Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

Synopsis

Today's top financial-risk professionals have come to rely on ever-more sophisticated mathematics in their attempts to come to grips with financial risk. But this excessive reliance on quantitative precision is misleading--and it puts us all at risk. This is the case that Riccardo Rebonato makes in Plight of the Fortune Tellers --and coming from someone who is both an experienced market professional and an academic, this heresy is worth listening to.


Rebonato forcefully argues that we must restore genuine decision making to our financial planning, and he shows us how to do it using probability, experimental psychology, and decision theory. This is the only way to effectively manage financial risk in a manner congruent with how human beings actually react to chance. Rebonato challenges us to rethink the standard wisdom about probability in financial-risk management. Risk managers have become obsessed with measuring risk and believe that these quantitative results by themselves can guide sound financial choices--but they can't. In this book, Rebonato offers a radical yet surprisingly commonsense solution, one that seeks to remind us that managing risk comes down to real people making decisions under uncertainty.



Plight of the Fortune Tellers is not only a book for the decision makers of Wall Street, it's a must-read for anyone concerned about how today's financial markets are run. The stakes have never been higher--can you risk it?

Excerpt

[T]here is…considerable danger in applying the method of
exact science to problems…of political economy; the grace and
logical accuracy of the mathematical procedure are apt to so fas
cinate the descriptive scientist that he seeks for … explanations
which fit his mathematical reasoning and this without first
ascertaining whether the basis of his hypothesis is asbroad…as
the theory to which the theory is to be applied.

Karl Pearson, 1889, speaking at the Men's and Women's Club*

Financial risk management is in a state of confusion. It has become obsessively focused on measuring risk. At the same time, it is forgetting that managing risk is about making decisions under uncertainty. It also seems to hold on to two dangerous beliefs: first, that our risk metrics can be estimated to five decimal places; second, that once we have done so the results will self-evidently guide our risk management choices. They do not. Even if they did, our risk metrics cannot be anywhere as precise as they are made out to be. This is not because we must “try harder”—say, collect more data, or use cleverer statistical techniques. It is because, given the problem at hand, this degree of precision is intrinsically unattainable.

Given what is at stake, this state of confusion is dangerous. To get out of this impasse we must tackle the task from a radically different angle: we must revisit our ideas about probability in financial risk management, and we must put decision making back at center stage. This is what this book is about.

*Quoted in A. Desrosieres (1998), The Politics of Large Numbers: a History of
Statistical Reasoning (Cambridge, MA: Harvard University Press).

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