We clearly have seen the demise of risk management as we have known it. Nassim Taleb spoke very eloquently about the Black Swan, but I suspect even he did not anticipate a gigantic flock of black swans soiling the world’s financial markets. So, where do we look for a better way?
My math is not good enough to know if some of the new approaches incorporating fractal geometry will be a reasonable solution, but they have the advantage of capturing more of the complexity of the real world than a trivial system of measures based upon unrealistic distribution assumptions. At least it is moving in the right direction by looking to capture the true complexity that we see around us every day.
Who is the ultimate hedger? Mother Nature. She has been protecting her portfolio of life for billions of years. She has suffered more black swans than we could possibly imagine. Forget working on the development of a species for millions of years and reaching an evolutionary dead-end. She can model that using normal distributions and hedge it simply by having enough uncorrelated projects. You want a BLACK SWAN? How about an enormous meteorite slamming into your planet and wiping out 97% of life?
You may be asking yourself, “Isn’t that what just happened to the world’s financial markets?” Well, not really. A number of people saw the crisis coming and were able to profit from it. What just happened is related more to chaos theory, hence the reference to fractal geometry above. In chaotic systems, it is very difficult, if not impossible, to anticipate results from even small inputs. Thus the concept of the flap of a butterfly’s wings causing a tornado. On the other hand, very large disturbances to the system may end up causing very small results. Credit redistribution was supposed to make the system better able to withstand shocks. It turns out exactly the opposite happened.
Someone smarter than me is going to have to figure out where to take the Mother Nature analogy as far as actual modelling goes. From what I can tell, the fractal geometry approach is a good start. The one thing that I would point out though is that even Mother Nature lost 97% of her NAV and it took a long time to make it back. But she did. As will we. Truly horrible things do happen and virtually everyone loses. You do what you can to hedge your bets, learn from your mistakes and get on with life.