Wednesday, October 29, 2008

The fallacy of number - financial maths, financial models and the global financial crisis

Many years ago while on an exchange program with a small merchant bank as the Manager, Corporate Finance, I handled their first leverage lease on a jumbo jet. initially, the apparently complicated spread sheets put me off. Then I realised that the critical issue was simply to understand the assumptions built into the spreadsheets.

Recently this experience has come back to me because of the global financial crisis. How did so many clever people get things wrong?

A post in Club Troppo by Peter Cebon, Peter Cebon on innovation and the financial crisis, suggested that the problem was due in part to systemic complexity. This rang true.

The central point with complex systems is that the more modules or parts, the greater the complexity of the systems, the greater the integration within systems, the more likely it is that things will go wrong. This comes about because the chances of unforeseen results rises with complexity, while close integration allows for faster spread of results through the system.

This said, I was still surprised at the failure of people to properly assess risk.  

In recent years, I have noticed the continuing rise of what I call the fallacy of number. In simple terms, if there is a number, it must be right. Present some overheads, an excel spread sheet, and people will accept what you say.

Financial models have their place. They allow complex issues to be tested and presented. However, they can also be a great danger because they are only as good as the assumptions and data on which they are based.

Like most managers or advisers, I am out of touch with the complexity of modern financial maths. I barely understand the Black-Scholes mathematical model, let alone all the things based upon it. However, I come back to this issue. If you are responsible for something and do not understand the implications, you must ask questions until you do.

This is not always easy. Working on a project recently I acquired a reputation as obsessive about detail, almost a pedant, because I would not accept things, but kept digging until I understood. Some of my professional colleagues laughed when they heard this, because I am not by nature a detail person - I like the broad picture. I did not make myself popular. However, in this case the project worked because of my obsessive approach.

Many of us are frightened of asking simple questions because we fear that we will be seen as dumb. Here I think of Bob Gregory, one of Australia's best economists, who taught me on my economics master's course. I suspect Bob would be very surprised to know how much influence he had on me. I was not one of his best students!

Bob was never afraid to ask simple questions. At seminars his line, look, there is something I do not understand, would send people running to check their assumptions and analysis. I always bear this in mind in my work.

Part of the problem in the current financial crisis is that there were simply not enough Bob Gregorys.        

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