May 15, 2012
The seeds of the next crisis have already been sown, according to James Montier – and they are fundamental flaws buried deep within the current theory and practice of finance. Bad models were the root of the financial crisis, Montier said, and a slew of behavioral biases are reinforcing financial instability today.
Montier is a member of the asset allocation team at Boston-based Grantham Mayo van Otterloo. He delivered the opening keynote presentation on May 6 at the CFA Institute Annual Conference in Chicago.
A mere four days later, JP Morgan’s CEO, Jamie Dimon, revealed that his firm lost $2 billion because of a derivatives-trading strategy that he deemed ill-conceived and poorly executed.
Montier did not mention Dimon or JP Morgan in his talk, but his warnings about the limitations of banks’ risk management tools all but foretold the disaster.
Dimon steered his firm away from the losses that befell other banks during the financial crisis, building a reputation as a shrewd risk manager during his time at the helm of the nation’s largest bank. But, as Montier warned, financial theory still lacks the tools to fully understand and manage risk, leaving practitioners vulnerable to predictable surprises.
The financial industry is guilty of a “massive neglect of risk,” Montier said. He blames our under-appreciation of Black Swans and our inability or unwillingness to confront what he called “predictable surprises.”
“Predictable surprises are really about situations where some people are aware of the problem,” he said. “The problem gets worse over time and eventually explodes into crisis.”
Montier offered some advice to investors for navigating the dangers posed by flawed theory, but first let’s review what he identified as the failures of modern finance.
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