The Risk of a Greek Tragedy

drachmaRather than duplicate the entire article here, I’ll simply point you to the Investor Analytics Blog, where I posted my article about the Grexit.

Risk Management on Wall Street and at the Supreme Court

pink-dress-shirt-black-striped-tie-black-belt-black-pantsOne of the first things I noticed as I started my early morning commute today was the number of men wearing pink shirts. On the train, on the ferry from Hoboken to Wall Street and on the streets of lower Manhattan pink shirts seemed to be everywhere. The gym was packed with guys wearing pink shirts too — and when I commented to one of them that we were both wearing pink shirts, he opined that “it’s a low risk choice: it’s a Friday in the summer.” Doing something ‘daring’ becomes easier the more people who accept the behavior. And if a slight majority is ok with it, it ceases to be daring at all. It becomes a low-risk choice.

Gay marraige graph

Click to Enlarge

Which brings me to today’s Supreme Court decision.  Without commenting on my reaction to the decision, it seems to be a low-risk option for the Justices: US opinion polls shows a slight majority of people across the country supporting marriage equality for the first time about 3 years ago. Among 18 to 29 year old voters, the trend is much stronger with 78% of them in favor of equality according to Gallup. While I don’t pretend to know what goes on inside a Supreme Court Justice’s head (I simply do not think like a lawyer does), each one of them must be fully cognizant that the tide of history is clearly on the side of equality. It had became the low-risk decision.

I think I may start to wear pink shirts to work more often.

The Magic of Mean Reversion: More Than Meets The Eye

While each flip is random, the aggregate is not.

While each individual flip is random, the aggregate behavior is not.

I flipped three heads in a row on the crowded floor at a conference. No big deal. The next toss comes up…heads. Some eyebrows are raised as I prepare to flip again…heads. That’s 5 in a row. A small crowd gathers. “He’s due for a tail” someone says as my thumb flicks the coin into the air…heads. “What are the odds?!” I hear. Someone chimes in – “the odds are growing that he’ll get tails next time.” The coin flips through the air once more…

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The Pre-Mortem: sidestepping disasters before they happen.

Projects fail for many reasons, even after enormous effect and planning.

Projects fail for many reasons, even after enormous effort and planning. Pre-mortems can help avoid disaster.

Let’s suppose your team needs to decide whether to pursue a project (investment related or not), and it’s time to discuss the risks. What’s the best way to do it? Gary Klein, a research psychologist and currently Senior Scientist at MacroCognition, found that ‘prospective hindsight‘ — imagining that an event has already occurred — increased the chances of identifying the reasons for failure by 30%! In any risk management context, that’s worth learning more about.

Enter the Pre-Mortem.

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Model Risk and Financial Charlatanism

But when we modeled it, the brakes worked!

But when we modeled it, the brakes worked!

One of the hot buzzwords in financial risk management these days is “Model Risk”, as if this concept is in some way new. Unfortunately, it’s only recently – a full 6 years after the onset of the Global Financial Crisis (GFC) – that the idea of Model Risk is getting wide coverage. The concept is rather simple: in essence, it says that a model is, well, just a model. It’s not reality. But since we quants / financial engineers / “rocket scientist” types tend to put things a bit more quantitatively than that, the notion of Model Risk includes what’s called “goodness of fit” or measures that assess the appropriateness of a given model for a given situation. They help you understand when the model may need tweaking, may no longer be appropriate or if it’s predictive value may have fallen too low to use. I take pride that Investor Analytics was the very first risk management specialist firm on Wall Street to actively share the results of our Model Risk measures. It wasn’t easy: for many years before the GFC people thought we were a bit nuts to call attention to the limitations of models in our industry.

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Italy’s Penchant for Convicting Scientists

No, this post isn’t about Galileo’s persecution and how Italian authorities suppressed scientific advancements for the past four hundred years.  But that tradition appears to be alive an well on the Apennine Peninsula.  After today’s verdict – in which seven geophysicists were convicted because they didn’t predict an earthquake– all I can say is that Italy really doesn’t deserve to have scientists anymore.  Four hundred years ago they burned Giordano Bruno for his heliocentric beliefs.  Ten years later, they confined Galileo to his house for the same crime.  Today, they convicted seven risk experts for not predicting an earthquake.

The earthquake leveled L’Aquila.

It is sad but true that the Italian city L’Aquila lies in what you might call earthquake alley.  It’s been hit many times in the past and I’m quite sure it will be hit again.  But the matter before the court was about the quake that struck on April 6, 2009 and that geologists in charge of risk didn’t warn the people enough.  The prosecution stressed that their crime was not an inability to predict the quake, but rather, that they did not adequately characterize the risks to people who live on a peninsula known around the world for catastrophic volcanoes and earthquakes.

Let that sink in a bit.

You can read the BBC account of the verdict here.  It stretches the farthest limits of my imagination to try and understand this court’s decision.  It demonstrates a complete failure to understand risk, chance, probability and uncertainty.  The prosecution maintained that the scientists made misleading statements and used the power of authority to put people in danger.  Well, duh.  Probabilities – chance – is inherently unclear and difficult to understand.  To all but the most knowledgable experts, this stuff is misleading, difficult to grasp, and easily misinterpreted.  And fundamentally, it is impossible to ‘adequately characterize’ the risks of a single event.  It’s impossible — even after you know the result!

If I make a probabilistic prediction that something has an x% chance of happening, it is fundamentally impossible to know if I was right or wrong by looking at only one event.  If I say there is only a 2% chance of rain tomorrow so you don’t need to take your umbrella and then it rains, that doesn’t mean I was wrong.  It’s quite possible that we just happened to have been in the 2% zone of “rain.”  In order to test my accuracy, I need to make several predictions and each of then needs to be tested.  And it is impossible – not hard mind you, but impossible – to correctly determine if a probabilistic prediction is accurate with only one observation.  In today’s court case, the judge clearly believes that the risks were higher than the scientists said.  This is probably the case because he only sees this one result – which was unfortunately fatal.  But he fails to understand that a fatal earthquake can occur even if the chance of it happening is extremely small.  And the chance of an earthquake happening at any point in time is extremely small.  So exactly how much warning should the geophysicists have given to these inhabitants of earthquake prone Italy?!?  Not more than it deserved, which is about as much as they gave.  Accurately.  His ignorance of probabilities results in a no-win situation to anyone who understands even the basics of risk management.

I can get quite passionate about science, education, and about a real need to understand probabilities even on a normal day.  In this case, my blood is boiling.  It’s simply sickening to think that experts’ careers are over and they are suffering in jail because the person in charge of deciding if they should suffer is ignorant of a basic understanding of what they’re accused of failing to do!

The seven scientists were sentenced to prison and barred from holding public office after only four hours of deliberation.  They were all members of the National Commission for the Forecast and Prevention of Major Risks.  I wouldn’t be surprised if all of the other members resigned today and left.  I know I would.

Is It Better To Have Loved and Lost?

Alfred Lord Tennyson may have had a thing with words, but he didn’t always get his facts right.  But then again, a good poet never let reality get in the way of composing compelling verse!  On this Valentine’s Day, let’s take a closer look at Tennyson’s haunting words (In Memoriam: 27, 1850):

“I hold it true, whate’er befall;
I feel it, when I sorrow most;
‘Tis better to have loved and lost
Than never to have loved at all.”

According to both behavioral economists and recent advances in neuroscience, it’s actually much worse “to have loved and lost / than never to have loved at all.”  In fact, it’s twice as bad to lose the same amount than to gain it.  The amount of pleasure we extract from winning something is about 1/2 the amount of pain we feel at losing the same amount.  In other words, losing a love imposes as much grief as there is pleasure in having two such loves.  Perhaps Tennyson should have written:

“The mind holds it true, whate’re the mood
Avoiding loss is what we do;
To have loved and lost is as bad for us,
As loving twice is good.”

I know, I know: “stick to your day job.”  So why do behavioral economists claim that the pain associated with losing something is twice the strength of the pleasure at gaining the same thing?  Here are three supporting stories:

  1. They’ve conducted plenty of experiments with physical objects (coffee mugs seem to be the canonical choice) in which students are divided into two groups: mug owners and mug purchasers.  The owners are allowed to take the mug home that night and the next day they have to sell the mug to one of the ‘buyer’ students.  Sellers usually want about twice as much as the buyers are willing to pay.
  2. Imagine a simple game of fair chance (50/50) in which you bet a certain amount of money.  Tails, you lose your money.  Heads, you win $X.  When people are asked what value of $X would entice them to play — the answer is that X has to be twice the amount you can lose.
  3. In brain studies, they have measured a factor of two in the sensitivity of the brain to pain than to equal pleasure.  For some reason, getting and losing a certain amount of gourmet chocolate is the canonical prize.

In all of these studies, it seems that the human brain is twice as sensitive to an object’s loss than to its gain.  If only poets read more science, they might get it right!

But hang on … perhaps Tennyson knew this all along, and his words are meant to express how valuable love is in the first place – so valuable that it’s worth the (doubled) pain of loss!

Now that is completely irrational.  And it’s also very human.  🙂

No (prospect of) Pain, No (prospect of) Gain

Did you know just about every year, someone falls to their death from the Rim of the

Following the Park Ranger along the Kaibab trail.

Grand Canyon, but that no one has ever fallen off the trail while hiking into the Canyon?!  When I heard this – from the National Park Ranger who was guiding us down the one and a half mile South Kaibab Trail to Cedar Ridge in the Canyon this past summer – I couldn’t help wondering why.  The trail is somewhat narrow – about six feet wide, with a sheer drop on one side.  But the Rim has a sturdy fence or stone wall to protect all those would be Ansel Adams-es.  Why do people fall at the Rim but are OK on the trail?  The explanation I settled on last summer came up in a conversation last week on a seemingly unrelated topic: how to grow a successful business.

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Downward Trend Risk

“Will the trend continue?  Will the numbers keep dropping?  They’ve been getting worse — every day! — for several months now.  It’s already getting quite bad and it’s only getting worse.  What can we do to reverse the trend?”

I’m not talking about the stock market or the value of European Sovereign Debt.  I’m talking about the number of hours of daylight for people living in the Northern Hemisphere.  Historically, humans did a lot of [what we now consider] crazy things to reverse the very real and downward trend of diminishing sunlight through the fall months.  In other words, they did whatever they could to get the powers that be to increase the number of daylight hours.  Their actions – some gruesome and tragic – were based on their understanding of how the diminishing sunlight phenomenon worked.  Similarly, our actions today to reverse downward economic trends are based on our understanding of how markets work.  My claim is that the current understanding of our economic issues is not much better than the ancients’ understanding of the dynamics of planetary orbits and the Winter Solstice. Read more of this post

NTSB for Financial Services

This is not a new idea – lots of people have called for financial regulators to set up a body for markets that resembles the NTSB.  It isn’t even all that brilliant – it’s more like the proverbial no-brainer.  Why don’t we have an NTSB for Financial Services?  Why don’t we treat market crashes the same way we treat airplane crashes?  The National Transportation Safety Board has made airline travel (and railway, ferry and other public transit)  extremely safe in a relatively short amount of time.  How did they accomplish this feat?  Simple – every time there is an accident, or a near accident, a team of investigators figures out what caused the accident/incident and then regulations are put in place to prevent that particular thing from ever happening again.  Airlines are required to adhere to the new rule.  Required – as in “you don’t fly if you don’t do this.”  The NTSB’s origins can be traced to the Air Commerce Act of 1926 in which Congress required the Department of Commerce to investigate the causes of airplane crashes.  At first the benefits were slow in coming.  But over time air travel has become much safer.  Sure, it takes time to investigate and it takes time to enact the appropriate new regulation, and the process is far from perfect.  But it works.  Today, I am completely comfortable getting on a commercial airliner (in the developed world) because of this.  It has reduced the accident rate to a negligible level.  And as long as this process continues, air travel will remain safe.

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Darwin Day 2011

Today is Darwin Day — the 202 anniversary of Darwin’s birth on February 12, 1809. Theodosius Dobzhansky (try saying that three times), a Ukrainian American biologist, is credited with saying that “nothing in biology makes sense except in the light of evolution.”  I think it’s fair to extend that well past biology – natural selection applies to a great many different systems including of course, economics.

Eric Beinhocker chose to entitle his groundbreaking book “The Origin of Wealth,” a clear echo of Darwin’s masterpiece “The Origin of Species.”  Actually, Beinhocker’s full title is “The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics.”   Not everything he writes about is directly related to evolution, but evolution plays a central role in the explanation of how the economy works.  Daniel Dennett – one of the greatest philosophers of our time – has described evolution as a method for “creating design without a designer.”  That sums up why evolution is so important: it shapes the participants into ‘better’ and ‘better’ designs as the environment around them changes.

When I started this blog and I created my reading list I included Beinhocker’s book and added “Everyone in the world should read this book.”  I really do mean that.  It’s not just that his book is well written and a joy to read.  It’s also that the contents are just that important. Read more of this post

A Childish View of Risk

Figure 1: Teenagers are missing part of their brains. Click the image for full size.

As a parent of three – my kids are 14, 11 and 9 – I try to teach my children how to make better choices.  It’s easy to just tell them “do this” or “don’t do that.”  Sometimes they even listen.  But what I really try to do it have them understand what’s behind the decision – what makes one activity safe and another dangerous.  For those readers who don’t have children, this is much harder than it sounds.  When I say something like “don’t you think that was a dangerous thing to do?” my children’s first reaction is usually something like “but Dad – Nothing bad happened!”  Their justification for taking a risk is that they didn’t get hurt.  “See – I’m OK.”  Read more of this post

Brains at the Museum

Yesterday, I spent a lovely morning with my family at my singularly favorite place in the entire world: New York City’s amazing American Museum of Natural History.  What drew me there was a new exhibit on the brain.  If you live anywhere near NYC, I have one very short word for you: go. Read more of this post

The Risk of Not Arbitraging

Comments are more than welcome – please take a moment to comment.

While I was traveling on business recently, my wife called one morning to tell me we had lost electricity in the house, and at the end of our discussion I reminded her to call the power company to report the outage. “Oh, the whole neighborhood has been out of power for hours – I’m sure someone has called by now” was her reasonable answer. But on second thought, I wondered “what if the reason that you’ve been out of power so long is precisely because everyone assumes that someone else has called, so no one has actually called?” I figured that given that it doesn’t cost too much time to call the electric company (but perhaps lots of frustration), it’s probably worth giving them a call so I repeated the suggestion. A few minutes afterward, I got this text from my son: “You were right, no one has reported an outage…Mom asked me to text you.” Even though everybody on the block had a vested interest in calling and ending the power outage, it took my wife’s call hours later to let them know that there was a problem [why they don’t have sensors to monitor this sort of thing is the topic for some other blog]. But most people, quite clearly, didn’t call, presumably because they also thought someone already had. The same psychological phenomenon – expecting someone else to do the deed – has been shown to prevent people in a busy city from helping someone who is laying on the sidewalk, possibly suffering a medical emergency, even in broad daylight. Psychologists tell us that if you ever find yourself losing consciousness on a busy city street, the best things you can do to save your own life is to get someone’s attention – anyone’s – and look them in the eye and tell them “get me help.” The combination of eye contact – to make it personal – and an authoritative tone might just save your life. Otherwise, you could lay there dying as hundreds or thousands of passersby assume that someone else has or will stop to help you. Read more of this post

I’ll Gladly Pay You Tuesday for a Hamburger Today

Yesterday’s Wall Street Journal article about Facebook’s privacy issues and this morning’s NPR story about people giving up private information in order to play games got me thinking about the risks people face by agreeing to something pleasureful today, only to pay for it some time later.

Wimpy, the man who will gladly pay you Tuesday for a Hamburger today!

Pay Tuesday, Play Today.

Just like poor old Wimpy, Facebook users are being tempted by something they want immediately – in this case, it’s not about a moist delicious burger but about playing one of the popular games that a friend just invited them to play, like MafiaWars or Farmville.  Never mind if you like these games or not – the point is that many people play them and that means we can learn something about risky behavior from them.  The price for access to the game is giving up some personal information – birthday, location, friend list, possibly income info, etc.  The risk, of course, is that the information is used in ways the person doesn’t approve, such as targeted advertising or examining friends’ credit ratings to estimate your likelihood of defaulting (after all, we are judged by the company we keep).  In order to be allowed into the game, you have to agree to share the information.  And given how many people play these games, it’s quite clear that many feel it’s worth the price.

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Risk at the Limit

You have a problem.  A big problem.  And it’s unfortunately a common problem for a Risk Officer.  What do you do when your risk measures are all in the red zone except for one of them, which happens to be your boss’s favorite?  And he just happens to be the Head Trader of your fund.  It’s like an engineer telling the captain of the ship that the engines can’t go any faster – “Captain (in good Scottish brogue), I’m givin’ it all she’s got.”  To which the Captain replies “No, Scotty, look at this other gauge – it says we’re only at half capacity.”  Which gauge is right – the captain’s or the engineer’s?  Fortunately, there is a way to tell.  Unfortunately, captains don’t like to accept it when they’re wrong.

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Beta to the Max

Last week, I was having a really hard time explaining myself until I realized that I was trying to explain in words how to take advantage of the fact that humans perceive images faster and better than we perceive words or numbers.  This has a lot to do with our evolutionary history and with behavioral finance.  My example was the interpretation of a fund’s beta – and my point was that it’s really really hard to get the right interpretation from the numbers without the right picture.  In this case, the right picture makes a BIG difference.  It was really frustrating trying to give an example of what I meant until I realized that I was suffering from the same thing I was trying to explain!  Wow, I guess I really can be that thick.  I should have been showing her the pictures rather than talking about them.  So that’s exactly what I then did. Read more of this post

Alphabet Soup

Note: this posting originally appeared in IPE (Investment & Pensions Europe) on January 4, 2010.  This version differs only in that I converted spellings to standard American English.

04 Jan 2010

W, U, V, L? It’s all a symptom of the misleading ‘patternicity’ that dogs traditional macroeconomic thinking, argues Damian Handzy

Much has been written about the shape of the recovery. Will it be ‘V-shaped’, implying as swift a return as we had a drop? Will it be ‘U’-shaped, implying a period of low economic activity before a swift return? Will it be ‘W’-shaped, implying a second crash before an eventual recovery? Perhaps it will be €-, £-, ¥-, or $- shaped, implying that some lucky country will lead the way and benefit handsomely while it does so. If I am forced to pick some symbol for the shape of the recover, then my choice is the Chinese characters 不 and 複, the first of several that together represent ‘uncertainty’ and ‘complexity.’

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Opportunity Risk

If you don’t want to read about September 11, I suggest you skip ahead to the alternative introduction.  My brother’s Facebook post today, that he’s glad I wasn’t hurt in the attacks, got me thinking about how different things would have been for my family had I died that day.  My first thought was that my youngest child would not have been born and I was deeply saddened that we (or rather they) would have never gotten to know that wonderful person (after I did the math, it turns out she had already been conceived but I ran with the notion that she had not, just to see where it took me).  In this case, the risk was not of losing something valuable (the father), but rather the risk of never getting something good (the future child). We don’t usually think of risk this way – risk is almost always cast as the risk of losing something you already have.  It’s not cast as a chance of not getting something beneficial that you don’t yet have.

Alternative introduction: One of the most amazing things I was taught by a college physics professor was to think of time flowing “backwards.”  When I first heard of this, it was just bizarre to me.  But she was persistent: “nothing in the equation forces time to flow in a particular direction, so it may help your understanding, if you think of time flowing backwards,” she told me.  When I entered financial services several years later, that’s exactly what helped me understand short selling.  Instead of buying low and selling high, a short seller is first selling high and then at a later time buying low. Conceptually, it’s no different than traditional investing except with the arrow of time flowing in the opposite direction (of course, in practice, it’s very different because of borrowing requirements and other realities).  I decided to apply this “time reversal” concept to risk management: instead of thinking about risk as the risk of losing something you have (today), why not think about a different kind of risk: the risk of not getting something you want in the future.  We don’t usually think of risk this way – risk is almost always cast as the risk of losing something you already have.  It’s not cast as a chance of not getting something beneficial that you don’t yet have.

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