Risk Management: Foundations for a Changing Financial World

CHAPTER 47

THE USE AND MISUSE OF MODELS IN INVESTMENT MANAGEMENT^au

Douglas T. Breeden

Financial models can be extremely helpful in adding disciplined thinking to the investment decision-making process. A failure to recognize some common misuses of models, however, such as overreliance on recent historical experiences and volatilities or a failure to identify nonlinear relationships, makes the use of models less effective than they would be otherwise. Understanding the difficulties and estimation risks associated with modeling complex securities can lead to better investment decisions in the future.

A problem with using models is that they are always imperfect descriptions of economic behavior and human decision making. Although they are often very useful, it is also easy to misuse them. Unfortunately, in the last two years it seems that the latter has been more the case. Oftentimes, we are overconfident in the efficacy of our models. Still, models can be very useful as long as investors remember their proper roles and limitations in the decision-making process.

WHERE FINANCIAL MODELS ARE USEFUL

Having been trained by Bob Merton and Myron Scholes, I became quite familiar with option-pricing models at Massachusetts Institute of Technology (and later at Stanford University with John Cox, Bill Sharpe, and Bob Litzenberger as teachers). When I cofounded Smith Breeden in 1982, I brought this type of modeling to mortgage-backed securities (MBS) when we began building prepayment models. ...