Monday, June 22, 2009

Financial modelers need to THIMK!

There was a cartoon from many years ago showing a man sitting at a desk. His eyebrows were furrowed and he was obviously deep in thought. He had a sign above him that read THIMK!

Long time readers of these pages know that I am an advocate of modelers to think long and hard about the assumptions behind their models before turning them on. Unfortunately, many are thimking instead of thinking.

Here is another example.

Using Altman Z for financials?
I recently participated in an online discussion in response to a financial modeler’s question about applying Altman Z to financial companies. (See my previous discussion on the limitations of Altman Z here.)

If you don’t know the Altman Z, the formula is a function of liquidity, balance sheet strength and earnings power:

Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets

The formulation was originally conceived for operating industrials, not financials. It appeared to me that for someone to even ask the question about applying Altman Z to financials indicates that he hasn’t sufficiently thought about the assumptions behind the model.

You could plug it the numbers, it would give you an answer. GIGO: Garbage In, Garbage Out. It would be as useful as newly minted MBAs trying to apply Black Scholes to fixed income instruments.

The Financial Modeler’s Manifesto
Over at his blog, Paul Wilmott posted the Financial Modeler’s Manifesto, which starts with an echo of the Communist Manifesto:

A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.

It concludes with “Modelers' Hippocratic Oath”:

~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

I wholeheartedly agree. Read the whole thing. Examine the assumptions in your models and apply them intelligently. If you haven’t seen Wilmott’s Newsweek profile, it’s also well worth a visit too.

Happy modeling!

1 comment:

Dieter said...

For your international readers, who might not understand the meaning of 'Thimk':

"The classic IBM 'THINK' sign was said to be a permanent feature of IBM offices around the world until the 1970s. The 'THINK' concept as company mantra originated with IBM founder Thomas J. Watson Sr. in the 1940s and was often parodied outside of IBM (in the.shtmls of Datamation, for example) when this high standard went occasionally unmet....
The IBM sign that said THINK was immensely popular in the business world for decades. The simple sign was seen everywhere. Then, in the late 1950s, there was a counter-fad: signs saying THIMK began springing up in offices and schools. The point was that whoever wrote the sign obviously was not following his own advice, since he could not "think" well enough to spell the word "think" correctly!
The THIMK sign originated in (or at least was popularized by) Mad
Magazine. Ironically, a rival humor magazine later named itself THIMK.
Imitation is the sincerest form of flattery!"


Thanks for your interesting blog.