We Failed to Learn From the Hedge Fund Failures of the Late 90s | Big Think

We Failed to Learn From the Hedge Fund Failures of the Late 90s

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Richard Thaler to overconfident risk managers: there’s more risk out there than you think.

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Richard H. Thaler:

Richard H. Thaler is an American economist. He is perhaps best known as a theorist in behavioral finance, and for his collaboration with Daniel Kahneman and others in further defining that field.

He currently teaches at the University of Chicago Booth School of Business, and is an associate at the National Bureau of Economic Research, and has organized a series of behavioral finance seminars along with Robert Shiller, another behavioral finance expert at the Yale School of Management. Previously he taught at Cornell University and the MIT Sloan School of Management

Thaler has written a number of books intended for a lay reader on the subject of behavioral finance, including "Quasi-rational Economics" and "The Winner's Curse," the latter of which contains many of his Anomalies columns revised and adapted for a popular audience.

Most recently Thaler is coauthor, with Cass R. Sunstein, of "Nudge: Improving Decisions About Health, Wealth, and Happiness" (Yale University Press, 2008).

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TRANSCRIPT:

Question: How can we identify and allocate risk better?

Richard Thaler: I think the people who’ve been the most overconfident in our business in the last decade have been the people that called themselves risk managers. And the reason is they failed to learned the primary lesson we should have learned from when Long Term Capital Management went belly up ten years ago. That is, investments that seem uncorrelated can be correlated simply because we’re interested in it.

LTCM lost money when Russia defaulted on a certain class of bonds, and then they had other investments like on the spread between two different kinds of shares of Royal Dutch Shell Oil Company. Now that seems completely unrelated to Russian bonds. But they were related because other hedge funds saw similar discrepancies and they were all making similar bets.

So the world is much more correlated than we give credit to. And so we see more of what Nassim Taleb calls “black swan events”-- rare events happen more often than they should because the world is more correlated.

I think one lesson we have to learn is that there’s a lot more risk than we’re giving credit to, a lot more what economist calls systematic risk.

I think we also have learned the lesson that we have to have better incentive structures.