Incorporating Human Behavior Into Wall Street Mathematical Models

After watching the stock market struggle for the past year, financial experts from Wall Street and academia are putting more effort into bringing behavioral modeling into their complex financial calculations. "The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic." Analysts are looking at research from other fields to supplement the hard mathematics of risk assessment. "Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets." Another avenue they're exploring is how we react to the spread of disease. Jon M. Kleinberg, a computer scientist at Cornell, said, "The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets."

Comments

Re:Such as?

[Anonymous Coward]

What? Like morality?

Like irrationality. (What was that sound? Oh yeah, it's the collapse of every economic philosophy proposed over the last few centuries as people realize there's no such thing as a rational actor!)

Please don't.

[Shihar]

I really wish wall street would get off their 'risk models' fetish. The financial systems of the world are wildly complex beyond all comprehension. "Risk models" make three, very shitty assumptions and, as a rule, eventually always fail. As we saw with the latest blow up, some times they fail with epic spectaularity. The three shitty assumptions are:

1) That the model has enough information to make predictions in this infinitely complex system
2) The system doesn't change.
3) We will see nothing in the future we have not seen in the past.

It is like watching someone try and figure out a way to predict the winner of a game where the rule book takes a library to hold AND the rule books are constantly being swapped out for new rule books. Everyone likes to blame the current recession on greed, evil bankers, and corporate corruption. While all of those things exists, they are not what caused the melt down. What cause the melt down was that a bunch of morons were using a 'risk' model that basically predicted that what happenend could NEVER possibly happen, so don't worry about it. Based upon this bad information, people made some very awesomely bad 'safe' bets. When the "impossible" (as the risk "models called them) happened, those very bad but "safe" bets imploded and you saw the wide spread destruction that happened as a result.

Wrong link

[QuoteMstr]

Corret one.

The bankers plan to buy "life settlements," life insurance policies that ill and elderly people sell for cash -- $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to "securitize" these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return -- though if people live longer than expected, investors could get poor returns or even lose money.

Keep in mind that these things will be securitized, tranched, and then the pieces will be securitized and tranched, greatly magnifying the risk. On top of that, there will be a new, brisk trade in various hedges on these instruments, including the infamous credit default swaps. In this way, a tiny diseases market can metastasize throughout the economy.

Re:Such as?

[thefinite]

Actually, irrationality in finance is not only prominent, it's rampant. It was certainly at play in this latest bubble and burst. For example, most bankers peddling the toxic CDOs were using a model that relied on only about ten years of economic data. This is the byproduct of the Availability Heuristic. Additionally, their models often excluded the possibility of such a huge decline in housing prices because there had never been one like it before. The Representativeness Heuristic induces this kind of behavior, in spite of the warnings from others.

None of this is rational behavior. The idea you proposed that this is some sort of Prisoner's Dilemma situation ignores the fact that there are two sides to every transaction. Any of the people who rationally cashed out did it with the money of the irrational people buying their toxic instruments. The Prisoner's Dilemma falls short as an analogue because it doesn't require a buyer for the players to make their decisions. No one has to take the other side of their decisions, which is the case in a market.

For a great review of the hundreds of ways we behave irrationally in financial markets, I highly recommend BehaviouralFinance.net.

Re:Such as?

[MrKaos]

What? Like morality?

I would have modded insightful because siloko's statement illustrates the tip of a very large and flawed model by which our world economic system is run, a model that is, as a whole, completely unsustainable.

Is there anybody out there that actually believes that we can keep going this way indefinitely, or even a few more decades? Is there anything in our economic system that is actually related to reality? Most of the world, that doesn't have our level of privilege, have no choice but to face that reality.

When you consider a countries GDP doesn't measure income but actually economic activity you realise it's a ludicrous measure that doesn't subtract the depreciation of assets like roads and factories or depletion of natural resources. So how is it valid when the resource base it draws from isn't included in the calculation?

So what is the true cost of the economy when the real actualities are taken into account, cause they don't seem to be in any economists 'equations'. True cost is what give economist's nightmares so (as I mentioned in a response elsewhere) it's not a science, or engineering it's a branch of psychology. None of the factors that should be included, like production of waste and depletion of natural resources are included in the economist's "equations". It's a fucking joke that the world is run this way, as if someone, who suddenly found themselves skydiving and realising that they didn't have a parachute, was told 'worry about that when you get closer to the ground'.

I want to know where the economist's have been for the past year of this meltdown *they* caused. They're happy to take credit in the good time, but when the shit hits the fans they just disappear. Where is the accountability? Where is the humility? Greenspan once remarked 'we can never have a perfect model of risk', ok, but what about an 'awareness of risk'?. These guys, now rebranding themselves from a science to an engineering profession could not even pick the sub prime collapse and have let people around the world with the mess to clean up while they vanish with their pockets stuffed full of cash.

To highlight the absurdity if we look back the template for neoclassical economics was based on Hermann von Helmholtz conservation of energy principle substituting physical variables for economic ones. Despite being told by physicists and mathematicians that there was no basis for these substitutions economists claimed that this had transformed their field into a rigorous mathematical science. Today the basis of economics in mid 19th century physics has been forgotten and the theory is accepted as scientific. Assumptions include;

• Natural resources are inexhaustible
• Costs of environmental damage lay outside of the system
• Natural resources exist in a separate domain
• the market system is a circular flow between production and consumption
• There are no biophysical limits to the growth of market systems

This is how the world economy is run, completely divorced from reality. Economics does not even acknowledge the cost of environmental problems or limits to economic growth and unless they start to take these realities into account all the crashes we have experienced in the past are going to be like the kisses in foreplay before we are well and truly fucked and in a worldwide economic tailspin from which there is no return.