Beware of the Alchemists


A Mark Buchanan article in Bloomberg last week was called “Beware of Economists Peddling Elegant Models”.  In it, the theoretical physicist proposes that – 
“Mathematics can be beguilingly elegant. It can also be dangerous when people mistake its elegance for truth.   Albert Einstein's theory of general relativity might be the best example of elegant math, capturing a wide range of subtle and surprising phenomena with remarkable simplicity.  Step toward the practical, though, and physics moves quickly away from elegance to makeshift usefulness.  There's no pretty expression for the operation of a nuclear reactor, or for how air flows past the swept wings of an aircraft.  Understanding demands ugly approximations or brute-force simulation on a large computer“.

A friend recently pointed out that there is also a book and YouTube video called the Alchemists of Wall Street which makes a similar point.  The point is that we cannot place all our trust in mathematics to model the real world in general or the real economy in particular. 

Needless to say, I agree with this view.  My study of Economics started at O Levels in the late 1980s, continued to post graduate level in the late 1990s and the early part of the last decade and continues to this day.  One thing that I never learnt in classrooms is that the markets are not ‘free’ but subject to extensive manipulation by agents hidden from everyday view.
    
At one time, this view was frowned upon as a fringe view held by weird conspiracy theorists.  Today, it seems that this is common knowledge and one of the most recent and more popular examples has to be the London Interbank Offered Rate (LIBOR) scandal.  LIBOR is a number used in the pricing of trillions in securities and was manipulated for years. Careers have been ruined, while RBS, UBS and Barclays have been fined because of this scandal yet no single person has been found to have been in violation of a law.USA Tax Singapore

The reason is that, according to a recent ruling by a federal judge in the southern district of New York, although banks conspired to manipulate rates, competition laws did not apply as it was already a cooperative process.  Feel free to Google more details on this story but to me this stands as a perfect reminder of the dangers of over-reliance in econometric modeling given the vagaries of human behavior.

A recent article in the Economist discussed findings from academics at the Oxford-Man Institute of Quantitative Finance.  They tracked the monthly submissions of 12,128 hedge funds to industry databases between 2007 and 2011, and found that just under half the managers subsequently modified their data.  While some tweaks were tiny, many were material.  Without getting too technical,it appears as if hedge fund managers routinely revise their performance data in a way that seems designed to fool outsiders.

So what do I see as the take away from this?  For me it is simple.  Forget theories and accept reality for what it is.  Human nature is an indistinguishable part of any econometric equation.  In November 2008, during a briefing by academics at the London School of Economics on the turmoil on the international markets, the Queen famously asked:"Why did nobody notice it?" The university’s Professor Luis Garicano, explained the origins and effects of the credit crisis. He told the Queen: "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing."

The markets seem destined to forever follow the cycle of boom and bust.  The trick must therefore be to be detached enough from the euphoria to gauge where we are along the cycle.  Think about the present rally in US equities, the US housing recovery and bond market performance?  I say no more. American Tax Singapore

In April 2008, Her Majesty's private wealth was estimated by Forbes magazine to be around £320 million.  This included a personal investment portfolio valued at £100 million.  By November 2008, London's Stock market had lost almost 25% of its value.  The Queen's investments, largely in British blue chip companies, have broadly tracked the market, resulting in a 25% decline. So she was right to ask tough questions. Like you and me, I am sure she was dissatisfied with the answers.  I am sure she does not trust mathematical models as much as she once did.

Readmore on DerrenJoseph.blogspot.com

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