Don’t Let Models Doom Your Portfolio
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Financial models are fine for explaining in general how markets should work, but it’s a mistake to over-rely on them when building an investment portfolio. All models are flawed to some degree. Often, when a model discovers easy money in the markets, it’s the model that’s wrong. These flaws tend to show their ugly face at precisely the wrong time.
In 1997, Long Term Capital Management’s once-profitable models failed to predict Russia’s default on foreign debt. This flaw put the firm’s solvency at risk and placed the entire financial system on the edge of a meltdown. It’s when the term “systemic risk” was born.
This happened again in 2007 when sophisticated institutional investors used flawed pricing models that told them sub-prime mortgages were a bargain. Too-big-to-fail U.S. and international financial institutions bought these mortgages, until they recognized the problem. But they were insolvent by that time. We’ll be paying for that mistake for a long time.