Sue the Swedish Central Bank and the Nobel Committee?

This is a very strongly worded statement about financial risk from today's news:

"Nassim Nicholas Taleb, author of 'The Black Swan,' said investors who lost money in the financial crisis should sue the Swedish Central Bank for awarding the Nobel Prize to economists whose theories he said brought down the global economy."

McCabe, Alex, 2010. Taleb says investors should sue Nobel panel for losses. Bloomberg News, Oct. 8.

Further the article quotes:

“'People are using Sharpe theory that vastly underestimates the risks they’re taking and overexposes them to equities,' Taleb said. 'I’m not blaming them for coming up with the idea, but I’m blaming the Nobel for giving them legitimacy. No one would have taken Markowitz seriously without the Nobel stamp.'”

My view of the risk models used in the financial services industry is similar to the statements by Prof. Taleb. I have written many articles about the general subject of risk. The following blog posts expand my views on the topic of risk models in finance.

Path to Economic Growth (2010)

Financial Risk (2008)

My blog contains many other examples.

Regarding Prof. Taleb's assessment of Sharpe and Markowitz's work, the reality of practical application speaks for itself. The saga of Long-Term Capital Management (LTCM), a hedge fund started by the two Nobel laureates with help from others, is an excellent example. LTCM failed miserably in 1998. An unanticipated default on Russian bonds caused the topple. An overview of the entire situation can be found at the following Wiki link:

LTCM

I do not believe that a law action should be filed against the Nobel committee responsible (The Swedish Central Bank), however, I do believe that there is too much trust in financial models and almost no understanding of the assumptions.

This became evident in the famous 1994 Orange County, California derivative loss when it was painfully apparent that government officials had no idea of the risks of derivatives. Billions of dollars of public money was lost. See the following NYT article for more details:

Malkin, Lawrence, 1994. Merrill lynch to bail out orange country on derivatives loss. The New York Times, Dec. 3.

Financial models often become nothing more than a questionable means to convince investors of the advantage of making a certain play in markets when no other means of fundamental analysis exists. This approach is nothing more than a smokescreen.

The re-adjustment of financial markets to rely less on financial models and other pseudo gimmicks such as high frequency trading will further roil the flows of capital and perhaps inhibit economic growth.

I very much caution that folks should take all forms of financial modeling with a degree of skepticism.