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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.
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!
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.
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
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
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.
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?