CFA Institute Speaker: The “Value at Risk” Model is of Limited Use in Assessing Risk

One of the problems with how financial institutions assess risk is that they rely on imprecise models.  Financial News’  Shanny Basar reports that in fact, just a few days before JP Morgan announced its multi-billion dollar trading loss, James Montier,a member of the asset allocation team at fund manager GMO, gave a speech on The Flaws of Finance.

In the speech, delivered on May 6 at the 65th Annual CFA Institute Conference in Chicago, Montier flagged up some of the key problems with the way financial institutions assess risk. These include the reliance on imprecise models and particularly the use of a system called ‘value at risk’ or VaR which, Montier suggests, has an inbuilt Achilles heel.

VaR gives a measure of the probability of trading losses in normal market conditions using data on how markets have behaved over a certain period of time in the past. As a result, the model falls apart when markets are stressed or illiquid – precisely when firms are likely to lose money.

Montier said: “Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying upon body armour that you know keeps out 95% of bullets. VaR cuts off the very part of the distribution of returns that we should be worried about: the tails.”

 . . . In Flaws of Finance, which has also been published as a paper, Montier points out that scientists are aware of the assumptions in their models, but this is not always the case for people using them. “Give a monkey a value at risk model or the capital asset pricing model and you’ve got a potential financial disaster on your hands,” he writes. The problem, as Montier expresses it, is that some people are willing to bet huge amounts of money of the basis of financial models they don’t understand.

[pullquote]Montier: Scientists are aware of the assumptions in models. But many people who use the models are not.[/pullquote] 

Download Flaws of Finance as a PDF here.  Watch a video of Montier explaining his point here.   In the paper, Montier elaborates:

The National Rifle Association is well-known for its slogan “Guns don’t kill people; people kill people.” This sentiment has a long history and echoes the words of Seneca the Younger that “A sword never kills anybody; it is a tool in the killer’s hand.” I have often heard fans of financial modelling use a similar line of defense.

However, one of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling. He points out that “Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands.