Risk - Fata Morgana

Here is a snippet from a Financial Analysts Journal Article on Models by Emanuel Derman. I like it. It succinctly encapsulates what risk is and what model risk is.

"Risk is future uncertainty. A coin flip is risky. We know the current state of the coin but not its future state. We can, however, perform an infinite number of mental flips and reliably calculate the probability distribution of heads and tails, which will match a physical coin's probability distribution to the extent that the coin is separable from its surroundings and uninfluenced by them. In that sense, a liquid stock price is risky. We know the current price and have no idea about the direction of its future change. But we cannot perform an infinite number of mental stock price moves with any reliability; the stock, the market, and the world are not clearly separable and they do influence each other, so the probability distribution of stock prices cannot be accurately known (and may not be time-invariant). The history of the world does not affect a coin flip. The history of the world does have a bearing on the next change in a stock's price. The risk of a stock price change is qualitatively different from the risk of a coin flip.

Financial models interpolate from liquid to illiquid prices by analogy and must necessarily change over time as the economic environment changes or as market participants become more sophisticated...The term "risk," therefore, inaccurately describes the indeterminate nature of financial models. If we want to describe this state of ignorance as risk, then we must not forget that it is shorthand for uncertainty, for something much vaguer than probabilistic risk. No ensemble of models exists in which each model has a known probability of being right.

The greatest danger in financial modeling is the age-old sin of idolatry. Financial markets are alive, but a model is a limited, human work of art. Although a model may be entrancing, we will not be able to breathe life into it, no matter how hard we try. To confuse the model with the world is to embrace a future disaster by the belief that humans obey mathematical rules."