Risk management is the topic of Nassim Nicholas Taleb’s bestseller The Black Swan. The author argues that mathematical models employed to manage risk are delivering results that are misinterpreted by current actors in the financial world. The main problem Taleb sees is that normal distributions are use in estimating gains and losses from investment projects. These distributions are well defined and easy to use for modelling, however, they are only important in Mediocristan. Mediocristan is a world where outliers are not very extreme, and harder to find the more extreme they are. Think of body height: Some people will be taller than others, but if you choose 100 random people, their influence on the average height will be small. Taleb states that Gaussian modelling (with well defined bell curves) does not work well in Extremistan. In Extremistan, outliers are extreme and hard to predict. Think of wealth: A sample of 100 people can be influence very heavily by someone like Bill Gates or Carlos Slim. Since the financial world lives in Extremistan, but uses tools certified only for Mediocristan, we hence have a problem at our hands.
The book is witty and well-written, I enjoyed reading it very much. Taleb’s prose is refreshing, and funny at times. Still, he gets his points across. A lot of footnotes and notes on further reading are provided. Taleb’s book is a manifesto on financial risk and how to manage it better. Another book on this topic is Ricardo Rebonato’s Plight of the Fortune Tellers. Rebonato describes the same problem, but his conclusions are a little bit different. He argues that risk management should use different tools next to each other, instead of relying on one mathematical model that produces just one final number. Also, he criticizes Basle II, the regulation framework for banks. He misses scientific rigor and the will of regulator’s to come up with their own approach, as opposed to recommending best practice. Rebonato’s book might be the better read for people who have no or little experience with how financial markets work, while Taleb’s probably is more enjoyable for people with an understanding of risk management. I would recommend both. Those in want of a condensed read can take a look at an article in the New Scientist from 1997 called Flight over Wall St. It describes the problem of bell curves and fractals in just 4 pages.