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The Perils of Simplifying Risk To a Single Number
A few weeks back we discussed the perspective that the economic meltdown could be viewed as a global computer crash. In the NYTimes magazine, Joe Nocera writes in much more depth about one aspect of the over-reliance on computer models in the ongoing unpleasantness: the use of a single number to assess risk. Reader theodp writes: "Relying on Value at Risk (VaR) and other mathematical models to manage risk was a no-brainer for the Wall Street crowd, at least until it became obvious that the risks taken by the largest banks and investment firms were so excessive and foolhardy that they threatened to bring down the financial system itself. Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future. Reliance on models created a 'false sense of security among senior managers and watchdogs,' argues Nassim Nicholas Taleb, who likens VaR to 'an air bag that works all the time, except when you have a car accident.'"
Hmmmm. Math or "subjective degrees of belief about the uncertain future".
I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel. Seems my supposition is being proven correct more and more each day.
Until recently, it was the smaller guys in the stock market that were getting screwed and the whole system kept the thievery down to a manageable level. Now from the largest, to smallest, they all seem to be getting destroyed, American in ruins, and the previously rich and powerful with outstretched hands at the Feds.
Of course maybe that is too cynical, but I always saw the stock market as rigged from the beginning. What do I know though? :)
So what's the VaR of using VaR? :)
When you don't have a leg to stand on, don't even get up.
I don't think that the problem is a single number it is connectivity. You might think that if you have three investments with a 10% risk of losing £1,000,000 the chances of all three of them losing £1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%. The thing is if one loses that much then the markets may lose confidence meaning the others go down too - they are not independent probabilities.
Indeed we did. And I think we came to the consensus that it was a load of bollocks.
Confucius say, "Find worm in apple - bad. Find half a worm - worse."
Is here any roleplayer that does NOT know how using an artificial value to describe "real" problems automatically leads to some people "playing the system" instead of playing the game?
Nobody here ever had a munchkin in his troupe? A powergamer? A minmaxer? Someone who learned the rules and immediately started to look for loopholes, how to play by the rules without actually taking them serious?
Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?
We used to have a Bill of Rights. Now, with the rights gone, all we have left is the bill.
Mmm. Herd instincts for the lose. But the few financial instituitions that stood against the headwinds are now reaping the rewards. For example, in the UK LTSB is taking over HBOS, despite the fact that HBOS was nearly twice LTSB's size at the height of the boom. The rational players are doing just fine.
[FUCK BETA]
Beyond the style of model, the trouble in finance is the feedback nature. If a big impressive model is developed to price an asset and all of the big boys buy in and use the model, then the model DOES describe the assets price. Because everyone is making decisions based on the model.
That's all great until reality intervenes. Then you have a bubble.
That sort of model feedback has always made finance seem "iffy" to me.
Use the Firehose to mod down Second Life stories!
Objective or subjective models don't mean anything to people who only care about short-term performance. Whether the investment is good or bad in the long term doesn't matter to an investment manager who stands to get a seven figure bonus based on the current year's numbers. So what if the company fails next year? Not his problem.
Liberal economics -- not liberal politics, quite the opposite most of the time -- explicitly derives its conclusions from three assumptions: that individuals make rational decisions, that they have access to information, and that they are free to buy/sell.
Those are pretty reasonable assumptions, and, when they hold, the conclusions tend to hold.
The difference with physics is that when physicists start saying "assuming that this body is of negligible mass and at non-relativistic speeds" they don't end their exposé with "thus we have a solution to the three body problem for three super massive black holes at 0.999 c"
Social psychology has shown repeated instances where rationality is seriously impaired. For example, social proof can make us all really stupid. And cognitive dissonance is a bitch. What do those words mean? When a million idiots do something stupid, you're very likely to think it's a very good idea, too. And the longer you've been doing something stupid without negative consequences, the less likely you are to stop.
Add to that the fact that those "investment vehicles" were designed to conceal information, specifically financial risk, and right here you have two out of three pillars of classic economic theory missing. Is it any wonder the whole thing went down?
Finally, I wonder if any free marketer / libertarian types actually read any Adam Smith. I remember reading a quizz, which unfortunately I can't find anymore, Marx vs. Smith, in which you were asked to identify whom had written what. Very hard to tell them apart in some cases.
Well, it's not so much that they wanted to minimize their risk of being fired as they wanted to maximize their bonuses... But your argument stands nonetheless...
The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc.
The key is not so much making a high ROI, as it was the separation of risk from transaction fees. My local bank would loan to anyone, as they immediately sold the loan and pocketed a transaction fee. They couldn't care less if any payments were made. Very few people realize how "investment"-type companies like banks turned into little more than a commissioned salesforce. And commissioned salespeople only make money on transaction volume, not long term return on investment.
"Science flies us to the moon. Religion flies us into buildings." - Victor Stenger
No, the problem was reducing to a single number, you yourself say that just looking at 95% VaR (2 to 3 times occurence daily over one year) is not enough. You're right they need to consider 95% and 99% VaR, among other levels of risk tolerance...and I know many firms do and have been. I believe the bigger problem was the faulty assumptions in calculating VaR, primarily assuming a standard distribution bell curve. Many portfolios do not have symmetric profit. Also, when prices start to soar or plummet, volatility increases. Furthermore, a random walk doesn't correctly articulate the complex actions of market participants (prone to fear, marriage to a position, etc.) and IMO underestimates the outer reaches of the bell curve. According to this flawed modeling, it wasn't a once in 30 year event being ignored, it was a once in 30 million year event. Obviously it is extremely probable that was an incorrect estimation of the risk, but it wasn't an error of only looking at 95% VaR.
Not quite. Risk models are important. However, at some point comes a very subjective view of how much is at stake with that risk. Let us call this resiliancy.
This is really what most of the western world is missing. Resiliancy.
Resiliancy is an attitude more than just a number. This is really what Taleb talks about with the black swan.
Before, they only knew of white swans. So if someone came up to you and made you a bet that there were only white swans, you would take it. Almost as if someone made a bet with you regarding pigs flying. You would take that bet. However, what happens when you find the black swan, which they did in australia... suddenly if you had made the bet, it could be disastrous.
Even if an action has 99% upside, and only 1% downside, you MUST consider what if that 1% occurs. It is a recognition of the complexity of the world we live in.
Since this is slashdot, it's like coding. It is resiliant to over allocate memory just for resiliancy sake. Maybe I only need an array of 30. Yet, I will allocate an array of 32... just for some safety even if I 'KNOW' it will never get to that point. You sacrifice some optimization for some resiliancy.
I would almost venture to say, most of the western world is operating completely on extreme theory. There is no resiliancy built into the system.
We bet on 'innovation economy' because we don't want to reduce our standard of living to where we are our own farm/textitle/manufacturers.
We bet on housing prices always going up (even though population growth is stabilizing/declining... see Japan/Germany/Italy...).
We bet on providing complete welfare from cradle to grave, giving up on the resiliancy of the family support structure.
The bad thing with all these is the downside risk is extreme... almost catastrophic.
Exactly. And one easy way to game the system is to bet that the authorities will always act to keep markets stable, which you can do by taking risks that would otherwise be stupid. In other words, traders are incentivized to leech off the taxpayer. I'm surprised the crash took so long.
Reduce, reuse, cycle
Economics is not a science.
Science is the application of the scientific method. When's the last time you saw an economist perform an experiment where only one variable was at play?
If he explores all forms and substances Straight homeward to their symbol-essences; He shall not die.
So, does anybody know whether Taleb is rich now?
According to Wikipedia:
W..w..W - Willy Waterloo washes Warren Wiggins who is washing Waldo Woo.
What you appear to be trying to describe is the neo-liberal paradigm. That's not really what I'm talking about, although it is my opinion that it is complete bollocks, but that's just my opinion.
My point is that you can't take liberal economic theory, keep the conclusions and expect them to hold when you've clearly removed the starting assumptions.
On top of that, what you write isn't even logical:
Or maybe, the assumptions are:
- that individuals make decisions which are more rational than if someone else makes it for them
What does "more rational" mean? Classical economic theory assumes that someone is rational in that it will buy something at a lesser price if it can, and will attempt to sell the least of something it's got (good, service, labor ...) for as much money as it can. That's it. How can you be less rational?
In any case, if there is government intervention, which is I suppose what you are against, it's got nothing to do with the rational part of the argument, it has to do with the freedom part of it. And I haven't talked about this.
- that they have access to better information
Again, what does that mean? If gov't regulation forces companies to be more transparent (a la Sarbannes-Oxley), it means less freedom for the company but more information for the market as a whole. It's once more an impact on the third assumption but clearly not on the second.
The rational players are doing just fine.
I smell a common mistake here: "rational players" and "lucky players" are indistinguishable at this point.
That's the problem with markets.
Hell, even with Buffet it is hard to be all one hundred percent sure that he's indeed a genius and not just one really-really lucky dude.
Furthermore, engineered systems have two separate control systems: normal operating controls and independant safety controls. Never the twain shall meet, for often the normal controls exacerbate the situation and must be pre-empted by the safety controls. The more advanced the normal controls (optimization), the more advanced the safeties have to be.
None of this is present in finance. VaR may be all well and good as a normal operating measure, but does nothing in the tail which will blowup. I do not see anything as a tail safety measure institutionalized. What measures are taken are done on "gut feel".
Too late and little comfort for those individuals in the "non-rational" companies who were fired (and possibly saw their careers go down the drain) because they were "too cautious".
For most traders, as an individual the "rational" thing to do was "do the same that all around you are doing and keep your concerns to yourself".
The ones that rode the ride all the way to the crash are the ones that still have millions in the bank from the last 5 years' bonuses.
In a couple of year time when the next boom comes, all this will be forgotten, "aggressive trading" will be all the rage again and caution will be thrown to the winds.
The biggest problem with those creating financial instruments from home loans is that no one tested their models with systemic housing price decreases.
Economist Arnold Kling said that many years ago, Freddie Mac actually did "stress testing" of their portfolios under a 20% systemic real estate market downturn, but during the early 2000's they abandoned this technique.
CDOs did a good job of reducing the risk of early repayment and "random" defaults on mortgages. However it ended up concentrating the risk for a systemic market downturn.
Unfortunately, I am sure that some time in the future there will be another huge systemic risk that both government and the private sector will miss and we'll get hit again. The only thing we can do is keep economic freedom high in the period in-between to allow the economy to restructure (less jobs in building, more in health care, for example) in order to return to growth.
Probability of something going wrong: 1.0
Rethinking email
It's pretty clear what they (classical liberal economists) mean by rational, information and freedom. The definition is part of the theory.
And since this is a theoretical model, it is also understood that nothing in reality fits perfectly.
When people are rational most of the time, are reasonably informed, and have some freedom to buy/sell, market will work for the greater good. That's the theory.
I'm just saying that here people weren't informed, and weren't being rational due to social proof + commitment; and that there's no need to invoke the dreaded loss of freedom to realize that the whole system couldn't work according to freemarket fundies' theories.
Access to information is never perfect -- being subject to scarcity like all other goods
Really? That's a very peculiar statement to make in this day and age, and on this particular site.
In essence, you seem to be treating freedom as an independent (even insignificant) aspect of economics, when in practice you cannot assume either rationality or optimal access to information without it.
I get it, you're a libertarian. You defend your opinions, if only just by parroting your usual lines.
Me, I'm just looking at the underlying theory. Rationality, information, freedom. Three conditions. Two of them are missing; whether the third is present or not is moot.
What's so hard about it?
I kind of suspect that Taleb's hedge fund is still underwater for long-term investors. I've seen many articles quoting him crowing about this year's returns, often with fairly specific ranges elsewhere in the article. And yet, nowhere has anyone cited, say, 5 or 10 year returns. The obvious conclusion is that he has still done poorly overall.
I am skeptical that whatever wealth Taleb has is due to any unusually great talent -- many untalented people have gotten wealthy in the financial markets, which pay for fame in addition to talent (albeit in different proportions to Hollywood).
There is academic research showing that the opposite of Taleb's strategy (basically, constantly selling SP500 puts) is a money-making strategy over long time periods, provided you can insulate yourself against the bankruptcy risk, for example by using no leverage. That's another reason to think he has lost money.
"It has to do with making and enforcing rules like: if too many sheep die, we shoot and skin the wolves responsible. "
Or we could ask, "why exactly do we think that we need wolves to lead us at all?"
I mean, other than that's the way it's always been done, that sheep and wolves have this wonderful symbiotic relationship, that we've got respected sheep-universities turning out degrees in applied wolfhood, that we actively promote at all levels that sheep must aspire to become wolves and if they don't they've got no ambition.
("Do you want to spend your life chewing grass like your mother and I did? Then get out there and sharpen those teeth! I don't want to hear none of this vegetarian talk! Get to like the taste of mutton! Bite! Bite! Bite! And howl! Yeah, that's it! You're doing it! Pursue that Happyness! Go sit the Baa Exam! We're with you, tiger! Hoo-ah! Wait... why are you looking at us with that hungry look? Ungrateful little...!")
You are not a brain: http://books.google.com/books?id=2oV61CeDx-YC