Never mistake the model for reality.

[randomness]

I figured my friends in the social sciences would appreciate this one.

From Why Banks Failed the Stress Test:

Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times:

“We are seeing things that were 25-standard deviation moves, several days in a row”

To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe.

A 25-sigma event would be expected to occur once every 6 x 10^124 lives of the universe. That is quite a lot of human histories. When I tried to calculate the probability of a 25-sigma event occurring on several successive days, the lights visibly dimmed over London and, in a scene reminiscent of that Little Britain sketch, the computer said “No”. Suffice to say, time is very unlikely to tell whether Mr Viniar’s empirical observation proves correct.

Fortunately, there is a simpler explanation – the model was wrong. Of course, all models are wrong. The only model that is not wrong is reality and reality is not, by definition, a model. But risk management models have during this crisis proved themselves wrong in a more fundamental sense. They failed Keynes’ test – that it is better to be roughly right than precisely wrong. With hindsight, these models were both very precise and very wrong.

Comments

[lyonesse.livejournal.com]

yeah. economics is a branch of biology, but folks like to forget that, and treat it as a mathematics. linguistics suffers the same.

[browngirl.livejournal.com]

*makes a note*

[meepodeekin.livejournal.com]

And then they blame the mathematicians for solving their bad models...

[allyphoe.livejournal.com]

"In theory, theory and practice are the same. In practice, they aren't."

Re: And on a completely unrelated note...

[r-ness.livejournal.com]

Thank you! :)

[achinhibitor.livejournal.com]

Yeah, financial crashes aren't part of a gaussian process. But if you devised the model, and it enabled the management to convince the regulators and securities buyers to engage in hideously risky and very profitable deals, and you didn't invest your bonus in your bank's stock, then your goals were satisfied, weren't they?