In my last post I mentioned physics. Longtime blog readers might remember a thread from 2007 which ended with Final Question on FAIR, where I was debating the value of numerical outputs from so-called "risk assessments." Last weekend I attended the 2009 Berkshire Hathaway Shareholder meeting courtesy of Gunnar Peterson. He mentioned two terms used by Berkshire's Charlie Munger that now explains the whole numerical risk assessment approach perfectly:
Physics Envy, resulting in false precision:
In October of 2003 Charlie Munger gave a lecture to the economics students at the University of California at Santa Barbara in which he discussed problems with the way that economics is taught in universities.One of the problems he described was based on what he called "Physics Envy." This, Charlie says, is "the craving for a false precision. The wanting of formula..."
The problem, Charley goes on, is, "that it's not going to happen by and large in economics. It's too complex a system. And the craving for that physics-style precision does nothing but get you in terrible trouble..."
When you combine Physics Envy with Charley's "man with a hammer syndrome," the result is the tendency for people to overweight things that can be counted.
"This is terrible not only in economics, but practically everywhere else, including business; it's really terrible in business -- and that is you've got a complex system and it spews out a lot of wonderful numbers [that] enable you to measure some factors. But there are other factors that are terribly important. There's no precise numbering where you can put to these factors. You know they're important, you don't have the numbers. Well practically everybody just overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in places like this, and doesn't mix in the hard-to-measure stuff that may be more important...
As Charley says, this problem not only applies to the field of economics, but is huge consideration in security analysis. Here it can give rise to the "man with a spread sheet syndrome" which is loosely defined as, "Since I have this really neat spread sheet it must mean something..."
To the man with a spread sheet this looks like a mathematical (hard science) problem, but the calculation of future cash flows is more art than it is hard science. It involves a lot analysis that has nothing to do with numbers. In a great many cases (for me, probably most cases) involves a lot of guessing. It is my opinion that most cash flow spread sheets are a waste of time because most companies do not really have a predictable future cash flow.
You could literally remove any references to financial issues and replace them with risk assessments to have the same exact meaning. What's worse, people who do so-called "risk assessments" are usually not even using real numbers, as would be the case with cash flow analysis!
Physics envy, leading to false precision, are two powerful ideas I intend to carry forward.
Richard Bejtlich is teaching new classes in Las Vegas in 2009. Regular Las Vegas registration ends 1 July.