 1987 was no exception: the great mathematical scientist Benoît Mandelbrot showed in the 1960s that these wild variations play a cumulative role in markets - they are "unexpected" only by the fools of econ­omic theories.

Then, in 1997, the Royal Swedish Academy of Sciences awarded the prize to Robert Merton and Myron Scholes for their option pricing formula. I (and many traders) find the prize offensive: many, such as the mathematician and trader Ed Thorp, used a more realistic approach to the formula years before. What Mr Merton and Mr Scholes did was to make it compatible with financial economic theory, by "re-deriving" it assuming "dynamic hedging", a method of continuous adjustment of portfolios by buying and selling securities in response to price variations.

Dynamic hedging assumes no jumps - it fails miserably in all markets and did so catastrophically in 1987 (failures textbooks do not like to mention).

Later, Robert Engle received the prize for "Arch", a complicated method of prediction of volatility that does not predict better than simple rules - it was "successful" academically, even though it underperformed simple volat­ility forecasts that my colleagues and I used to make a living.

The environment in financial econ­omics is reminiscent of medieval medicine, which refused to incorporate the ob­servations and experiences of the ple­beian barbers and surgeons. Medicine used to kill more patients than it saved - just as financial economics endangers the system by creating, not reducing, risk. But how did financial econ­omics take on the appearance of a science? Not by experiments (perhaps the only true scientist who got the prize was Daniel Kahneman, who happens to be a psychologist, not an econ­omist). It did so by drowning us in mathematics with abstract "theorems". Prof Merton's book Continuous Time Finance contains 339 mentions of the word "theorem" (or equivalent). An average physics book of the same length has 25 such mentions. Yet while economic models, it has been shown, work hardly better than random guesses or the intuition of cab drivers, physics can predict a wide range of phe­nomena with a tenth decimal precision. 

Every time I have questioned these methods I have been abruptly countered with: "they have the Nobel", which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudo-science among financial in­stitutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools. The previous dozen crises and experiences did not do so. It will be dying with us, unless we discredit that absurd Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel commonly called the "Nobel Prize".


The writer is author of The Black Swan: The Impact of the Highly Improbable, shortlisted for the FT/Goldman Sachs Business Book of the Year Award. The winner will be announced at a ­dinner in London tomorrow night.

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