From MachineDesign.com, By Engineers For Engineers:
That sense of security plays directly into what happened with banks and financial instruments based on mortgages. “It gets back to the use of historical data,” says Groenendaal. “One critical assumption people had to make was that the past could predict the future. I believe in the case of mortgage products, there was too much faith in the idea that past trends would hold.”
Therein lies a lesson. “In our experience, people have excessive confidence in their historical data. That problem isn’t unique to the financial area,” says Groenendaal. “You must be cynical and open to the idea that this time, the world could change. When we work with people on models, we warn them that models are just tools. You have to think about the assumptions you make. Models can help you make better decisions, but you must remain skeptical.”
Did the quantitative analysts who came up with ineffective financial models lose their jobs in the aftermath? Groenendaal just laughs at this idea. “I have a feeling they will do fine. If you are a bank and you fire your whole risk-analysis department, I don’t think that would be viewed positively,” he says.
Interestingly enough, Groenendaal suggests skepticism is also in order for an equally controversial area of modeling: climate change.
“Climate change is similar to financial markets in that you can’t run experiments with it as you might when you are formulating theories in physics. That means your skepticism should go up,” he says.
We might add there is one other similarity he didn’t mention: It is doubtful anyone was ever fired for screwing up a climate model.
* Huybert Groenendaal is a partner and senior risk analyst with Vose Consulting LLC in Boulder, Co., a firm that works with banks and other companies trying to mitigate risks. His Ph.D. is in modeling the spread of diseases.