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Another View of Risk Management

Oscar Foulkes November 2, 2010 Uncategorized No comments

Benoît Mandelbrot, who died recently, is the mathematician who invented fractal geometry. His work, which covered a wide variety of fields, also included examining the models that are generally used to predict the behaviour of financial markets.

He came to the conclusion that most such models operate on the ‘Joseph’ principle (i.e. 7 good years, followed by 7 lean years). These models, potentially to the ruination of those employing them, neglect what he described as the ‘Noah’ effect, which is similar to Nassim Nicholas Taleb’s ‘black swan’, except that Taleb is more of a philosopher.

It isn’t difficult to find examples of such cataclysmic events, which could euphemistically also be called ‘outliers’. Basically, they are not easily (if at all) predicted on the basis of historical data. A proper assessment of risk needs to make allowance for such events, but generally doesn’t.

I’ve been thinking about people’s attitude to, and management of, risk. I may be in danger of being branded a heretic by the rest of man-kind, but I’m wondering if women and men don’t have different ways of viewing and managing risk. The fact that the majority of participants in financial markets are men may skew the whole thing, in the sense that there are fewer women with the potential of having cocked-up the world economy to the extent that men have (see, it’s even called a ‘cock’-up).

I can’t think of a single rogue trader who was a women (perhaps they’re just better at not getting caught). And, what are infidelity scandals, other than the outcome of inappropriately applied risk assessments?

Think about it, if you are the president of the United States, what are the chances of indefinitely hiding your naughty behaviour? As to Tiger, keeping a lid on that many indiscretions is nigh impossible. Just one moment’s rational thought would have told him that the risks were vast, and growing every time he made a new conquest.

And yet, on the golf course, he successfully managed risk all the time. Any ball in the rough, or the layout of the course (water in a danger position close to the green, for example) requires an assessment of the respective outcomes of each strategy.

I can’t think of a prominently placed woman who got herself involved in an infidelity scandal. Yes, there are women involved when powerful men are being unfaithful, but I think it’s a somewhat different risk analysis.

I also can’t think of a colossal corporate collapse perpetrated by a women. Two of the biggest – Enron and WorldCom – were both headed by men. Name any large Ponzi scheme, and you’re likely find a man at the top of the pyramid.

The origins of the credit crunch lay in vast amounts of money being lent on the basis of historical default rates (“safe as houses” mortgages). Those were the existing models of risk assessment, as criticised by Benoît Mandelbrot, which didn’t take into account what would happen to default rates when mortgage interest rates increased, or when property values started going down. Or, if banks indiscriminately dumped mortgages on millions of people who couldn’t actually afford them (which they then on-sold to pension funds and other investors all around the world).

Men may joke about women’s driving abilities, but it’s certainly preferable to get home from work and say, “Honey, I crashed the car”, than to say, “Honey, I crashed the economy”.

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