Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

by Riccardo Rebonato

Today's top financial professionals have come to rely on ever-more sophisticated mathematics in their attempts to come to grips with financial risk. But this excessive reliance on quantitative precision is misleading--and puts everyone at risk. In Plight of the Fortune Tellers , Riccardo Rebonato forcefully argues that we must restore genuine decision making to our financial planning. Presenting a financial model that uses probability, experimental psychology, and decision theory, Rebonato challenges us to rethink the standard wisdom about risk management. He offers a radical yet surprisingly commonsense solution: managing risk comes down to real people making decisions under uncertainty.



Plight of the Fortune Tellers is a must-read for anyone concerned about how today's financial markets are run. In a new preface, Rebonato explains how the ideas presented in this book fit into the context of the global financial crisis that followed its original publication. He argues that risk managers are still stuck in a probabilistic rut, and need to engage with the structural causes of real events.

Genres: Finance, Nonfiction, Economics, Mathematics

328 pages, Paperback

First published September 17, 2007

Reviews

[Andy · Rating 5 out of 5]

Published shortly before the crisis of 2008, this is a thoughtful, minimally technical book about the misuse of statistics in finance by a relatively well-known figure in the industry.

The early chapters that describe Bayesian statistics in layman's terms were excellent. The way Rebonato cast the problem of bad financial statistics into inadequate weight and formulation of priors was a kind of "a-ha" moment for me. The lessons of history at very long timeframes can and should influence our opinions on future outcomes, and our ability to make statistical statements based on a few years of data is necessarily weak regarding phenomena that occur at longer cycles. (Let us hope no one ever says or publishes anything more about "10,000-year" financial events; not only do we definitionally not have enough data, but data today may not be good in a decade's time, much less ten millennia.)

The inadequacy of some of the financial industry's models has been covered at length since 2008, but too often I think the message ends up being something like "toss math out the window." The real problem is the abuse of math, and the false sense of certainty that quantification can bring. Thinking about risk in a Bayesian context requires us to acknowledge the prior assumptions that go into our models on one hand and the subsequent effect our data has had on our beliefs about what may happen in the future, from which point we can ask ourselves whether our new beliefs are reasonable or whether we have structurally assumed possibilities away.

The book has some overlap with topics discussed by the much more famous Nassim Taleb, but compared to Taleb's writings, it is less dyspeptic and contains fewer philosophical digressions, which for my money makes it a better read. (I did greatly enjoy Fooled by Randomness, but the various more recent online articles by and about him have greatly discouraged me from reading him further.) It gets a little dry towards the end - the "economic capital" chapter and the prescriptive chapter at the end are primarily of interest to people in banking and less so to casual readers. But overall, great read for people who want to seriously understand the capabilities and limitations of quantitative methods in social settings.

[E · Rating 5 out of 5]

Thought-provoking study of risk management

Reading this book is like reading the prophecies of Cassandra, whose fate was to speak the truth to the unbelieving. In the wake of the fiscal crisis, no one can question the observation that the practice of financial risk management has serious flaws. Business journalist Riccardo Rebonato’s discussion of why and how financial institutions misunderstand and mismanage risk provides valuable insights. He works to make his ideas accessible beyond the narrow circles of financial economists and quantitative risk managers. He uses no equations in the text, and his few graphs are clear and accessible. He states his case against excess reliance on statistical methods in plain language. getAbstract believes that his analysis should interest any manager or regulator whose responsibilities include oversight of finance.

[May Ling · Rating 4 out of 5]

This was suggested by a client. It's a good way to think about the misleading aspects of financial risk. I'd add it to any read related to liquidity and the financial markets.

[Mike Cheng · Rating 2 out of 5]

Riccardo Rebonato warns against overreliance on quantitative risk management tools (e.g., Value at Risk (VaR)) and other statistical probability models. Humans conflate risk and probability. Thus cognitive biases such as the “System 1” errors (coined by Daniel Kahneman and Amos Tversky) coupled with an erroneous assumption that the likelihood of events always adheres to a standard bell curve distribution (vis-a-vis the Central Limit Theorem) paints a false picture of the world, especially in the realm of financial risk management. Professor Rebonato is instead a proponent of a more Bayesian approach of updating assessments and behaviors as more information becomes known. To his credit, some of the book’s assertions were quite on the nose considering the book’s October 2007 publication date, including the discussion of mortgage backed securities and collateralized debt obligations about a year before the 2008 financial crisis. There is also discussion about how people wrongly judge the likelihood of catastrophic events, namely Black Swans (popularized by the Nassim Taleb book that was also published in 2007).