Tuesday, August 21, 2007

The Abuse of Math

Economist magazine had a wonderful series of stories on the recent financial crisis. Wall Street forgot the lessons of Long-Term Capital Management and embraced math in a big way. Unfortunately, they forgot that all models are based on something called assumptions, and any model is only as good as its assumptions. How way off base were the models?
Goldman Sachs admitted as much when it said that its funds had been hit by moves that its models suggested were 25 standard deviations away from normal. In terms of probability (where 1 is a certainty and 0 an impossibility), that translates into a likelihood of 0.000...0006, where there are 138 zeros before the six. That is silly.

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