FEATURE: NEW DISCIPLINES
because they are not grounded in the same mathematics as scenarios that our guts tell us are unrealistic as
traditional economics. Th e frustration of many next-generation well as the ones that we genuinely fear as
economists and other thought leaders is captured in the plausible. Th e chances are that the extreme
oft-quoted “economics advances one funeral at a time”. Th e events are more likely than we realise and that
screeching cries of this fi nancial crisis may be its fi nal requiem. the truly dangerous scenarios are not
While it may take decades before these fi elds coalesce and necessarily the ones we naturally fear.
provide tools for practitioners, we are already beginning to While we wait for the researchers in
glimpse what the future holds. Two important lessons are: behavioural economics, cognitive science,
models’ predictions come in varying degrees of accuracy and evolutionary biology and complexity to
that humans are not particularly good at estimating develop a reality-based approach to
probabilities of future events – especially unlikely events. understanding market dynamics, let’s start
taking advantage of the things that we
CONFIDENCE INTERVALS already know – limitations of models’
All modellers know that the outputs produced by their models accuracy should be part of every output,
have associated confi dence intervals. In other words, they not and simulations of extreme events should be
only know qualitatively that “sometimes models work better than a staple of all risk analysis. Th e evidence is
at other times”, but they also know quantitatively how much one overwhelming: unlikely scenarios happen
should rely on the numbers from a particular model in a much more often than we think.
particular situation.
Confi dence intervals, goodness of fi t, accuracy measures,
PROFILE – FACT BOX
variances of outputs and false positive rates are all ways of
quantitatively assessing the quality of a given model’s output.
While these quality assessment tools are prevalent in fi elds like
engineering and medicine, they are almost non-existent in
fi nancial services. Imagine a physician telling you that a
particular blood test is ‘error proof’ and that the results are
100% accurate, or an engineer suggesting that a particular
bridge or airplane has a 0.00% margin of error. Nonsense.
Similarly, all risk management models have an associated degree
of accuracy that can be calculated and that should be known by
the users. Without such information, a risk manager can easily
be lulled into a false sense of security (from a false negative) or
end up worrying about bogeymen (from a false positive).
We know from both cognitive science and basic
anthropology that we did not evolve a good sense of estimating
small probabilities (we essentially equate them with zero)
because being accurate with very small numbers did not
materially increase early humans’ survival. Nature had no reason
Damian Handzy
to give us the skills we now desperately need: to understand and
Career highlights:
interpret the materiality of very improbable but highly
Damian Handzy is chairman and CEO of
impactful events. To that end, extreme market movements and
Investor Analytics, a risk-management
presumably unlikely scenarios should be tested regularly.
services provider he co-founded in 1999.
One of the easiest stress tests to implement is setting all
He has more than 15 years’ experience in
correlations to one – an unforgiving phenomenon that is
the risk-management industry, having
observed in all real-world fi nancial crises. Another is to create
advised many of Wall Street’s largest asset
nightmare scenarios that stress multiple markets and determine managers on risk management, internet-
the eff ects on the portfolio. Th is type of analysis is important based reporting and data management
because it does not limit us to presumably probable scenarios – while at Deloitte in the mid-1990s. Handzy
it allows us to double up the nightmares and consider what has a doctorate in nuclear physics, and
would happen if several of them happened simultaneously. has been an advocate of incorporating
Because we know that humans have a natural blind spot when it advancements from other disciplines to
comes to making sense of small numbers like the probability of a
improve risk management in the
prime broker (or two) collapsing, we should consider both those
investment industry.
WWW.CFAUK.ORG PROFESSIONAL INVESTOR 35
32-3532-35 adaptive markets.indd 35adaptive markets.indd 35 1/6/091/6/09 11:56:0511:56:05Professional Investor Summer 09.37 37 4/6/09 15:40:59
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