Four days before J.P. Morgan’s CEO Jamie Dimon first revealed that his firm had lost US$2 billion and could lose more on poorly conceived and executed derivatives trading strategies, James Montier of Grantham, Mayo, Van Otterloo LL C (GMO) delivered a timely warning to attendees of the 65th Annual Conference of CFA Institute in Chicago. Montier’s message: overly complex and unrealistic financial models continue to present serious risks. GMOs asset allocation specialist warned that the pitfalls of modern financial theory and practice have not been fully addressed. He also explained how flawed models, policies, incentives, and behaviour are interacting to facilitate financial failures, small and large.

Blinded by science

Montier argues that professional investors and their clients are all too often “blinded” by science when it comes to complex mathematical models. In other words, practitioners embrace mathematics and complexity because it creates an aura of scientific precision, impresses others, and ultimately, allows them to charge high fees and protect their careers. But in reality the models they produce and apply are stylized and vastly oversimplified reflections of the real world. As such, they fail to reflect the ever-changing dynamics of the marketplace over an extended period of time.

“Do not rely on volatility as a risk measure – risk is far more complex”

The Capital Asset Pricing Model (CAPM), on which modern portfolio theory is based, assumes that volatility is the only risk, illiquidity can be ignored, and that leverage is freely available and can be deployed without consequences. The financial crisis of 2008–2009 and the fate of Long Term Capital Management in 1998 are just two examples of the fallacy of these assumptions.

Value-at-Risk* (VaR), says Montier, is another example of a risk management tool that has been blindly used by investors. A widely used tool for measuring the size and likelihood of potential portfolio losses, VaR ignores the extremes of distribution: the “black swans” that are unlikely but potentially devastating. These unusual events are in reality predictable surprises that practitioners overlook due to over-optimism, illusions of understanding and control, group-thinking, self-serving biases, or myopia. In effect, VaR ignores the very part of the distribution of returns investors should be worried about: the tails. VaR also ignores the systemic risk created by the large number of institutions and financial industry regulators who have come to use it. In other words, widespread use of VaR leads participants to act in unison when volatility and perceived risk change, thereby increasing price fluctuations.

Montier cites five behavioural biases at work today:

1. Automation bias: Our tendency to assume that technology, including computers and models, is more reliable and accurate than human judgment;
2. Framing bias: Prevents practitioners from seeing the big picture because they are tied to narrow definitions of risk (i.e., in statistical terms or based on past price fluctuations when many other risk factors are at work);
3. Optimism bias: Where practitioners overestimate the probability of positive outcomes;
4. Cognitive dissonance or intentional blindness: The habit of seeing only what one intends to see; and
5. Anchoring and illusory correlations: Where investors incorrectly perceive that unrelated events are related (when in reality they are not).

Such problems are compounded by asymmetries of incentives, which Montier argues create bad behaviour. For example, misalignments exist in the structures of bonuses paid to loan officers and in the payments that managers and traders award for the upside of taking risks in the absence of disincentives for downside exposures.

Beware of innovation

Overcoming the limitations of modern finance and avoiding its pitfalls can be very difficult. To help, Montier offers five key pieces of practical advice for investors and their advisers:

• Practitioners should heed Derman and Wilmott’s Modeler’s Hippocratic Oath and strive to do no harm and refrain from sacrificing reality for elegance (Boxed text, right).
• Investors and their advisers should be skeptical of all financial innovation. All too often it is thinly disguised leverage.
• Practitioners should discard the use of volatility as a measure of risk. Risk is far more complex, and managing it involves assessing the prospects for permanent impairments of capital, either through valuation (buying an overvalued asset), business risk, and/or financing risk.
• Investors should focus on the long term to avoid missing the woods for the trees.
• We should all abandon our obsession with optimality or the quest for the best risk-adjusted return. Optimality is elusive and is really only discernible in retrospect because the future is unpredictable. Instead, all practitioners should seek robustness, i.e., portfolios that are designed to survive and potentially thrive in multiple different environment

Montier also has a few key pieces of advice for regulators:

• Lean against the wind rather than be cheerleaders for manias—act to deflate bubbles in their early stages rather than let them inflate and burst;
• Abandon market fundamentalism and the notion that the markets are always right;
• Avoid regulatory capture and self-serving biases, e.g., allowing banks to infiltrate financial regulation and policy making and permitting them to use their own models to assess risk; and
• Make capital adequacy requirements contra-cyclical rather than pro-cyclical by ensuring reserves are built up in good times.

The Modeler’s Hippocratic Oath

Written by the quantitative financial engineers and authors Emanuel Derman and Paul Wilmott.

I will remember that I didn’t make the world, and it doesn’t satisfy my equations.

Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

I will never sacrifice reality for elegance without explaining why I have done so.

Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

* A widely used measure of the risk of loss on a portfolio of financial assets, e.g., if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one-day period. In other words, a loss of $1 million or more on this portfolio can be expected on 1 day in 20.