Still, the natural tendency to assume that all risks are to the downside is the larger problem/ The converse is the idea that upside moves are the natural order of things (we worry more about a stock that goes from 70 to 50 than one that goes from 30 to 50).

Standard deviation should be indifferent to the direction of a move. Moreover, the only demonstrable long-term tendency is for markets to revert to a mean (or, as the historical data reveals, to overshoot on both sides of the mean).

Mean reversion suggests the greater “risk” is for markets that are above trend to go down, and for markets that are below trend to go up. That doesn’t guarantee that an above-trend market will fall tomorrow - or even next year. Rather, it would suggest the risks are to the downside, because the longer a market is above or below some reliable measure of trend or value, the more likely its direction will reverse. Using many of the tools of volatility and VaR, however, we can catch one side of this tendency but not the other.

Little wonder, then, risk management utterly failed Wall Street precisely when it was most needed. In VaR’s defense, Nocera cites Goldman Sachs (GS), which adjusted its metrics after a series of money-losing days. It’s kind of a limp vote of confidence, however, since Goldman subsequently took its lumps on massive write-downs, and only federal intervention with AIG (AIG) reduced its astounding exposure to counterparty risk in the CDS market.

Flawed risk metrics and greed brought the financial system to the brink of collapse, but there are 2 final reasons why the crisis became a calamity. One is leverage; the other is Wall’s Street inherent herd instinct. Risk metrics gave the green light for living dangerously, and greed supplied the motivation. Leverage provided the rocket fuel and made statistically improbable events fatal.

Perhaps most importantly, what made these fatal but supposedly rare events likely was Wall Street’s tendency to say “me too” when anyone finds a money-making strategy. If Wall Street was a football league, the teams would only play offense, every coach would run up the score, and everybody would use the same set of plays.

Put it all together, and you have an ugly picture. Risk metrics gave the financial community the illusion of a precise measure of risk - “Look, we know our risk carried out to 5 decimal points!” The embedded optimism in VaR’s assumptions enabled financial institutions to increase their leverage (and compensation) beyond what prudence might allow for a true estimation of risk at any given point.

The leverage narrowed the firm’s margin of error, and -- with every other firm doing the same thing -- markets simply froze when a series of improbable events (delinquencies in mortgages that exceeded historical norms, counterparty insolvencies in derivatives transactions, etc.) became reality.

Could it have been otherwise? Yes, but not with the compensation incentives that have governed the financial industry in recent years. At Merrill Lynch, Jeff Kronthal, the Head of Global Principal Investments and Secured Finance, began warning about the dangers of mortgage-backed securities in 2006. Kronthal is a certified expert on these bonds, having earlier worked with Louis Ranieri, one of the Salomon Brothers team that first developed mortgage-backed bonds.

In 2006, packaging mortgages was one of Merrill’s most profitable activities. Had Stanley O’Neal listened to Kronthal, Merrill would still have taken some losses, but the big investment bank would arguably still be independent today. Instead, Kronthal was fired.

Like the target audience of perfume advertisements in Vogue or Elle, Wall Street loves its illusions.