Mckinsey Quarterly has an excellent interview of Nassim Nicholas Taleb, author of the revered book- Black Swan (free subscription required). He says Black Swans are of both types – positive and negative. We should we be careful of latter and be more risky towards former.
What caught my eye was this:
The Quarterly: You question many of the underpinnings of modern financial theory. If you were the dean of a business school, how would you overhaul the curriculum?
Nassim Nicholas Taleb: I would tell people to learn more accounting, more computer science, more business history, more financial history. And I would ban portfolio theory immediately. It’s what caused the problems. Frankly, anything in finance that has equations is suspicious. I would also ban the use of statistics because unless you know statistics very, very well, it’s a dangerous, double-edged sword. And I would ban linear regression. All these things don’t work.
(emphasis is mine)
The Quarterly: What are your concerns with statistics and portfolio theory?
Nassim Nicholas Taleb: The field of statistics is based on something called the law of large numbers: as you increase your sample size, no single observation is going to hurt you. Sometimes that works. But the rules are based on classes of distribution that don’t always hold in our world.
All statistics come from games. But our world doesn’t resemble games. We don’t have dice that can deliver. Instead of dice with one through six, the real world can have one through five—and then a trillion. The real world can do that. In the 1920s, the German mark went from three marks to a dollar to three trillion to a dollar in no time.
That’s why portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.
This is pretty straight forward. Taleb’s criticism for portfolio theory and modern finance is well known. In this FT article he criticised the Nobel Committee for crowning the finance theories.
I also came across this recent piece from Harry Markowitz (Father of Portfolio Theory) where he defends portfoilio theory:
The second objection might go like this, “You, Harry Markowitz, brought math into the investment process with your 1952 article and 1959 book. It is fancy math that brought on this crisis. What makes you think now that you can solve it?”
This objection fails to distinguish between my contribution, portfolio theory, and a later development, financial engineering. A typical application of portfolio theory chooses a portfolio similar to a 60-40 or 70-30 or even 80-20 mixture of stocks and bonds, but more sophisticated, combining more asset classes in a way that minimizes risk for a given level of return on the average.
Financial engineers create new financial instruments from old. This can be a good thing—not all financial engineering is always bad—but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing.
Neither my own portfolio, nor those which my clients supervise or advise nor, to my knowledge, any of the large institutional investors (e.g., pension funds) who apply portfolio theory in a generally accepted manner, have suffered excessively from the crisis of the last thirteen months. Most have lost of course. It is part of a risk-return view of portfolio selection that if you want more return on average, and you proceed efficiently, you will have to accept greater fluctuations in the short run.
This is interesting – difference between portfolio theory and financial engineering. Markowitz says portfolio theory if used properly does not damage as much (if you take higher risks you have to bear with higher losses and vice-versa) but same cannot be said for financial engineering.
Mostly Economics 
