Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

5.1 Value of Simple, Approximate Answers

One theme of this chapter is the value of simple, approximate answers. It is better to have a broad outline of the risk today than a meticulous and detailed understanding one year hence (after the business has blown up). Physics students are taught to estimate orders of magnitude for physical problems. The delightful “Order of Magnitude Physics” (Sanjoy, Phinner, and Goldreich 2006) is devoted to the topic.

Most technical education emphasizes exact answers. If you are a physicist, you solve for the energy levels of the hydrogen atom to six decimal places. If you are a chemist, you measure reaction rates and concentrations to two or three decimal places. In this book, you learn complementary skills. You learn that an approximate answer is not merely good enough; it's often more useful than an exact answer. When you approach an unfamiliar problem, you want to learn first the main ideas and the important principles, because these ideas and principles structure your understanding of the problem. It is easier to refine this understanding than to create the refined analysis in one step.

So it is with understanding financial risk. We always meet new risks and it is incredibly important to have tools and techniques for understanding the main ideas and the broad outline of the risks. Effective risk management occurs when a firm can integrate management expertise with technical skills.