Let’s hope someone posts in every quant meeting room that “in theory, theory and practice are the same thing, but in practice they’re not.”

And directly beneath it?  “the market is flawed because all human constructs are flawed.”

(Economics, markets…is not a science; it’s more like an offshoot of psychology.)

I have already commented on why Prof. Taleb’s black swan critique of quantitative risk models, while real, is superficial, rather, the primary concern should focus on the efficient market hypothesis (EMH) as an underlying theory of financial models, go to the link below for more information:
http://www.theastuteinvestor.citymax.com/page/page/1425688.htm

However, financial risk modeling has an interesting almost haphazard history which further complicates bank “stress testing” ongoing today. Harry Markowitz, the father of modern portfolio theory, for which he received a Nobel Prize in Economics in 1990, in his 1952 paper in “The Journal of Finance” assumed market efficiency, because his entire theory relied on stock prices being random variables, and a normal distribution to model stock returns because mean and variance would then be the only two measures that investors need consider. Mean, is desirable, and equated to “expected return” and variance of return, is undesirable, and assumed to adequately model “ risky-ness of the investment.” Markowitz never explained why variance/standard deviation measures of price volatility should be a good proxy for the “risk of loss,” although academe readily accepted it.

Warren Buffett criticized using volatility measures for risk measurements because that precludes knowing anything about the company’s intrinsic value. A company’s stock which is highly volatile would be considered mean-variance risky, however, if that same company had a very high intrinsic value and the stock price dropped to the low of its range, Buffett would then rightly consider the company to be a buy and a relatively risk-less purchase. Buffett’s explanation is logical while Markowitz has a mathematical solution in search of a problem, or as Yves Smith would say, “computational convenience trumped empirical findings.”

Eric L. Prentis is the author of “The Astute Investor” and “The Astute Speculator.”