Quant Fever 2
March 1, 2009
Well, risk is in on everyone’s’ mind nowadays, to say the least. I came across an article awhile back that discussed the use of sophisticated risk quantification formulas in the financial industry, and how they’ve proven to be inadequate in the face of real-world events that are difficult to model (e.g. politicians firmly pressing their thumbs on the scales of a supposedly “deregulated” market by artificially depressing interest rates while propping up a landfill for bad loans in Fannie & Freddie – but I digress). For example, check out the complex-looking ”Value at Risk” (VaR) formula cited in the original article – would you base a business decision on the outcome of that!?
Many colleagues have made similar points to me over the years about the temptations of quantification – no formula will ever sufficiently model real-world events. While this is a truism, the above article raises two thoughts in my mind:
1. Garbage in, garbage out. Even the best model produces useless results if fed inadequate data. Data-driven decisions are generally preferable to the opposite, at least in business. So perhaps we are shooting the messenger when the real problem is inability to collect and manage data.
2. All too frequently we forget the point of the whole exercise: decision support. Models are by definition imperfect, but they may only need to provide enough insight to enhance human judgment. We shouldn’t blindly accept what the formula spits out, but neither should we throw the baby out with the bathwater.
I remain a believer in quantitative analysis: even if the final decision becomes a “gut call,” it’s likely inflected with perceived data points and thus more well-reasoned.
“If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.” – Friedrich von Hayek
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