Tuesday, April 10, 2012

Are financial theories useless & dangerous?

We are living in times when formal education has almost become a basic necessity. Much of what goes on in the world of business and finance is a result of what is taught inside classrooms. So when there is a problem outside, one needs to pay careful attention to what the professors are teaching.

Take for instance the ongoing economic and financial crises that kicked off with the bursting of the US housing bubble in 2007. It was more than just a consequence of the greed and ignorance of investment bankers and policymakers. It was a blatant expose of the several flaws in the theories of modern finance. Who would be a better person to point this out other than Mr Nassim Taleb, himself a professor of risk engineering and author of the highly acclaimed book Black Swan?

According to him, highly sophisticated and complex financial models are useless in predicting rare but highly impactful events. In fact, they are extremely dangerous. He gives a very interesting analogy to explain his point. Say you are a passenger on an airplane. The pilot comes up to you and says that his map is a bit faulty. But that is the best map available. Would you still want to take a ride on such an airplane? Certainly not! Unfortunately, the financial world often rides on half-cooked theories.

Whether risk managers, investment bankers and finance professors will learn their lessons is a different thing. But any such crisis is a great opportunity for investors to learn some very important lessons. One, it is always best to keep things simple. Using complex tools to understand complex phenomena is often not the right way to take. That is why we strongly believe in the value investing approach propagated by Warren Buffett, Benjamin Graham, Peter Lynch and the likes. Because of its simplicity yet firm adherence to solid principles, it eliminates several risks that a complex approach would fail to account for.

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