Aggravation (but keep reading)

May 16, 2009 in Finance,Risk

I happen to like this article by Niall Ferguson for the Times Magazine, in particular this bit:

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins.

But I found the opening chafing to the point that I almost did not continue reading. Witness:

If financial crises were distributed along a bell curve — like traffic accidents or people’s heights — really big ones wouldn’t happen very often. When the hedge fund Long-Term Capital Management lost 44 percent of its value in August 1998, its managers were flabbergasted. According to their value-at-risk models, a loss of this magnitude in a single month was so unlikely that it ought never to have happened in the entire life of the universe. Just over a decade later, many more of us now know what it’s like to lose 44 percent of our money. Even after the recent stock-market rally, that’s about how much the Standard & Poor’s 500 index is down compared with October 2007.

Ugh - such an oversimplification of so many concepts. Highlights: Bell curves do produce large events! LTCM had poor risk management ("value-at-risk models" says it all)! There is absolutely no comparison between LTCM -44% and Joe Investor -44%!

It's time for financial journalists (or guest journalists, in this case) to decide whether they want to go on critiquing mathematical models for ruining the world, or start making gross mathematical misstatements of their own. I don't even know where to start with the bell curve statement, so I leave my aggravation to your imagination. Ferguson seems sarcastic when he talks about LTCM's managers being flabbergasted, even throwing in the disclaimer "according to their models." But in the next sentence, he seems to imply that the S&P 500 losing 44% is a similarly unlikely event. I don't know if he is embracing the LTCM models' results or not (I assume not), but there's no connection between LTCM and the S&P 500.

And the last sentence - "even after the recent stock market rally"? If there are still investors out there who think -50% followed by +50% leaves you flat...

But after you make it through the opener (which I'm going to let slide because, come on, you have to draw people in somehow), it's actually an interesting read.

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