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Dependence on numbers and charts leads to misunderstanding of risk. July 8, 2009

Posted by shaferfinancial in Finance.
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Peter Bernstein wrote a brilliant essay in 1996.  It warned us of being overly dependent upon numbers, charts, and past performance.  To read the essay in its entirety click here.

This is my favorite part:

The English journalist G.K. Chesterton had the picture more clearly in mind when he wrote, “The real trouble with this world of ours is not that it is an unreasonable world, nor that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”
We all have memories of occasions when the wildness broke loose. Many of us can recall the moment in the late 1950s when bonds first yielded more than stocks, blowing apart a relationship sanctified by more than 80 years of history.3 Others will remember the early 1970s, when long-term interest rates rose above 5% for the first time since the Civil War and then dared to remain above 5%. That wildness was followed shortly by another, even more frightening paradigm shift, when the price of oil broke loose from the long-standing grasp of the Texas Railroad Commission, which had regulated world oil prices since the early 1930s by controlling U.S. oil production.
The amazing stability of key relationships over so many years depleted the capacity of people to imagine anything different. Worse, nothing suggested that they even should try to imagine something different.
Consequently, the calamities may not have been unpredictable, but they had become unthinkable. Now, consider this: If no one was able even to imagine that stock yields would remain below bond yields for decades, that bonds are in fact risk investments, and that OPEC could dominate the world energy scene, how could we have expected a computer to imagine wildness like that? How can we instruct a computer to model events that have never occurred, that exist beyond the realm of human imagination? How can we program into the computer concepts that we cannot even program into ourselves?................I have concerns about a similar process at work today among conservative institutional investors who use broad diversification to justify their large exposure in untested areas. Diversification is not a guarantee against loss, only against losing everything at once.


He warns us against many of the now obvious risks financial firms were taking.  He warns us against the dominant financial planning strategies being put out there by those attracted to computer analysis of the past.  He lays bear the reality of investing; part belief part analysis, part luck!

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