Things investors should hate 1/5: Models

30th July 2012

I don't hate all models. I'm quite keen on the tall, leggy ones.  It's the mathematical ones that come trailing clouds of false precision that are the subject of my ire.  Yet the world is a complicated place, too complex for our complex brains, so assisting them with some expert mathematical models is entirely sensible.

However, entirely replacing human analysis, intuition and commonsense with a computer program isn't so much not sensible as unbelievably stupid.  People responsible for such behavior should be barred from any position of responsibility higher than a barista, and even then should be carefully watched when making anything more complicated than an Americano.  And do not, on any account, let them near a cash register.

Models bring many benefits, one of which is that they allow us to manage risks and investments better.  If you can model the load that a bridge can take then you can design it optimally to ensure that money isn't wasted on unnecessary materials and labor.  On the other hand, the tendency in such situations is to design for exactly the situation you've specified: four axle trucks, say.  So what happens when six axle trucks come along?

The Romans had a different way of dealing with the problem.  They had their bridge architects stand underneath the structure when the supports were removed.  They figured that this would concentrate the minds of their chief modellers.  And of course it did, but at the cost of over-specification: structures built before the days of computer aided modelling were usually far better built, and far more expensive, than they needed to be.

The benefit of this over-specification is that these structures are able to deal with the unexpected, not just the precise circumstances for which they were designed.  Six-axle trucks would be no problem.  Likely sixteen axle-trucks would be too. There's a 2000 year old Roman aqueduct in use in Spain today.

Of course, in reality, if a bridge was designed for lower weights then we wouldn't let the new trucks drive over them.  We would direct them to other routes or build a new bridge – these might not be the most efficient outcomes but they would, at least be safe.

The problem with our financial models is that the people using them – the truck drivers – don't understand the weight limits and that the people who designed them don't do enough to make them understand.  Often the view seems to be that if the bridge hasn't failed yet then it's OK.  Unfortunately if you build a bridge that's an efficient short-cut you may find yourself dealing with a great deal more traffic than it was ever designed for: and if you don't understand the risks you may find that it collapses when you least expect it.

Continue reading…

 

More on Mindful Money:

Mindless With Money: How to be a mindful investor

Islamic Finance – An alternative banking model?

Investing in a recession

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