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

Optimism Risk?

Time Magazine has a solid article about the optimistic nature of the human mind.  Instead of summarizing its points, I suggest you read it before continuing this post.  While some may complain that I should provide a short version of the pieces I refer to, I think it’s better to take the 10 minutes it requires to absorb the author’s intended interpretation.  Besides, many of my previous posts already summarize it.  How’s that for justification.

Our optimism has obvious implications for how we think about risk and the last paragraph really sums up the situation nicely.  We’re all inclined to overestimate our chances of success and we downplay the negative consequences.  This approach has many benefits to the survival of our ancestors (uh, and for our decedents!) but it can cost us individually because we suffer the consequences when things don’t go our way.  Risk Management is about much more than preventing loss — it’s about keeping us in the game to take advantage of future opportunities.  The author’s last paragraph is key — knowledge about the downside of optimism is a very good way of preventing those losses.

As a very optimistic person, and a risk taker, I’m fascinated by the simultaneity of the benefits of believing we will prevail with the need for limiting danger that directly contradicts that optimism.  Since our brains appear to be hardwired to discredit (and sometimes not even notice) the downside, it’s that much more important for us to learn about how we naturally tend to view the world.  I for one do not plan on trying to be less optimistic.  Rather, I want to better understand the chances of different losses and what might lead to them.  That, it seems to me, gives me a solid chance of having the best of both worlds.

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

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

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

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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Bayesian Learning

We know that probabilities are hard for us humans to understand and estimate.  Even seasoned professionals are fooled by seemingly easy problems (take, for example, Marylyn vos Savant’s Parade Magazine fiasco with the Monte Hall Puzzle), and sports fans around the world are fooled whenever they subscribe to the notion that their favorite player is “due” or is on a streak.  I hope I didn’t just alienate too many readers.

Anyway, today I learned about research that investigates some of the evolutionary origins of our troubles with probabilities, and seems to indicate that even purely rational thinkers would come to the same conclusions if their world view was similarly shaped (skewed?) as ours.  In other words, human decision making should be viewed as rational within a model-based framework, and that our decision making is not consistent with blank-slate / model-free learning.

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