Incorporating Human Behavior Into Wall Street Mathematical Models 300
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."
Re:Such as? (Score:4, Insightful)
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!)
Re:Such as? (Score:1, Insightful)
>irrationality
I can model all your irrational behaviour to 98% given enough data. What appears to be a greater concern is simple-minded, animal, territorial, and greedy behaviour that isn't in tune with Game Theory; which says that it makes sense for people (and mathematical entities) to cooperate for mutual profit. It's when one entity tries to grab more than their equal share that the trouble starts. People can become ingeniously self-destructive when motivated by anything but altruism and solidarity.
Re:Such as? (Score:3, Insightful)
if conditions exist that favor making money through "immoral behavior" then that is what will happen. people didn't magically become depraved sociopaths who inevitably caused the recession- the conditions which favored that behavior did. The models were not sophisticated enough to model human behavior rational or not under these conditions.
Voodoo (Score:3, Insightful)
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.
NO! Not again! (Score:3, Insightful)
Between these revived, yet still pernicious models and Wall Street's darling new death bonds [businessweek.com], 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.
Please don't. (Score:5, Insightful)
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 (Score:5, Insightful)
Corret one [nytimes.com].
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.
it wont work (Score:4, Insightful)
Re:Consumer based ecomomies must consider social e (Score:2, Insightful)
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 [techguy.org]
Asimovian (Score:1, Insightful)
Psychohistory, anyone?
Good luck with that (Score:3, Insightful)
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.
Yeah thats it (Score:2, Insightful)
This is the same bullshit they have been spouting among stock traders all along. Its all just because people are panicing and afraid. Sure the stock market works that way but the real world does not.
It couldn't possibly be that we trade debt and have changed our production system to solely attempting to maximize profit rather than total production. Never that.
A highly liquid economy is NOT a substitute for a solvent one backed by actual tangible assets of innate and functional value. Encouraging people to borrow and spend is NOT better than encouraging them to save and produce.
Yes that is old outdated thinking. From back when the economy was self sustaining, before the past few decades of turning liquid the foundation built by those before us and blowing it.
Re:Get rid of Economic Man (Score:4, Insightful)
Most of these financial models, in essence, assume people are Vulcans, when they're not
Worse than that, they assume that our primary goal is to maximize our money. I can tell you for me it's not.......my goal economically is to make sure I have enough money to supply my needs; after that, I'd rather spend my time posting on slashdot. Seriously. Even if I were a Vulcan, I wouldn't fit into their models, and I am sure I'm not the only one.
Re:Austrian Economics, anyone? (Score:3, Insightful)
Firstly, may I be the first to link to the Gaussian Copula [wikipedia.org]. If you'd like to point to one equation that did more than any other bit of modelling to bring about the collapse in the credit derivatives market and the ensuring banking finance, David Li's horribly misused [wikipedia.org] work is what you're looking for. Google is your friend for far more than you want to know.
Secondly, your assertion that "Human behavior is the basis for the Austrian school of economic thought" is, frankly, nonsense. I'm a great believer in markets, but human behaviour is a lot less invariant then you believe. Behavioural [behavior.org] Economics [wikipedia.org] is a fascinating field, and I warmly recomment reading around the subject if you'd like to learn something about it.
Re:Please don't. (Score:4, Insightful)
> complex beyond all comprehension. "Risk models" [...] as a rule, eventually always fail.
>
[emphasis mine.]
I'd be interested to hear your proposal for alternative ways for banks should manage risk without mathematical models. Wet finger in the air? Lottery numbers? Astrology?
Re:Austrian Economics, anyone? (Score:2, Insightful)
Uh, you're contradicting yourself. If this statement is true:
Then this statement is false;
Anyone who knows anything about game theory can tell you that groups of self-interested participants working for their own betterment is precisely the kind of thing game theory exists to model. And I have bad news for you: game theory is based on, you guessed it, mathematics. Moreover, your claim that "no model accounts for the variability of the individual" is simply absurd: the whole point is you *don't* need to look at the variability of the individual, as you *can* model they behaviour of groups as an aggregate, as the noise of individual variability tends to cancel itself out.
As an aside, Austrian economists had no monopoly on knowledge of the impending crisis. Plenty of economists, Keynesian or otherwise, could've told you that sub-prime mortgages being used as the foundation for an economic house of cards was going to lead to a crash. And you didn't need to be omniscient to see that government policy (keeping interest rates extremely low) was leading to a misallocation of investment funds into real estate. Furthermore, you need only look at the CDS debacle to see what happens when government opts for a hands-off approach to markets, as you seem to be proposing.
Re:Smarts can be a liability. (Score:4, Insightful)
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.
Re:How is daytrading not gambling? (Score:3, Insightful)
So you're saying that a good investor will make money consistently except when they don't.
Re:Wrong Direction (Score:2, Insightful)
Blah blah same old bullshit.
If you want the markets to price things correctly then you should want government not to interfere in them other than to eliminate fraud and force.
There is no guarantee of profit in markets.
Creditors and shareholders who invest poorly in speculative markets are not simply "unfortunate" and deserve no sympathy or bail-outs.
The causes of the financial meltdown are not "universal" to all humans or even to all Americans. Many of us didn't take out loans we couldn't afford or make poor investments or otherwise live beyond our means.
Sometimes growth should be limited rather than wasting natural resources on ill investments.
The end of "easy money" is the solution to the problem, not the problem itself.
Re:Such as? (Score:5, Insightful)
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 [behaviouralfinance.net].
Re:Such as? (Score:5, Insightful)
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 [wikipedia.org] 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;
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.
Re:I foresee... (Score:2, Insightful)