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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."
High math and analytical GRE scores, a degree in psychology, previous work in the speech group at IBM Research, lots of programming and simulation knowledge... :-)
Might as well make a little money out of the market before post-scarcity issues obsolete it. :-)
http://www.pdfernhout.net/post-scarcity-princeton.html
A 21st century issue: the irony of technologies of abundance in the hands of those still thinking in terms of scarcity.
Whether people think they're rational doesn't make their acts rational. Professors Daniel Kahneman and Vernon Smith challenged the old Libertarian thought that people act in their own self-interest. "human decisions, rather than being based on a full analysis of the situation, often rely on shortcuts or rules of thumb. The studies developed the idea of representativeness, in which people are too quick to see patterns in data that are actually random."
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http://www.independent.co.uk/news/business/news/irrational-studies-lead-to-nobel-prize-for-us-economists-613675.html
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They won a Nobel prize in economics for this.
If someone believes that it is in their best interests to sell their stock it would be irrational of them to just sit there and watch their wealth erode away... but it would also mean that if they did sell their stock under incomplete information conditions the entire system becomes comparatively irrational... Again, no. Your premise is wrong that they are acting in their own self-interest, your premise is also wrong that they are acting rationally, and your presumption that the entire system becomes irrational because people act on incomplete information is... well, incomplete. This is behavioral finance.
The baby's fine -- please stop sending business cards.
While I dislike how suddenly the financial markets have gotten back into these windfall risky investments, there's little push to stop it, so I guess taking into account the kind of behavior that, you know, actual people would do, is better than nothing.
Most 'risk analyses' done by these things almost go as far as to assume everyone involved acts as Economic Man - the theory that everyone will always act in such a way as to best improve their position, in a 100% rational way. This is a pipe dream put up in economic theory and doesn't always work. If you assume everyone involved acts that way, then some possible outcomes - like the ones we saw in the past year - can't be the slightest bit possible, therefore the models that were being run at the time disregarded them. Of course, the models were wrong - because people don't act that way.
Consider what is sometimes called the Ultimatum Game - everyone's heard of it. Person A has a pile of money to divide between themselves and Person B. They split it, and Person B can either accept the division, in which case each gets their share, or reject it, in which case neither player gets one red cent and the money is lost.
Economic Man theory would say Person A should give the smallest possible amount (let's say 1%) to Person B, and keep 99%, or whatever the maximum share is, and that Person B should then readily accept, because they're better of taking something rather than nothing. In reality, when this "game" is tested, it doesn't work that way - if Person A doesn't offer enough to B (say, 20%), Person B tends to reject it, whether out of spite, or a sense of fairness. The responses change depending on how much money is involved, and culture (different countries and regions have different thresholds) and everyone seems to have their own threshold of course - but very few Person B's say "OK, I'll take one penny and Person A can have $99.99" even if that's what Economic Man would do.
Likewise, Economic Man doesn't see that much of a difference between, say, 10% chance of loss, or a 5% chance of losing double that amount and a 2 1/2% chance of losing quadruple - while real people tend to disregard a small chance of large losses, but be quite averse to a reasonable chance of smaller losses - they'd probably go for the last option, even if percentage wise the "odds" are the same.
Most of these financial models, in essence, assume people are Vulcans, when they're not - they're people, and no amount of economics saying "You should act like Economic Man!" is going to change that.
If they're going to continue using these models, a push to start getting them better is at least some progress.
It's true that the Austrian school of economics correctly realizes that human behavior is the central component of economics. But they base their entire subsequent theory on an absurd model of human behavior with no scientific support:
This is making a pretty huge assumption about human behavior that most scientific studies of human behavior, in any field, don't bear out.
10 PRINT CHR$(205.5+RND(1)); : GOTO 10
I hate to break it to you, but no one actually believes this. No one cares whether the market "prices things correctly" as long as the losers are allowed to fail.
I care. One of the fundamental social purposes of financial markets is to price things correctly. These financial markets, by deciding how much it costs for a particular company to invest or be bought, have huge impacts on the real economy by helping to choose which investment projects in which industries go ahead. There's an irrationally large risk premium for oil refiners? We'll have too few oil refineries in a decade. Dot-com shares overpriced? We'll waste huge amounts of economic output creating websites nobody needs. Risk of a housing market crash underestimated in lenders' shares? We'll build lots of houses nobody is living in. Doing this badly has huge economic impact. Occasionally dumping some of that cost on unfortunate creditors and shareholders doesn't help one bit when the causes are common to all humans or to the financial or social structures they operate in. All the creditors and shareholders can do in the face of market problems they don't know how to or can't solve is to make less money available for investment, which only makes the misallocation worse and reduces growth. REAL growth, not stock market growth. Research in to human cognitive biases or the effect of principal-agent problems, for example, CAN make a difference.
Just because they are acting on incomplete information, doesn't mean they aren't acting based on their own self interest. They are. It's just that it may turn out that their action ended up working against their best interest. Even when you think you have all possible information to make an informed decision, you don't because it's not possible to see the future. If someone buys stock in an undervalued company with strong financials but then the company's factory experiences a devastating earthquake and ruins the company, he would have failed your "self interest" test based on the way you define it. Sorry but it's a fucking straw man argument.
What is predictable is that people will do what they "think" is in their own self interest and whether that turns out to be true is pointless for purposes of this discussion.
Are agnostics skeptical of unicorns too?