Sunday, December 21, 2008

Magicians and Mathematicians

[via Tao of Gaming]
Paul Wilmott writes about Magicians And Mathematicians, and I might have a bone to pick.
Quantitative finance and risk management are not just about the numbers. Numbers play a part, but so does the human side of the business. When analyzing risk it is important to be able to think creatively about scenarios. Unfortunately the training that most quants get seems to actively discourage creativity.
I certainly agree,

This is really a question about whether modern risk managers are capable of thinking beyond maths and formulas. Do they appreciate the human side of finance, the herding behaviour of people, the unintended consequences, what I think of as all the fun stuff. And this is a nice question because it very quickly sorts out different types of thinkers.

and

Once you start thinking outside the box of mathematical theories the possibilities are endless. And although a knowledge of advanced mathematics is important in modern finance I do rather miss the days when banking was populated by managers with degrees in History and who'd been leaders of the school debating team. A lot of mathematics is no substitute for a little bit of commonsense and an open mind.

How can we get quants and risk managers to think beyond the mathematics? I'm afraid I don't think we can, the way the majority of them are currently educated.

[The emphasis is mine. ]

I'm OK with the part about training the quants to understand these things, and it's somewhat criminal that they were not required to understand these things before being allowed to play in that particular sandbox, thus precipitating a financial meltdown. However, this in no way removes the problem from the "box" of mathematics. It's still math, but it has to be applied in a consistent and conservative way, and founded in a basic knowledge of the subject area. -- And now I'm going to contradict my self -- It is more than math, it is statistics. It was once suggested to me that the difference between math and statistics is the manner of application (of stats), which might fairly be described as an art. A herd of quants well versed in the application of statistics ought to have realized the most obvious error (dependencies among risks).
That there is an essential art to understanding financial markets I do not doubt. It's too bad so many people forgot, or were blinded to that fact by greed.

[UPDATE: The rant continues here!]