Slashdot Mirror
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."
Incorporating Human Behavior Into Wall Street Mathematical Models
What? Like morality?
Personally I think this is a terrible sign. Irrational investors should be discouraged from gambling in the markets instead of coddled and encouraged through tax breaks and an extensive regime of inconsistent regulation. Governments and the fraudulent investment advisors they subsidize and fail to regulate have done us all a disservice by suckering the average person into investing in derivatives markets like the stock exchanges. And now instead of letting the market correct the problem all sides are dragging us further down the path of government interference and command economy. They actually have the brazen stupidity to think that a command economy will work if only they can come up with some better computer models of market behaviour.
"I assumed blithely that there were no elves out there in the darkness"
Why is it that these people insist on trying to apply a veneer of respectability to this shit?
Financial engineering is not engineering.
Economics is not a real science.
Finance is not real math.
Between these revived, yet still pernicious models and Wall Street's darling new death bonds, we look poised to blow another bubble, destroy another decade of growth, and funnel more money into the hands of the obscenely wealthy when the system flies apart.
We cannot allow that to happen. Finance needs to be returned to a staid utility that forms a relatively minor part of our economy. We need to be deeply skeptical of innovation in the financial sector: it's been around for a long time, and we've already explored most of the beneficial ideas. What remains is deception and fraud.
Human behavior is the basis for the Austrian school of economic thought. Has been from its roots. Ludwig von Mises, one of the founders of Austrian economics, titled his magnum open "Human Action". The basic idea of Austrian economics is that the study of economics is an a priori discipline. In other words, you can't implement, from both a practical and ethical standpoint, experiments to study economics on a useful scale. Instead, economics must be viewed as a study of human behavior. Humans are the principle actors in an economic system, so their behavior and drives must be the primary focus of economic study. The study of economics can therefore be viewed as a study of groups of self-interested participants working for their own betterment.
Incidentally, Austrian economics also posits that interference with the operations of markets produces a boom-bust business cycle, by promoting misallocation of scarce resources. It's worth noting that many Austrian economists were predicting our current economic crisis well before it occurred, when the more mainstream Keynesians were still calling it a golden age of economic development.
What is being proposed here is to continue to view markets as purely mathematically modelable phenomena. Economic decisions occur on the most local of levels, the individual level. No model accounts for the variability of the individual. For a Keynesian-style planned economy to function requires omniscience.
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.
Corret one.
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.
if conditions exist that favor making money through "immoral behavior" then that is what will happen.
Some point to (substantial) evidence that the playing field itself could be called as you say, "immoral": http://www.chrismartenson.com/crashcourse/chapter-15-bubbles (ch16 and 17 as well) and some related news: http://www.google.com/search?q=audit+the+fed
to steal a quote, markets can remain irrational long after a rational trader becomes insolivant. This includes rational predictions about human behavior.
If video games influenced behavior the Pac Man generation would be eating pills and running away from their problems.
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.
A predictive model of human behavior? Sure. If I recall, Harvard Law states that under carefully controlled conditions, human beings will do what they damn well please.
+ + +
Read "Terrifying Vindication" at http://klurgsheld.wordpress.com/
often times it was closer to being fraudulent than risky... the current system allows companies to leverage far more capital than they have in assets [fractional reserve banking] that is very dependant on the stability of the money supply... consequently when there are monetary expansions followed by monetary restrictions by the federal reserve we observe a collapse of the system catalysed by panic.
Sigs are too short to say anything truly profound so read the above post instead.
The biggest problem with some economic models is that they don't consider the irrationality of a consumer. This is fine when an economy is based on manufacturing or processing/export of natural resources since that follows more rational processes.
The US economic meltdown was long overdue since the writing was on the wall with housing screaming up in value while any job that could be outsourced overseas was sent regardless of the quality and logistics issues it may create.
A consumer-based economy with jobs for the consumers disappearing is going to fail unless money is being pumped in elsewhere (AKA government welfare through various programs such as low-income assistance, subsidies, stimulus checks, etc.). This itself cannot be sustained and now our government looks for more loans from the countries we made wealthy by sending most of our manufacturing jobs (China).
Increasing taxes for the wealthy and businesses will force people to leave the US or find other ways to evade taxes. This means the middle class will bear more of the tax burden over time. There is a good analogy of beer drink buddies of various incomes splitting the tab based on income that illustrates the tax and spending dilemma.
So my opinion is that human behavior models are long overdue to be applied to economics.
I Cater to the Needs of Stupid People. - from a coffee mug Christmas gift
They're just *now* trying this?
.
Seriously?
Here is a link to that beer analogy for the US tax system.
http://forums.techguy.org/civilized-debate/697617-us-tax-system-described-beer.html
I Cater to the Needs of Stupid People. - from a coffee mug Christmas gift
bringing behavioral modeling into their complex financial calculations.
Am I the only one who read that as 'fictional calculations'? It may be more appropriate ...
"How Did Economists Get It So Wrong? "
http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&em=&pagewanted=all
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.
The human behaviour they should put into those models arent panic or riots, but what humans do when know what those models predict. Thats the biggest problem about predicting what people will do, what if that people know that prediction?
That was the problem, too much people "knowing" what will happen, acting in a big way, and of course, failing because those predictions didnt included that behaviour.
Human behavior is the core of all economic thinking. It either directly or indirectly is the basis of every model and every theory. The problem might be that the behavior assumed is over simplified to 'greed and fear of risk' when it should include something more, but that's nothing new.
This doesn't mean the right thing to do is give up on modeling risk and simply give up and go back to simply letting the king (or the five year plan) decide what is worth funding. Venture capital and stock markets are capitalism's attempt to estimate what technologies and businesses are the most promising and most efficient. Is it wrong? Often. But its wrong less often than other methods.
So, is financial engineering really engineering? It depends how you define both the terms. Marketing guys that add 'engineering' to something to make it sound trustworthy are not, but I'd say that the forecasts financial analysts and economists make can be as legitimate in approach and method as the forecasts civil engineers make about traffic flow, water needs, sewage requirements and infrastructure development. Both are mathematical forecasts of what human behavior will be in the future and both can have good or bad underlying assumptions that drive results. Both can be right or wrong based on the math or the assumptions.
Lets say the people who have the Federal Reserve Board of Governors on speed dial decide that the dollar needs to move in a different direction. So they call up Alan Greenspan and have him dump a few billion in foreign reserves. Exchange rates change, followed by interest rates. Pretty soon, people with marginal mortgages get caught short. Investment banks figure this out and pull the rug out from under mortgage backed securities. Commercial banks' capital ratios collapse. Wall Street sees this and responds. Panic ensues.
But its too late. Understanding the market by analyzing panic is like trying to diagnose diarrhea by looking in the public sewers. The people who initiated the problem have taken their profits and run long ago. Their lackeys have moved on and retired. If you want to know what the market is up to, you're going to have to collect data a lot earlier in the investment cycle.
Have gnu, will travel.
Mark my words, there's some guy named Hari Seldon to blame for this....
Apparently some of these guys pay as little as 20% which is how they can offer the returns they do. The problem is that when a regulator hears that you're ripping off a sick grandma who has trouble even understanding the forms they tend to pass laws. Some of these may invalidate existing agreements or put the companies creating them out of business. When the companies aren't there you run into all sorts of management issues - like the premiums not being paid, paperwork not being filed and payments not forwarded. I think Virginia has laws dictating at least 60% of the face value be paid (not sure on the % - search for viatical settlement for better info).
The other main risk is when the company simply can't find enough suckers as one company now being prosecuted for fraud in Texas found out. They found and took investors money but never bought the life settlements and burned through much of the cash. It could be they never intended to buy them, but I suspect if they could have found them they would have bought them as its a small amount to pay to keep the state off of your back - certainly less than they've lost from being put out of business.
Investing in life insurance scams is plain gambling. No wealth is created and the insurance company generally is smart enough to set itself up as "the house". And the house always wins.
Oh, not at all. The insurance companies HATE this idea, they do NOT want people to be allowed to invest in life insurance policies, because these investors will do anomalous things like PAY THE POLICY PREMIUMS, and not let the policies lapse. As it is now a huge number of life insurance holders let their coverage lapse (either through financial problems, laziness, cost gets too high, etc.) In that case the insurance company gets the benefit of all those payments already made (sometimes DECADES of them), without any of the cost (i.e. having to pay out the policy when the holder dies).
Assumptions are okay so long as you only treat them as elements of long-term planning that will need to be revised periodically. I think that's the only safe way to view financial models.
But the financial engineers have committed the unforgivable sin of truly believing in their assumptions because they create a pleasant reality where you can bound risk into a little box. Reality is far less forgiving.
My only political goal is to see to it that no political party achieves its goals.
So you're saying that a good investor will make money consistently except when they don't.
I challenge you to name one Austrian economist who predicted our current economic crisis. In fact, the free-marketeers who worship Friedman (I know that's Chicago school, not Austrian, but bear with me) ignored the potential for the current crisis while Keynesians like Krugman, in point of fact, predicted it. And Keynesianism hasn't been mainstream (in the US) for decades, so I don't know where you're getting the idea to say "the more mainstream Keynesians". The trend has been to trust markets more and more, and the very deregulation that the Greenspans and Bernankes of the world championed created the crisis on a fundamental level.
( http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1 is one of many good articles on this subject)
Besides which, Austrian economics claims to deduce all of economics a priori, which fundamentally contradicts your premise that it takes account of human behavior. Human behavior is known a posteriori from observing humans. If some "a priori" deduction about human behavior contradicts empirical observation of human behavior, then we must conclude the a priori deduction describes not human behavior but some abstract concept of how a human ought to behave. Likewise, Austrian school economics is powerless to describe a real economy, because when it contradicts empirical observation, it says, in essence, "fie upon empirical observation!", but by doing so, describes not a real economy but an abstract conception of how economies should behave
"I don't care about the Constitution!" --Bill O'Reilly, November 17, 2009
I was about as bitter as you were, until I heard about Behavioral Economics, which uses the results of *scientific* tests in psychology and human behavior as the basis for (or at least a counterbalance to) economic theory; this stands in contrast to traditional economic theory, which is based on the idea that rational self-interest will cause markets to function perfectly, and will, in a larger sense, reroute funds to those who would put it best to use. Dan Ariely gives a good overview of Behavioral Economics in his book, "Predictably Irrational," in which he describes how the conventional wisdom often is completely wrong, both through anecdotes and descriptions of rigorous scientific experiments: http://www.amazon.com/Predictably-Irrational-Revised-Expanded-Decisions/dp/0061854549/ref=sr_1_1?ie=UTF8&s=books&qid=1252910997&sr=8-1 So while in theory it would be *possible* to improve financial models by incorporating lessons from Behavioral Economics, you would have to trust that those with the power to influence markets would correctly apply them. And that's a big "if." If the misuse of the Gaussian Copula to price mortgage-backed securities is any indication of private industry's ability to take the ball and run with it in the wrong direction, then it'll take more than just good science to save us...