Does your adviser really understand risk?

And should you find out sooner rather than later?

Mencken. Clear, simple and wrong

Benoit Mandelbrot had a beautiful mind for risk.

A Polish-born, French and American mathematician – he was the guy who discovered the idea of “self-similarity” in nature.

You may have heard the term ‘Fractal’ which he coined to describe the beautiful and ‘apparently complex’ shapes in nature.

This extraordinary simple concept explains how snowflakes are formed – and why trees and leaves are shaped the way they are.

It even helps to explain how our lungs and the veins in our bodies acquire their ‘tree like’ shapes.

The truly fascinating thing about all these beautiful shapes is that they’re all, fundamentally, very simple.

They just repeat the same shape, over and over again.

Now, if you’re not familiar with these shapes, watch the video above. They are really quite wonderful.

Fractal image

Mandelbrot’s explanations for how these shapes are formed (from simple repeating processes) have opened up whole fields of understanding in science and nature.

(and as a side effect, they’ve also enabled computer graphic designers to create the incredible, natural looking images we see in computer games and film special effects today)

Okay, so what has this got to do with money or investing?

Well, as long ago as the 1960s, Mandelbrot was challenging the ‘models’ being used to explain the price behaviour of markets (shares, commodities etc.)

Unfortunately, for all of us, his ideas were ignored.

Our ‘establishment’ of economists, bankers and regulators failed to properly manage the risks building up in asset prices.

So what?

Well, the result was the (almost) complete collapse in our financial system in 2008-09.

Okay, but that was back then – and it’s all fixed now, right?

Sorry, No!

We still have a ‘super fragile’ banking system today because all that was done ‘back then’ was to pass the losses from the bad lending of the banks to the taxpayer.

Now, it’s true to say that some of those bailouts might get repaid – as has just happened here in the UK with Lloyds – others will likely not. RBS is not doing so well.

And, as any intelligent economist will tell you – another banking crisis is probably building up right now.

You only have to read Professor Steve Keen’s wonderful (and surprisingly short) new book, ‘Can we avoid another financial crisis?’ for more on that.

So, what’s been going on?

Well, for most of the last 50 years our regulators have chosen to base their rules (or rather their lack of rules) on a flawed theory about self-righting markets.

But as Mandelbrot points out in the wonderful video below

the accepted theory of  RISK hides the ‘hard to explain’ stuff… under the carpet

Well, the carpet is up now 😉

And Mandelbrot’s ideas are not ignored any more – at least not by central banks.

That said, it does seem to be taking a very long time for his ideas to be understood more widely – and taught to financial advisers and those ‘perfect market’ fanatics out there.

Examination authorities, it seems, take a very long time to ‘move on’ from old ideas.

In the meantime, it seems that you really do need to LOOK OUT for yourself when it comes to investment risk

You need to choose your adviser carefully – because it’s clear that some of them don’t have a clue about risk and some are quite happy to mislead you about it.

Read more on that here

Final thought

Sadly, Benoit Mandelbrot passed away in October 2010 so we’re especially lucky that the F.T. managed to capture this interview.

Let’s hope that the world of risk managers and investment advisers catch up with Mandelbrot’s evidence before another 50 years passes!

In the meantime, you might like to read ‘Black Swan’ and ‘Antifragile’ by Nassim Taleb which you’ll find listed among the books IRATE here.

And, if you’re a bit worried about your investment adviser’s knowledge – here’s how you can test them.

And thanks for dropping in

Paul

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