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“Highly paid people produced worthless predictions.” Bank’s Financial Forecasting

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Mistakenly of falsely portraying “uncertainty” (unknown probability) with “risk” (known probability) is a core failing on financial services.  However, because there is a sales advantage, it won’t be corrected.  Predictably, banks have had huge losses from perpetuating this fundamental error/misstatement.

Take Away

  • It’s hard to predict currency values worse than the banks did.  Highly paid people produced worthless predictions.”
  • most economists and other risk modelers don’t distinguish between risk and uncertainty.

    Banks Err By Confusing Risk, Uncertainty by Bruce Bower

Monday, October 8th, 2012

WASHINGTON — Major banks conduct an annual ritual of financial forecasting futility: Their complex risk models consistently flub predictions about the relative values of the dollar and the euro in the coming year, a new analysis finds.

Annual forecasts of currency values from December 2001 to December 2010, which guided banks’ investment decisions, badly missed the mark nine out of 10 times, says psychologist Gerd Gigerenzer of the Max Planck Institute for Human Development in Berlin. Banks incorrectly foretold the fates of the dollar and the euro in the years leading up to, during and after the recent financial crisis.

Gigerenzer described his findings October 4 at “Reckoning with the Risk of Catastrophe,” a meeting of German and U.S. scientists trying to devise ways to measure the probability of financial calamities, natural disasters and other catastrophes.

It’s hard to predict currency values worse than the banks did.  Highly paid people produced worthless predictions.”

The problem, Gigerenzer asserted, is that most economists and other risk modelers don’t distinguish between risk and uncertainty.

  • Economic models assume that the financial world consists of known risks that can be calculated based on prior behavior of stock markets and other elements of the monetary system
  • But uncertainty rules in the real financial world, where risks can’t be known in advance because a complex tangle of factors triggers new, extremely unlikely hazards.

In an uncertain environment, the past is an untrustworthy guide to the future.

Financial predictions based on calculations of allegedly known risks underestimate the possibility of downturns caused by unlikely events. Banks welcome that flaw, because it provides mathematical cover for pursuing high-risk investments.

“Confusing risk with uncertainty was one of the causes of the financial crisis,” he said.

  • simple decision heuristics, or rules of thumb, can work better than complex calculations when navigating uncertain domains.
  • Distributing money evenly among available investment options, for instance, yields more money over the long haul than complex formulas for maximizing profits and minimizing losses.

Financial risk modelers at the meeting acknowledged past failures of their mathematical creations but described efforts to strengthen the current approach. Economist Brenda González-Hermosillo of the International Monetary Fund in Washington, D.C., said that she and her colleagues are developing a statistical toolkit to predict upcoming financial crises based on complex analyses of currency exchange rates, money movements across countries and other factors.

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Written by Rich and Co.

October 9, 2012 at 2:04 pm

Posted in Investments

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