Thread: In Modeling Risk, the Human Factor Was Left Out

New York Times
By STEVE LOHR
Published: November 4, 2008

.......The miss by Wall Street analysts shows how models can be precise out to several decimal places, and yet be totally off base. The analysts, according to the Fed paper, doggedly clung to the optimists’ mantra that nominal housing prices in the United States had not declined in decades — even though house prices did fall nationally, adjusted for inflation, in the 1970s, and there are many sizable regional declines over the years.
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Indeed, the behavioral uncertainty added to the escalating complexity of financial markets help explain the failure in risk management. The quantitative models typically have their origins in academia and often the physical sciences. In academia, the focus is on problems that can be solved, proved and published — not messy, intractable challenges. In science, the models derive from particle flows in a liquid or a gas, which conform to the neat, crisp laws of physics.

Not so in financial modeling. Emanuel Derman is a physicist who became a managing director at Goldman Sachs, a quant whose name is on a few financial models and author of “My Life as a Quant — Reflections on Physics and Finance” (Wiley, 2004). In a paper that will be published next year in a professional journal, Mr. Derman writes, “To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”

Yet blaming the models for their shortcomings, he said in an interview, seems misguided. “The models were more a tool of enthusiasm than a cause of the crisis,” said Mr. Derman, who is a professor at Columbia University.......
http://www.nytimes.com/2008/11/05/bu...gewanted=print