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Monday 23 July 2012

Things Investors Should Hate 1/5: Models

I don’t hate all models. I’m quite keen on the tall, leggy ones.  It’s the mathematical ones that come trailing clouds of false precision that are the subject of my ire.  Yet the world is a complicated place, too complex for our complex brains, so assisting them with some expert mathematical models is entirely sensible. 

However, entirely replacing human analysis, intuition and commonsense with a computer program isn’t so much not sensible as unbelievably stupid.  People responsible for such behavior should be barred from any position of responsibility higher than a barista, and even then should be carefully watched when making anything more complicated than an Americano.  And do not, on any account, let them near a cash register.

Models bring many benefits, one of which is that they allow us to manage risks and investments better.  If you can model the load that a bridge can take then you can design it optimally to ensure that money isn’t wasted on unnecessary materials and labor.  On the other hand, the tendency in such situations is to design for exactly the situation you’ve specified: four axle trucks, say.  So what happens when six axle trucks come along?

The Romans had a different way of dealing with the problem.  They had their bridge architects stand underneath the structure when the supports were removed.  They figured that this would concentrate the minds of their chief modellers.  And of course it did, but at the cost of over-specification: structures built before the days of computer aided modelling were usually far better built, and far more expensive, than they needed to be.

The benefit of this over-specification is that these structures are able to deal with the unexpected, not just the precise circumstances for which they were designed.  Six-axle trucks would be no problem.  Likely sixteen axle-trucks would be too. There's a 2000 year old Roman aqueduct in use in Spain today.

Of course, in reality, if a bridge was designed for lower weights then we wouldn’t let the new trucks drive over them.  We would direct them to other routes or build a new bridge – these might not be the most efficient outcomes but they would, at least be safe.

The problem with our financial models is that the people using them – the truck drivers – don’t understand the weight limits and that the people who designed them don’t do enough to make them understand.  Often the view seems to be that if the bridge hasn’t failed yet then it’s OK.  Unfortunately if you build a bridge that’s an efficient short-cut you may find yourself dealing with a great deal more traffic than it was ever designed for: and if you don’t understand the risks you may find that it collapses when you least expect it.

The key points are that the people overseeing the use of mathematical models need to understand the risks.  One of those risks is that if the model becomes popular then the temptation to use it – and abuse it – will become ever greater.  The second risk is that designing a system to be entirely reliant on one particular point of failure is plainly stupid: models should only ever form one part of a risk management culture.

When things are going well taking on more risk allows more traffic – and more tolls – to pass over your bridge.  When things go wrong your bridge collapses.  Having an intelligent policeman routing the traffic isn’t a sensible precaution, it’s an absolute necessity.

Further reading:

The idea that I have a bee in my bonnet about this issue is plainly wrong, as commentary on it only dates from the second ever post here - Newton's Financial Crisis: the Limits of Quantification. It's also been covered in Quibbles With Quants, Risk, Reality and Richard Feynman, and One Price To Rule Them All.  And lots of other articles like Moral Hazard, But Thanks For All The Fish. For the story of the famous Roman aqueduct in Segovia go to On Incentives, Agency and Aqueducts.

Next >> Things Investors Should Hate 2/5: Gurus


  1. Hi,

    I'm an usual reader of your blog,

    Could you please recommend me a certificate, part-time master or online course about behavioural finance?

    Thanks in advance

  2. Dear Anonymous

    The obvious choice at the moment would be to start with Dan Airely's free Coursera beginners course and then work from there: A Beginner's Guide to Irrational Behavior.

    Unfortunately this is some time away, but you might also keep an eye open at Class Central for new courses from the big three online universities. There's new stuff coming out all the time.

    However, I wouldn't want to recommend any specific paying course, because I haven't taken any of them.

  3. Thank you very much (sorry for not having been quick in the response)...

    I have checked the course you have told me about, and they seem like a good start.

    I understand that you don't want to recommend any course you haven't taken, but I would appreciate that you give me a list and I'll check them by myself.

    Thanks again