Nobel Laureate in Economics and MIT professor Robert Merton has written an excellent article on Innovation Risk in the April issue of Harvard Business Review. Here’s one of the most valuable excerpts, which gives a good high-level overview of the whole article: “Some models turn out to be fundamentally flawed and should be jettisoned, while others can be improved upon. Some models are suited only to certain applications; some require sophisticated users to produce good results. And even when people use appropriate models to make choices… it is almost impossible to predict how their changed behavior will influence the riskiness of other choices and behaviors they or others make.” If you only care to remember three sentences about decision-making, make it those three. You’ll already be ahead of the pack.
I also liked Merton’s brief discussion of the Black-Scholes formula in option pricing, which he helped develop, the 2007-2009 financial crisis, which he mentions to illustrate unintended consequences, and his use of pi to make his point about models: for instance, using a value of 4.14 for pi is clearly wrong (although incorrectness may be difficult to spot), while a value of 3.14 or 22/7 is simply incomplete, but may be appropriate in applications such as high school exercises.
He also makes a valuable aside in a side box about the credit-rating debacle, a good example of “how adopting a model not fit for your purpose – in this case, using a model for predicting the likelihood of default rather than one for valuing bonds to manage the portfolio – can result in disastrous decisions.” Another side box focuses on systemic risk.
Merton’s framework can be summarized in the following five steps:
- Recognize that you need a model for making judgments about risk and return,
- Acknowledge your model’s limitations,
- Expect the unexpected,
- Understand use and user (“A model’s utility depends not just on the model itself but on who is using it and what they are using it for… A model is also unreliable if the person using it doesn’t understand it or its limitations.”),
- Check the infrastructure, i.e., the environment into which an innovation is introduced.
This will without a doubt emerge as one of the most important HBR articles of the year.