Model Risk

Fundamentals of Market Investing by Adam J. McKee

Since the advent of cheap computing power, statistical models have become the norm on Wall Street.  For every good old fashioned value investor out there, there is a “quant” that is predicting the future of companies or stocks using prediction equations.  These models are by definition a distortion (usually a gross oversimplification) of reality and are prone to error.  These models are also used by high-profile rating and investment firms, and errors in those models can hurt the price of stocks, at least in the short run.  Ultimately, incorrect models should be proven incorrect, and the stock price should recover.

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