Thursday, March 25, 2010

Financial Management Requires Polyvalence

A frequent problem in advanced financial management is the task of interpreting (and understanding) probabilistic forecasts. The following exercise illustrates the essence of the problem.

Suppose that the following (very simplistic) financial projection for the “next” period arrives in your hands:

The financial analyst who handed you the report then comments “…the projection is based on historical data…” You focus your attention on the positive net profit number and conclude that the projection looks reasonable based on your “gut.” Having reached your conclusion, you head home to enjoy your life.

Unfortunately, a forecasted numerical value is rarely accurate, because the projected “number” is inevitably “off” by some (often significant) amount.

Contrast the above with this second story. In this instance, the analyst hands you a financial projection for the same next period; the report begins again with the worksheet displayed above. However, the report continues with additional information as shown in the tables and graphs that follow:

After looking over the report, you listen as the analyst interjects that a lognormal distribution was used to model gross revenues based on a fitting of available historical data, and the analyst confides that your feedback regarding that decision would be helpful. The analyst also expresses concern about net profitability for the coming period by predicting “…there appears to be a significant chance that we won't be profitable…” (see the last histrogram projecting a 30% chance of losses). With this information, you call your spouse with a message that you will be working late in the office to “deal with some problems…”

The moral of the story is that a “number” in itself is rarely sufficient information and justification for financial decision-making. In many ways, financial managers must be able to “hear” and “feel” the meaning of probabilistic reporting much like the conductor of a symphony orchestra must hear and feel the meaning of a musical score. Effective financial managers maintain a polyvalent sensitivity toward a complexity of factors and dependencies in order to transcend numerics as guidance for decisions. In this manner, the art of financial economics embraces its science.

Financial managers might take comfort in these words by Nobel Laureate Prof Robert J Aumann (2000, p. 141):
The best art is something that strikes a chord with the viewer or listener. It expresses something that the viewer or listener has experienced himself and it expresses it in a way that enables him to focus his feelings or ideas about it. You read a novel and it expresses some kind of idea with which you can empathize, or perhaps something that you yourself have thought about or experienced. Take a sculpture or a cubist painting. It expresses some reality, some insight, in an ideal way. That is what the best mathematical economics does. It is a way of expressing ideas, perhaps in an ideal way.
By the way, probabilistic (stochastic) reasoning is now integral to finance, so if any of the reporting above is a challenge (for you or your staff), please consider my training and software offerings here.

Source: Aumann, R J (2000). Economic Theory and Mathematical Method: An Interview. In Collected Papers (Vol I, pp. 135-144). Cambridge, MA: MIT Press.

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