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ntro Stats: Islamic Approach -- Part 2: Probability and Statistics -
Lecture 1: Random Samples, Concept 1: Models and Reality Slide 6: Confusing Models With Reality
6: Confusing Models with Reality
Even though models are simplified idealizations of a complex reality, and hence are NEVER the same as the reality, THEY ARE OFTEN CONFUSED with the reality. This mistake happens AGAIN and AGAIN. It is called mistaking the map for the territory. In probability theory, this has happened in many different ways, which has caused a large amount of confusion in the understanding of what probability is. Probability models are simplified representations, which allow us to make some crude calculations about the real world. They can be more or less accurate but are NEVER perfect. People who think that there models are perfect end up making HUGE mistakes. One example is given below. Noble Laureates Scholes and Merton used their models to devise very successful stock market trading strategies -- but they did not realize that there models were approximations, and took risks which were VERY LARGE in reality, even though the model said these risks were VERY SMALL. The model was WRONG, as a crisis showed
LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".[3] Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.
When Genius Failed - The Rise and Fall of Hedge Fund Long Term Capital Management.
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