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Your Money: The trouble with portfolio models

We replaced so much experience and common sense with ‘models’ that work worse than astrology, reads a sentence in an interview in an American magazine. Dhirendra Kumar finds out.

india Updated: Apr 13, 2008 23:15 IST

We replaced so much experience and common sense with ‘models’ that work worse than astrology, reads a sentence in an interview in an American magazine. It’s an interview with a man named Nassim Taleb about what is wrong with the way investment portfolios are managed, and what he is saying seemed to perfectly sum up what’s been happening around the world.

In the same interview, Taleb goes on to say, “Trying to model something that escapes modelisation is the heart of the problem. We like models because they do not require experience… Sometimes you need to say, No model is better than a faulty model-like no medicine is better than the advice of an unqualified doctor.

Taleb, whom you may have heard of as the author of a book called The Black Swan: The Impact of the Highly Improbable, describes himself as a scholar of randomness and knowledge. An American of Lebanese origin, Taleb had a two-decade Wall Street career as a trader but now characterises himself as a ‘Scholar of Randomness’.

Taleb’s central idea is what he calls the ‘Black Swan’, which symbolises a random event that no one could have predicted. He thinks that the financial industry of the world, with the collusion of academia, is making its living by pretending that there is a science and a process to activities that actually have no such thing. In his years on Wall Street he noticed that while portfolio models got worse and worse at tracking reality, their use kept increasing as if there was nothing wrong. Part of the reason is that business schools have accelerated their teaching of portfolio theory as a replacement for experience.

There’s a whole new generation that thinks that this stuff must be science because it looks like science and claims to be science. Taleb believes that while the exact nature of timing of catastrophic events like the current global financial crisis are unpredictable, the fact that there will be some catastrophic blow-ups periodically is inevitable. In this interview, Taleb notes that crises in the financial world are getting rarer but more serious.

One very interesting idea he expresses is that the increasing homogeneity of businesses is a danger. And he expresses this idea in biological terms, saying that earlier, the financial world had a very diversified ecology and that today, the entire system in the US is dominated by a few very large banks, and they all have the same kind of exposure.

This is an interesting variation on the value of diversity. I think it’s the same reason that farms and plantations are devastated by plant diseases but forests are resilient. It’s the same reason why Windows PCs are hit by computer viruses but Linux and Mac computers are not. A dominant but non-diverse system becomes less and less volatile while paradoxically getting riskier and riskier. A larger and larger financial industry in which everyone is doing the same kind of things based on the same kind of junk theories will lead to long periods when everything looks fine and then crises that seem to be much deeper and spread much wider than seems logical. Are we in the middle of such a crisis? I suspect we are.