Beware of Geeks Bearing Formulas

3 November 2008 at 3:00 pm 3 comments

| Peter Klein |

The entrepreneur, writes Mises in one of my favorite passages, “is a speculator, a man eager to utilize his opinion about the future structure of the market for business operations promising profits.” The entrepreneur relies on his “specific anticipative understanding of the conditions of the uncertain future,” an understanding that “defies any rules and systematization.”

This passage was in my mind today as I read the WSJ front-pager about the computer models used by AIG to analyze asset risk. Poor Gary Gorton, who designed many of AIG’s models, is put on public display. AIG’s catastrophic failure is likely to fuel skepticism about the use of such models for risk analysis, though Gorton maintains the problem was the application of the models, not their basic design. (His Yale colleague Ian Ayres will likely agree.) Longtime skeptic Warren Buffet has the best line: “Beware of geeks . . . bearing formulas.”

Today’s paper also includes an item on Harry Markowitz, including this:

As with all new information tools at our disposal, applying portfolio theory to investing entails its share of trial and error. Mr. Markowitz admits some people might object to asking him how to repair the credit crisis. “You, Harry Markowitz, brought math into the investment process,” he imagines some people thinking. “It is fancy math that brought on this crisis. What makes you think now that you can solve it?”

He draws a line between his portfolio theory and its later misapplication. “Not all financial engineering is always bad,” he says, “but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing.”

Update (Nov. 5): See this related piece from the Times.

Entry filed under: - Klein -, Austrian Economics, Entrepreneurship, Innovation.

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3 Comments Add your own

  • 1. spostrel  |  3 November 2008 at 10:08 pm

    I thought the article about AIG was pretty fair to Gorton. It mentioned repeatedly that his models were only designed to predict actual security defaults, which so far they seem to have done OK at. The problem was that the default swaps had provisions for collateral calls when the underlying assets dropped in value, and they never modeled that at all. If you call in an engineer to model the effects of wind on a bridge and it collapses because a heavy truck goes over it, I don’t think the engineer should be on the hook.

  • 2. Rafe Champion  |  4 November 2008 at 12:31 am

    A nice point and one that can probably be extended to the role of regulations and regulators and especially their failure in the sub-prime collapse. Because there was so much regulation going on, there was quite likely a false sense of security but, like the engineer who was only checking for wind hazard, the more important hazards were overlooked.
    But how did that happen. Heaps of people must have known what was happening, and the outcome was predicted in the New York Times in 1999.

  • 3. Beware of Greeks Bearing Formulas | Simoleon Sense  |  8 November 2008 at 4:31 pm

    […] wrote an excellent post on the complexity of risk models and their recent spectacular failure (which can be found here). In addition to linking to Peter’s post, I would like to present a New York Time’s […]

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