Friday, March 6, 2015
Turbulence
Supposedly, the great physicist Enrico Fermi was
once asked what question he would ask first when he died and met his
maker. His response was “what is the
cause of turbulence”? Of course Fermi
was talking about turbulence in physical systems such as air flow or water flow
– systems where turbulence remains a mystery.
However what causes turbulence is also a question that many a risk
manager would also like to know the answer to.
Despite the fact that turbulence is a fact of life for the risk manager,
it is almost certain that the answer to the question will indeed only come with
the meeting of one’s maker.
Wednesday, March 4, 2015
Rule Deviation
All rules, regulations, laws, standards or
mandatory practices suffer from people deviating, dodging, ignoring, working
around, cheating, willful ignorance or simply not comprehending them. Rule deviation is to be expected. In fact in some cases rule deviation should
be encouraged. Virtually all rules
should be broken at some time or another.
One of the primary goals of the risk manager is to set up a set of rules
that encourage compliance when appropriate (obviously most of the time) and
deviations when exceptions warrant them.
Rules without allowance for deviations is firstly not good risk practice
and secondly just plain naïve.
Tuesday, March 3, 2015
Simple, Complicated or Complex?
By Rick Nason,
PhD, CFA,
Partner, RSD Solutions Inc.
Partner, RSD Solutions Inc.
(Repost of blog from September 6, 2009)
I have a
confession; my first training and career was as a physicist. As a physicist we calculate natural phenomena
to astounding degrees of precision, often under highly controlled laboratory
conditions. Yet, with all of that precision,
and hundreds of years of theoretical and experimental development, physicists
still embrace and accept the concept of complexity as the term is scientifically
defined.
Conversely, in
finance and risk management – fields with much shorter histories of study, and
nothing like laboratories with controlled conditions – we insist on making
measurements to ever higher degree of precision (such as in option pricing),
even though it is widely accepted that the models may be incomplete and the
input data subject to uncertainty or interpretation.
In the sciences
there is a classic distinction between those processes which are Basic, Complicated
and Complex processes and systems. The
best explanation that I have ever read is in the book “Getting to Maybe: How the World is Changed” by Frances Westley,
Brenda Zimmerman, and Michael Quinn Patton, with a forward by Eric Young.
(Random House 2006)[1] This book has nothing to do with risk
management but I would most highly recommend it to every risk manager as one of
the best books on how to think about risk management and how the practice of
risk management might evolve.
In Getting to
Maybe, the authors explain Basic, Complicated and Complex systems using the
analogies of “Baking a Cake”, “Sending a Rocket to the Moon” and “Raising a
Child” respectively. Their description,
greatly summarized and adapted, is as follows.
In baking a cake it helps to follow a recipe and it helps to have
experience, but even if a few mistakes are made, and a few measurement errors
are incorporated it is likely that something resembling a decent and edible
cake will be produced. In sending a
rocket to the moon it is critical that each and every step (and there are a
great many steps) must be followed exactly, and if each step is followed
exactly then the space mission will be a success. In other words, getting a rocket to the moon
is a complicated process, but if followed exactly then success is assured. Raising a child on the other hand is a
complicated process. Even if the parent
does everything correctly, there is no guarantee of success. Furthermore you cannot break the process of
raising a child into a set of discrete steps or processes. Raising the child is an integrated and
holistic process. Furthermore it is
impossible to a-priori say exactly what the most necessary or important steps
for raising a successful child are going to be as each child is unique even
though most children exhibit common characteristics. Finally post raising a child it is virtually
impossible to state what the most critical factors were in the success or
failure.
A moments
thought allows one to see the many parallels between raising a child and
implementing risk management. We tend to
think of risk management as a complicated process, where if we simply (?) get
all the pieces in place then success will follow. But the risk management field is littered
with risk debacles that occurred at organizations that were the acknowledged
leaders in risk management.[2] The point is that risk management is complex,
not complicated. Best practices in risk
management do not guarantee success.
Furthermore, it is nearly impossible to tell exactly and precisely after
the fact what were the key factors that led to success or failure of a risk
management program. Additionally risk
management is a holistic process – for example you cannot manage market risk
while ignoring liquidity or credit risk.
That is not to
say that risk management is an alchemist’s game. As in raising a child, we know there are factors
and actions that lead to a higher probability of success or failure. Also, as anyone who is a parent knows,
raising children requires experience, wisdom and flexibility to adapt to
changing environments and to changing cycles in a child’s development. In other words, it is actions (technical
knowledge), wisdom (experience and listening / watching the best and worst
practices of other parents) as well as intuition all taken together that lead
to higher probabilities of success or failure.
To put it bluntly,
technical knowledge alone is not sufficient for success in risk management. Realizing that risk management is a complex,
and not a complicated profession is what is required. In a complex system you need the technical
knowledge, wisdom, intuition, and as I argued in a previous blog[3]
creativity are all necessary to increase the probability of risk management
success.
Risk management
is not basic. Risk management is not
complicated. Risk management is complex,
and accordingly requires a complex package of knowledge and skills to manage.
Monday, March 2, 2015
Why Is It Only The B.Music Grads Who Are Driving Lamborghinis?
By Rick Nason,
PhD, CFA,
Partner, RSD Solutions Inc.
Partner, RSD Solutions Inc.
(Repost of blog from September 4, 2009)
I recently gave
a speech with the above title to the risk group at a large financial
institution. It was a very exciting yet
intimidating audience to talk to. Most
of the audience members had advanced degrees in Mathematics or Physics, while
most of the younger audience members had Masters degrees in Financial
Engineering or Financial Mathematics. It
was a thrill and an honour for me to be invited to spend some time with them.
The title of my
talk might seem a bit strange – and perhaps even insulting to such an
audience. To insult them however was the
exact opposite of my objective. The
point of my talk instead was to focus on how the career in risk pendulum may
have shifted and that mathematical skill may not be the competitive advantage
it once was. Instead my hypothesis is
that mathematical skill combined with creativity, artistic and humanistic
skills are the portfolio of skills
that are now necessary in risk management.
Before
continuing I should explain some of my personal basis for my arguments. I am a physicist that converted a graduate
career in physics into a graduate degree in finance during the early
1990’s. I very much benefited from the
Wall Street hunger for physicists at the beginning of the “math boom” in
finance. However it is my liberal arts
undergraduate degree that I consider to be the most valuable in my development
as risk manager. I believe that the
ability to think in liberal arts terms as
well as mathematical terms is the new black in risk management.
Knowledge of
risk techniques is a commodity. The
ability to think and implement risk management is the value added, and in order
to think and implement risk you need to understand a variety of aspects of risk
– some quantitative but most qualitative.
Additionally you need to be creative and flexible in your thinking. Unfortunately the business schools and
financial engineering schools (and corporate training programs that produce
cookie cutter analysts and consultants) are very good at disseminating
knowledge, facts and frameworks, but knowledge, facts and frameworks are not
the same as the ability to think and do!
One could argue
(and I will argue in a future blog) that risk management is more about
understanding people at both the individual level (within an organization and
within the level of immediate stakeholders) as well as at the sociological
level. Economists and Finance academics
are currently rushing to make their mea culpas that their models cannot work in
a world composed of irrational masses.
The Behavioural Finance field has evolved to chronicle our collective
mass irrationality (stupidity?) but offers few if any solutions for overcoming
this collective handicap.
We thus come
back to the fact that it is the artists of the world who may be best prepared
to deal with the current shortcomings of quantitative risk management and
repair the image of the field.
Ironically physics and mathematics used to attract the creative types –
those who dreamed and thought creatively.
When I was a graduate student in physics it was common for students to
use psychedelic drugs not for pleasure but to help them think more creatively
and more outside the box. (Names
withheld for obvious reasons.) While I
am most certainly not advocating illegal drug use, I do believe that there
needs to be a call made for more creativity and artistic license in the field
of risk management. Physicists and
financial engineers also like to drive Lamborghinis and should release their
inner artist in order to regain the comparative value added that allows them to
do so.
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