Banning VaR as Heresy
I wonder what goes through the head of someone like Pablo Triana. He authors a book and a series of articles designed to highlight how conventional risk management tools have failed us, but it’s written for an audience that understands even less about the problem than he does. And to those of us who know better it’s abundantly clear that he doesn’t understand all that much at all.
The broader point of his work is ‘flat earth’ like. He writes about quantitative finance as if it’s the source of some new type of evil. This seems a popular enough rant since much of the 'angry mob' views financial models and higher math with increasing suspicion. And he makes the next natural argument that the best thing we can do in this increasingly complex world is to do away with them entirely. He makes this claim because, like his intended audience, he apparently lacks the facility to understand them. And he’s insisting that the government use it’s considerable force to make sure that the rest of us who know better are all brought down to his level.
Take for example this business week piece he authored. At first glance it looks like just another Goldman hit piece from a mainstream media outlet; just another in a string of countless articles designed to enrage the public against Wall Street’s most successful, and therefore least popular bank. But if you read into it a little you realize that it’s something more. In reality what he’s trying to do is to use the hatred of Goldman, the bank that all self appointed sophisticates loves to hate, as a tool for de-legitimizing the use of VaR (Value At Risk) as a metric for understanding portfolio risk.
To me, someone who’s devoted a sizable portion of his career to understanding all of the commonly used methods for describing risk, this reads like stupidity on stilts. It’s a demand for a government imposed Dark Age. In essence Pablo Triana is trying to argue that because our tools aren’t perfect, we should be forced to cast them aside. He’s saying that since our compass, sextant and pocket watch can’t pinpoint our position with a clarity that even he can understand, we should all be forced to throw them overboard and simply stay within sight of the coast. That way, he says, anyone can manage to understand the rules of navigation, even if it means that we no longer get to go anywhere.
In effect it's a demand by a blind man that the rest of us should all be forced to pluck out our eyes.
Pablo Triana would have you believe he's a deep thinking intellectual but he's not. What he really is, is just the latest in a long line of pseudo-intellectuals who decry all knowledge that they themselves can’t find a way to comprehend. And just like those that came before him, his supreme arrogance is that he can’t admit that the real problem is with his understanding rather than with the tool itself. He presumes himself infallible so if there is any confusion then it must be the fault of what VaR had to say, not with his inability to understand it.
Instead of confessing his ignorance and trying to get a better grasp on what VaR actually does say, he spends his time tearing down straw men for an audience too mathematically illiterate to realize that his villains don’t actually exist in the real world. He wants to ban the use of VaR because it can’t predict the future to his satisfaction, but no one who understands it ever claimed that it did. He scratches and tears at modern portfolio theory and the Black-Scholes options model for their lack of precision but those imprecision’s have been the subject of debate in the industry for two decades, so they are hardly un-acknowledged. And he does his best to depict quants and quantitative risk managers as heretics for claiming that their models speak the whole truth, when no one who understands the models would ever say anything of the sort. We professionals know what approximations these tools are and we never claimed otherwise. It was only neophytes like Triana who did.
He also conveniently forgets that the world that existed before VaR and modern portfolio theory was even more imprecise than the world we see today. It was a world where animal spirits and geometric patterns were the sum of all explanation for the behavior of market prices. It was a world where superstition, bias and ignorance dominated the markets and the industry that worked in them. He ignores the fact that while our present tools may be imperfect, the world we had before them was even more so.
And what he also ignores is that it wasn’t the models that created the financial crisis, although he would clearly have his readers believe otherwise. What actually created the financial crisis was people just like him who misunderstood the models and misinterpreted the results. But that’s probably just his self declared infallibility again. He doesn’t want to his readers to see that the math was all correct and that it was the interpretation of it which was in error because it's the very mistake that he’s making himself.
As an example he compares a CDO and a treasury bond showing them with equivalent VaR statistics and then claims that VaR is inaccurate because it doesn't call attention to their differences. But to those of us who base our livelihood on it, it's abundantly clear that there is a difference between an illiquid CDO and a highly liquid treasury bond so we don't look to VaR to tell us that. It's a question that the tool was never designed to address.
The bonds he compares may also have a similar notional amount or a similar coupon or duration. Those numbers may be similar or exactly the same for both bonds, and aren't considered any less accurate simply because they don't include the difference between them. VaR is a description of one property of a portfolio given certain limits and assumptions. It was never presented as anything more than that. And everyone who makes use of the tool already knows that.
So in effect, Pablo Triana wants to eliminate the use of VaR because it didn’t answer a question that no one but him was ever stupid enough to ask of it.
For decades we in the industry have debated the merits of using one strategy or another to deal with the inadequacies of quantitative portfolio analysis. We discuss, we examine, we debate we consider… and so on over a period of years. That’s how new ideas are brought to light. Even now, many of the best minds in the world are struggling to understand liquidity risk (which was the real spark that set off the credit crisis) and to produce methods to quantify its behavior. But one thing is for sure… no one ever thought it was something that VaR was ever designed to describe… no one that is … except Pablo Triana.
And just to be clear, that doesn’t mean that VaR isn’t excellent at describing other things. But Pablo Triana still wants it banned anyway, and has asked the Obama administration to make it so. OK… fair enough… he’s entitled to his opinion. So what does he propose the industry adopt in its stead? According to him we should use “intuition and experience-honed common sense” in place of quantitative methods for valuing risk. To use an analogy from science, he's demanding that we abandon Newtonian physics for it's imprecision, and instead embrace astrology and 'diving the the humors' when trying to understand the world. And I'm sure that no one will be able to misinterpret something as clear, reliable and proven as that.
The media elite all say that they revere things like intelligence and insight, but the truth is they have always been deeply resentful and suspicious of it. Like any uninformed mob, they don’t trust anything that they themselves can’t understand. It's resentment of the successful that has turned the media against Goldman Sachs. And it's also that resentment that has led Triana to try to link Goldman and quantitative finance to further his argument against both. his view isn't based on anything reasonable or rational, but it will still be popular with people like Arianna Huffington, Jon Stewart and Bill Maher. And that’s exactly who he’s trying to impress. His argument doesn’t lead to enlightenment (quite the contrary), but it’s far more likely to get him a TV spot than a more serious idea which does.
Of course, none of those people (including Triana) are really the intellectuals they pretend to be. The truth is they possess unremarkable intelligence, and don’t really understand any more about complex issues than the average Joe. So when a guy like Triana with just enough knowledge to be dangerous claims to have discovered a bit of heresy and offers a chance to cast real intellectuals into the pyre, those same media elites become the leading edge of the illiterate mob. They are just as anxious as anyone to throw all rationality aside and grab a torch.
Triana is really just a fool who mixes populist ranting against straw men with just a hair of actual knowledge. But he's bound to get a sizable audience because he says what everyone wants him to. A flat earth And speaking for those of us who make our living near the edge of the map in those waters he's so afraid of,. "There be no dragons here" and we won't fall off the edge.
VaR is a useful tool with known limitations. Well ...at least they're known to everyone but Pablo Triana.
This reminds me of a scene from that classic movie ‘A Fish called Wanda”. This clip has got Triana’s name all over it:
Triana doesn’t understand VaR so he says it should be banned. Thankfully, it doesn’t look like anyone but the pseudo intellectuals are taking him seriously.
