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Math The Almighty Buck Science

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."
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Incorporating Human Behavior Into Wall Street Mathematical Models

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  • I foresee... (Score:1, Interesting)

    by Anonymous Coward on Sunday September 13, 2009 @01:31PM (#29406053)

    ... more miserable failure. Sorry folks, interdisciplinary research does not work. The people who build the financial models will never understand psychological theories; the people doing psychology will not understand (nor care) about financial models. Moreover, what "behavioral models" we are talking about here? I would very much like to see one that actually has predictive power. Alas, most of this so-called research in, say, "web social networks" is merely a collection of useless results designed to get published and raise the academic status of the researcher. Academia is a fraud... la-la-la *blasphemy*

    Am I bitter? Yeah.. please, someone prove that I am wrong. I would like to be wrong on this one.

  • Wrong Direction (Score:2, Interesting)

    by benjamindees ( 441808 ) on Sunday September 13, 2009 @01:33PM (#29406073) Homepage

    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.

  • Sign me up... (Score:4, Interesting)

    by Paul Fernhout ( 109597 ) on Sunday September 13, 2009 @01:40PM (#29406135) Homepage

    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. :-) []

  • by Brewmeister_Z ( 1246424 ) on Sunday September 13, 2009 @01:49PM (#29406207)

    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.

  • Re:Such as? (Score:4, Interesting)

    by Helpadingoatemybaby ( 629248 ) on Sunday September 13, 2009 @01:55PM (#29406261)
    "nonsense. what happened was people acted in their own rational [so they thought] interest..."


    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."

    . []


    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.

  • by GTarrant ( 726871 ) on Sunday September 13, 2009 @02:08PM (#29406331)
    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.
  • by gmuslera ( 3436 ) on Sunday September 13, 2009 @02:14PM (#29406369) Homepage Journal
    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.
  • by BigSlowTarget ( 325940 ) on Sunday September 13, 2009 @02:15PM (#29406377) Journal

    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.

  • by Trepidity ( 597 ) <> on Sunday September 13, 2009 @02:33PM (#29406495)

    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:

    The study of economics can therefore be viewed as a study of groups of self-interested participants working for their own betterment.

    This is making a pretty huge assumption about human behavior that most scientific studies of human behavior, in any field, don't bear out.

  • Re:Voodoo (Score:3, Interesting)

    by martas ( 1439879 ) on Sunday September 13, 2009 @03:43PM (#29407009)
    what is this "real math" you speak of? it's an application of mathematics, simple as that. is computational biology "real" biology? is it real computer science? who cares! i don't mean to use a buzzword, but we see more and more interdisciplinary applications of different theories emerging as autonomous fields. this applies to computational biology, pretty much every kind of modern (>1980) AI research, and, of course, economics and finance. it's not a bad thing that people are learning that applying knowledge from one field to solve problems in another is a good idea. quite the opposite, in fact.

    truth is, this is a pretty normal way in which all fields develop. first there is heavy partitioning and abstraction, so that people can start to make sense of things. once a level of maturity is reached, the partitioning starts to become less well-defined, often leading to huge benefits.

    for example, this is a trend we're seeing in wireless networking technology recently. at first, the physical layer (communication between two, and only two, machines) was completely separate from the MAC layer (communication between a physically proximate set of machines). once the field matured, and there wasn't that much room left to improve throughput of wifi networks through pure MAC layer protocols, the research started spilling over into the PHY layer. today there's a bunch of work cropping up that violates the layering principles people so neatly thought of in the early days of wireless networking. is this communications research? is it networking research? signal processing? nobody cares, as long as there's an improvement in performance. same applies to finance and econ. if you can make more money from your investments, nobody's gonna ask if you're using mathematical models, voodoo dolls, or pure guesswork (the latter of which, unfortunately, seems to be the most preferred choice up to now...).
  • Re:Wrong Direction (Score:5, Interesting)

    by xelah ( 176252 ) on Sunday September 13, 2009 @04:28PM (#29407315)

    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.

  • Re:Such as? (Score:4, Interesting)

    by ahabswhale ( 1189519 ) on Sunday September 13, 2009 @04:39PM (#29407397)
    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.
  • Name one! (Score:3, Interesting)

    by fishexe ( 168879 ) on Monday September 14, 2009 @12:20AM (#29410245) Homepage

    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.
    ( [] 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

Top Ten Things Overheard At The ANSI C Draft Committee Meetings: (5) All right, who's the wiseguy who stuck this trigraph stuff in here?