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You Don't Know The Math(Quant got the market wrong)
Forbes ^ | 09/29/09 | Michael Maiello

Posted on 09/29/2009 3:59:54 AM PDT by TigerLikesRooster

You Don't Know The Math

Michael Maiello, 09.29.09, 06:00 AM EDT

The complexities of the financial markets are beyond your broker's abilities.

Four years retired from Yale, Benoit Mandelbrot, the inventor of fractal geometry, is still trying to teach the essential lesson of his life's work--nature and markets defy easy description. Anyone who tells you otherwise is either trying to sell you something, doesn't know the math or both.

Last week, Mandelbrot, 84, spoke to a gathering of diplomats, business leaders and philanthropists at the Louise Blouin Foundation's Creative Leadership Summit. Mandelbrot has also served as mentor to economist Nassim Nicholas Taleb. Mandelbrot's work on fractals and complex systems is inextricably tied to Taleb's concept of the "Black Swan," or those once in a lifetime events that seem to happen far more often than once in a lifetime.

In 2004, Mandelbrot and Richard L. Hudson wrote The (Mis)behavior of Markets: A Fractal View Of Financial Turbulence. It was thankfully reissued with an update about the credit crisis, but it would have been better had people read and heeded the warnings in the first edition. Though we often speak about markets reverting to the mean (and they do) we frequently forget that the road to the mean is quite chaotic.

(Excerpt) Read more at forbes.com ...


TOPICS: Business/Economy; News/Current Events
KEYWORDS: fractal; mandelbrot; quant; taleb

1 posted on 09/29/2009 3:59:55 AM PDT by TigerLikesRooster
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To: TigerLikesRooster; PAR35; AndyJackson; Thane_Banquo; nicksaunt; MadLibDisease; happygrl; ...

Ping!


2 posted on 09/29/2009 4:00:25 AM PDT by TigerLikesRooster (LUV DIC -- L,U,V-shaped recession, Depression, Inflation, Collapse)
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To: TigerLikesRooster

Excellent, but funny how these lessons need to be relearned every decade.


3 posted on 09/29/2009 4:04:13 AM PDT by 1010RD (First Do No Harm)
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To: TigerLikesRooster
Though we often speak about markets reverting to the mean (and they do)

This is a bit like a self-fulfilling prophecy -- nearly tautological. The "mean" is always going to be somewhere within the data's range, and so a volitile series of data will always "revert" towards it.

Anyway, the sooner people realize (again) that markets are *people* in action, the less blind faith they'll be inclined to put in complex analysis.

That said, they can be fun tools to play with (the tools of analysis, I mean).

4 posted on 09/29/2009 4:09:46 AM PDT by the invisib1e hand ("Isn't the Golden Mean the secret to something," I parried? "Yes," Blue replied. "Mediocrity.")
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To: TigerLikesRooster
The mathematically fluent financial engineers at AIG ( AIG - news - people ), Goldman Sachs ( GS - news - people ) and Citigroup ( C - news - people ) mistakenly thought that a diversity of holdings would protect their complicated mortgage and debt-related securities. Everything can't default at once, right? An implication of Mandelbrot's work is that they can and will.

The same would hold true for a retail investment portfolio. In 2008, none of the traditional hedges worked. Foreign stocks fell along with U.S. stocks. Commodities spiked but then fell. The stock market's volatility spread to other markets, proving that they are interconnected rather than discreet.

I think Mandelbrot is missing a key point. The main reasons there was a systemic failure was a lack of risk management, a lack of self-restraint and a lack of transparency. Entities were leveraged to the gills, from investment banks to homeowners - which meant the impact of any downturn would be grossly magnified. Systemic risk was thought to be a thing of the past - it wasn't. And ratings agencies had issued pure bunkum - so suddenly, all around the world, banks holding what they thought were AAA mortgage-backed securities all of a sudden had no idea what they were worth once they figured that the ratings were meaningless and done only to keep the issuers happy.

Capitalism didn't fail - men did. A very, very modest amount of regulation and a modicum of self-restraint, like what happened in Canada, would have helped keep the correction fairly modest. Instead, we let Wall Street completely off the leash, not realizing that they had 'their guys' positioned to cover the risk on the taxpayer's dime.

5 posted on 09/29/2009 4:19:57 AM PDT by dirtboy
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To: dirtboy
What happens is that players in the market incrementally destabilize the system. They want more and more growth(profit) out of the market. In the name of spreading the risk, they got everybody hooked to their scheme. Then they leverage it to moon, confident that it would never collapse. However, it will collapse if they keep on leveraging. And it did.

Moves and countermoves to outdo one another will lead to such a destabilization. It is a temporal process.

When you see it from the angle of stochastic time-series, you may term it black swan or fat tail.

When it gets to find out what makes black swan or fat tail, you can argue institutions or players contribute to increasing moral hazard.

6 posted on 09/29/2009 4:37:15 AM PDT by TigerLikesRooster (LUV DIC -- L,U,V-shaped recession, Depression, Inflation, Collapse)
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To: dirtboy

Also:
— Many of these complex models were based on relatively simple assumptions that were just wrong.
— Many of the models users relied on the model instead of tempering the results with their own judgement
— Garbage In, Garbage Out


7 posted on 09/29/2009 4:40:17 AM PDT by rbg81 (DRAIN THE SWAMP!!)
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To: TigerLikesRooster
The Canadian banks never faced collapse. There are a lot of object lessons there:

- You just don't walk away from a mortgage - banks can go after them and take assets.

- Government regulation is centered in the risk management department - leaving executives the ability to engage in basic operations with minimal government involvement.

- Bankers willfully walked away from riskier investments.

A sound mix of self-restraint, self-responsibility and focused, practical regulation.

What are the Dems proposing here? Typical liberal micromanagement. We'll go from one extreme to another, as we typically do in this country.

8 posted on 09/29/2009 4:45:41 AM PDT by dirtboy
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To: rbg81
— Many of these complex models were based on relatively simple assumptions that were just wrong.

Mandelbrot and the other practitioners of chaos theory would say that even simple models will lead to chaotic behavior.

The problem really isn't oversimplification, the problem is that the mechanisms are inherently non-linear and chaotic. A good introduction to the history of chaos theory is Gleick's "Chaos".

However, the mathematics that were used by the quants to predict the market are similar to those used to predict global warming. That should give you warm fuzzies.

9 posted on 09/29/2009 4:48:41 AM PDT by kosciusko51
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To: dirtboy
liberal ‘is’ micromanagement.
Liberals are control freaks by nature.
10 posted on 09/29/2009 4:49:44 AM PDT by TigerLikesRooster (LUV DIC -- L,U,V-shaped recession, Depression, Inflation, Collapse)
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To: kosciusko51
You mean, the kind of model in which things often go ‘iid’ at the convenient places?
11 posted on 09/29/2009 4:58:30 AM PDT by TigerLikesRooster (LUV DIC -- L,U,V-shaped recession, Depression, Inflation, Collapse)
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To: rbg81

I build financial models for a living (for a single corporation) and have been doing so for nearly 20 years. Two thing are absolute certainties:

1) The models are only as good as the assumptions that drive them.

and

2) The model is wrong. It might be close but you will ALWAYS be wrong.

Another absolute, the vast, vast majority of models will never get the inflection points (i.e. changes in the market from growth to decline) correct. Everyone always assumes that the current trend will keep going.

They are also subject to individual/political biases in the assumptions. i.e. make the models output the answer you wish to see.

Forecasting is an art, not a science.


12 posted on 09/29/2009 5:00:46 AM PDT by Wyatt's Torch (I can explain it to you. I can't understand it for you.)
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To: Wyatt's Torch
Nobody will fund the model research which will throw cold water to the boom.
13 posted on 09/29/2009 5:04:40 AM PDT by TigerLikesRooster (LUV DIC -- L,U,V-shaped recession, Depression, Inflation, Collapse)
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To: kosciusko51
A good introduction to the history of chaos theory is Gleick's "Chaos".

That's a great book. 

I think about chaos whenever morons start talking about "climate models" and "global warming".

Sensitive dependence upon initial conditions is apparently a fundamental law of the universe that God designed to keep us suitably reverent.

14 posted on 09/29/2009 8:59:10 AM PDT by zeugma (Life is short. Thank God.)
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To: dirtboy
think Mandelbrot is missing a key point. The main reasons there was a systemic failure was a lack of risk management, a lack of self-restraint and a lack of transparency. Entities were leveraged to the gills...

I don't think he missed the point at all. In any nonlinear system, when everything gets lashed together so nothing can fail unless everything fails, then eventually, one day, everything will fail. Anyone who has studied the theory of nonlinear systems knows that. Of course that includes some graduate level engineers and physicists. Those are not the guys who end up running the financial system.

15 posted on 09/29/2009 1:33:57 PM PDT by AndyJackson
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To: AndyJackson
when everything gets lashed together so nothing can fail unless everything fails,

But it wasn't about a function of hedges failing. Instead, it was a function of effective hedges not even being in place. Credit Default Swaps were not backed by adequate capital. 40-1 leverage ratios meant a wicked feedback cycle in a downturn.

The results were quite foreseeable to those not intoxicated by all the money that was being made as the bubble inflated.

16 posted on 09/29/2009 1:36:31 PM PDT by dirtboy
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