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Risk Management Watch: The Fat-Tailed Straw Man

I don't understand the risk managers job. Surely if the risk manager knows that fat tails exist, and that a fat tail event will result in a particular trade yielding and enormous and consequential loss (perhaps larger than all the profits ever made), they would advise that the bet not be taken and to look elsewhere for trading opportunities.

Also, why is VAR a useful measure of day-to-day risk on the days the fat tail event does not occur, but not a useful measure on the day it does occur? If you don't know in advance the day it is not going to be a useful measure, and that day results in you losing all the profits you've ever made and more, surely it was never a useful measure on any day? I.e. didn't you just not yet know it wasn't useful on the other days?

You also seem to suggest (although I may have misunderstood this) that a thorough analysis of market dynamics could allow us to predict future unlikely events. I find this rather optimistic for a great many reasons. For a start, how will we know in advance that we've analysed the right market dynamics to predict future shocks? We will only know what happened in the past, any future shocks are unlikely to be from the same source, not least because past shocks will result in changes to the market dynamics!

Defending VAR - But You Still Need Common Sense

I admit I was confrontational in my last comment and I apologise, but this debate is not academic. Thousands of real people can lose their homes, pensions and their livelihoods on the basis of what happens in the real economy and as we have seen with the banking crisis, incorrect risk evaluations have extremely severe consequences. If these models were not held in such high esteem, the banks could not turn to them as reasons to relax legislation in the good times or as excuses for failure in the bad times.

However, specifically what part of the arguments I made are incorrect? Also, if I were to reveal my real identity would this prove or disprove them? If I were joe the plumber would this make my argument false, and if I am Benoit Mandelbrot would it make them correct?

Finally, what then specifically did you mean by your statement:

"A little quantum mechanics will teach everyone about black and white. Is light a particle or a wave? What about the uncertainty principle? What about electron spin"

And what is the analogy to the VaR model or my statements about the use of models? Again I apologise for being rude and invite you to clarify this.

To answer some of R Heaths comments:

You are right that we should make models, and then test them. This is exactly what doesn't seem to happen with VaR. When VaR fails it is assumed that it can be tweaked to fix it, or that this particular failure was some 'special' one-off event which could not be accounted for etc.

"Sometimes bad information is better than no information"

In your shorting scenario, how do you know when to close the short position? You assume you have shorted AAPL and the market has moved by some fixed amount at which you know (or happen by luck) to always close out, and you were not whipsawed by the market when the real news came out. Let's say the next day you receive the same information again, would you take the same action? What you are describing is luck, not the good use of bad information. If you do not act on the information you run no risk, if you do, you could be risking a large part of your capital on false information. I for one do not want my banks to be run like this.

Defending VAR - But You Still Need Common Sense

"A little quantum mechanics will teach everyone about black and white. Is light a particle or a wave? What about the uncertainty principle? What about electron spin? "

Well, having done a little quantum mechanics at university, I can say first of all that the difference between quantum mechanics and VaR is that if an experiment showed some part of the many theories of quantum mechanics to be patently false, it would be abandoned. The same practise is not being followed for VaR. Instead excuses are made.

In any case you make the wrong comparison, in quantum mechanics, the model is that particles exhibit both wave and particle type behavior. There is not one model for the particle behavior which competes with the wave behavior model. In other words, if someone came forward with evidence that particles never act like waves, or never act like particles, the entire model of wave/particle duality would be abandoned.

Similarly with the uncertainty principle, if someone showed that you can in fact make an exact measure of the position and velocity of a particle, the uncertainty principle would be abandoned as false.

What about electron spin? I don't even know what point you're trying to make here? That it exists? That it doesn't exist? That the theory is wrong?

There is a further distinction with these models. If they are wrong, the results are inconsequential, if VaR is wrong the consequences can be enormous! Therefore we must be much more careful with this untestable (although many could argue it has been tested and failed many times) model than an approximate physical model whose results are rigorously tested through experimentation.

Defending VAR - But You Still Need Common Sense

You're argument for VaR mainly appears to be that people forgot to ignore it?

Taleb's point is that sometimes no information is better than bad information. The use of VaR implies some knowledge of the underlying probability distribution, regardless of which version of the gaussian it is based on. This is a black and white issue, if the models are wrong they are wrong, not a little bit right. They will appear to be good models until the enormous consequential event which they have miscalculated the probablity of occuring occurs. Implying that VaR is useful because,

"A financial model is never a complete representation of what is going on in the markets and was never meant to replace judgment as well as common sense. "

i.e. that they should have known to ignore what VaR was telling them, is hardly a ringing endorsement. How do we know when to ignore it and when not to ignore it? It seems to me that it would be best to ignore it all of the time and in every situation for full security.

Value at Risk: The Good, Bad and Ugly (with a Black Swan or Two Thrown in)

carey_jim says: "I hate to bring up, again, such a trivial example as a map of a city but it's as good an example as any. I wont belabor the point but just say that even though maps and our GPSS are invaluable, they are not the city."

This would only be a comparison with the commonly used financial risk measures if we insisted on following the GPS advice blindly and if very occasionally the GPSS directed us into high-speed oncoming traffic.

Why Give Nobels for Financial Economics?

There is no Nobel prize for economics, I think what you are referring to is the Swedish central bank prize for economics in honour of Alfred Nobel. I don't believe he mentioned economics in his will?

The 'Peak Oil' Myth: New Oil Is Plentiful

anaconda, have you ever seen an article on theoildrum.com specifically advising that you trade long on oil? And I mean an article, not a comment. Perhaps others here should visit it for peak oil info, even if just to see what everyone's going on about. It's run by scientists, not traders.

Based on the evidence, I'm long on renewable energy and electric vehicle manufacturers, not oil. Why speculate on oil, which will be increasingly volitile as the results of constrained oil production play out, when you can invest in the certainty of that demand destruction you mentioned?

"Sure, oil will never be "cheap" again"

Why not if there's so much supply? Isn't there some economic relation between supply and demand called price? Lots of supply = low price? Less supply = high price.

Anyway, I'm glad you don't believe in it, because if you did you might be bidding against me in my investments, and as long as people don't know about the oil situation, the longer I can pick up growth companies at a discount to their real future value.