Wednesday, March 31, 2010

Do Easter Bunnies Lay Eggs?

Commenting on a previous post Debra, a devoted (smile) reader, had this to say:

It would seem that man is a gambling animal that JUST HAS TO HAVE HIS DOSE (fix ?) OF RISK, (like he has to have his dose of arguing about the number of angels on the head of a pin...).

What is obvious to Debra and the millions who work in the gambling industry essentially escapes the academics who create theories and algorithms to explain financial markets.  To wit, they start with the premise that investors want to minimize risk or, to put it more correctly, to maximize their risk-adjusted return.  It sounds reasonable, but show me someone who claims human beings are reasonable and I will show you a fool.  Or a chick barely out of its egg.

When it comes to markets, human beings are in perpetual pendulum motion, swinging from fear to greed and back again.  If anyone thinks this can be expressed in algebraic form, go ahead and  try.  But I should point out that there are already dozens of technical cycle analyses, astrological correlations, chaos theories, chart patterns, etc.  And as far as I know, the only way their creators made any money is by selling books and seminars. 

Indeed, there are only two books on markets everyone should read (many times and with great care, because they can be very dangerous to your financial health if their wisdom is abused).
So, instead, how about using Debra's premise as the starting point to construct market-related academic theories? We could put it thus: investors aim to maximize their profit-adjusted risk appetite.
 
Now try to put that in mathematical notation to use it in portfolio theory... 
 
Have a very nice Easter holiday.




24 comments:

Lord Blagger said...

What is obvious to Debra and the millions who work in the gambling industry essentially escapes the academics who create theories and algorithms to explain financial markets. To wit, they start with the premise that investors want to minimize risk or, to put it more correctly, to maximize their risk-adjusted return. It sounds reasonable, but show me someone who claims human beings are reasonable and I will show you a fool. Or a chick barely out of its egg.
======================

Really?

Modern portfolio theory. Does that say minimise risk? Nope.

It says how do you maximise the chances of achieving a goal which is what people want.

ie. Saving for retirement. How do you maximise your chances of getting the income you need in a risky world.

Completely different from your assertion that its all about minimising risk.

Debra said...

Yes but Lord Blagger, the problem is that people are looking at all those how to books, those algorithms, and the people who are putting them out, and... BELIEVING.
Believing that if they believe in the algorithms, the risk will go away...
Hell gave a truncated version of me (even if I am pleased that he quoted me...).
I said that human beings have to feel a sense of risk, there has to be risk in order for them to be able to live vitally, and fully.
And I think that the insurance industry has skewed that necessary risk by creating in the minds of all involved in it that risk no longer exists or SHOULD exist.
And I think that this development is highly responsible for what is happening in the financial industry.
Because collectively and individually WE NEED TO EXPERIENCE RISK.
And if we go so far getting rid of it (or our perception of it...) in one area, WE ARE GOING TO INJECT IT BACK ELSEWHERE.
You see what I mean ?
If you don't... you STILL have the option of reading "The Merchant of Venice".
Better than the books Hell has quoted, I.. BET.

Debra said...

Thought y'all would like to know that I DO BELIEVE in Santa Claus...
Particularly when I am Santa Claus.
It makes it easier...

Hellasious said...

Debra, I wouldn't even know how to present a full version of you. Or anyone else, for that matter.

Be well and may you enjoy many happy risks ;)

Debra said...

As long as you don't try pushing the "copy" button...

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OkieLawyer said...

I would like to see a comment on this article:

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Study Shows Economic Crisis and Response a Victory for the Rich

Edwardo said...

With Hell's most recent entry as our platform and premise, we are, for all intents and purposes, back to Taleb's assertion that all the high falutin' models out there that are undermining, er, underpinning innumerable investment decisions, are just so much merde.

But let's take the merde meme further, shall we, (because we can) and observe that the entire U.S. financial system is a creaking, calamitous structure built atop a foundation of swiftly shifting sands. Pardon the plentiful purple prose people.

Edwardo said...

I have several responses for you Okie Lawyer:

http://disasterporn.blogspot.com/2010/04/keep-repeating-big-lie-tax-dodger.html

http://attempter.wordpress.com/2010/04/01/the-jokes-on/

Debra said...

Good link, Edwardo, disaster porn.
Nice purple prose too.
And disaster porn has some nice acid prose too.
A Hell of a lot more acid than mine...
I chased you down a rabbit hole over there...

Thai said...

@Lord Blagger

Responding to a variant on this theme in the question you asked me earlier, please remember:

A conservation of energy= a conservation of risk

So within a closed system, risk can neither be created nor destroyed, it form can only change form.

... Now it is fair to point out that the earth is technically not a closed system, yet for all practical purposes with the state of human knowledge as it is today, I think it fair to say it is
pretty darn close.


Remember that old thought experiment where knowing the future changes your behavior and in so doing changes the future?


People can (and do) try as much as they will to elimante risk and predict the future, but as we both know "even the best laid plans of mice and men go astray". It is what it is.

Be well

Thai said...

Or as Colin Powell once remarked "No battle plan survives contact with the enemy".

;-)

Debra said...

Hey Thai, I miss you.
The saloon is not the same without you...

Laxmi said...

Debra says - "I said that human beings have to feel a sense of risk, there has to be risk in order for them to be able to live vitally, and fully."
"Because collectively and individually WE NEED TO EXPERIENCE RISK.
And if we go so far getting rid of it (or our perception of it...) in one area, WE ARE GOING TO INJECT IT BACK ELSEWHERE."

I disagree on several accounts. Debra - you make a blanket statement , and Hell, I am a little disappointed that you took a generalization and wrote up a blog on it...
Risk is inherent in life because life is uncertain, and every action is filled with unknown consequences. I could go out right now and be hit by a speeding motorist, I could go to work on Monday and be given a pink slip, etc. We attempt to reduce the uncertainty by trying to understand it and counter it - and we give it a fancy term - risk reduction.
Most individuals attempt to completely remove risk. But the attempt fails because no body can really remove risk from their lives. Does the attempt really morph and come back and hit us? Our ancestors decided to remove the risk of starving and decided to engage in agriculture. If "people need[ed] to feel risk", we would not have the society that we have today. I am by no means suggesting that there are no risk-takers - I am suggesting that Debra's blanket statement does not withstand scrutiny.
There are sociologists whose careers are dedicated to finding patterns in collective behavior, and to generalize the behavior of some people to "everybody, collectively and individually" is fallacy.
Hell - you say about academics - "to wit they start with the premise that investors want to minimize risk...sounds reasonable." And then you state "show me someone who claims human beings are reasonable..." I am a lawyer - we discuss the "reasonable person" standard ad nauseum(sp?) - as a person who deals with the "reasonable person standard" on a daily basis, let me tell you - there is no such thing. People, generally, act in what they think is in their best interests. If that is not a choice you would make, it doesn't mean that their choice is unreasonable. And please enlighten me - what is wrong with that premise that investors want to minimize risk? Given that "reasonable people" tend to study a problem that they don't understand, which premise would you begin with? People are not reasonable? Tell me then, what is "reasonable".
And give me a proof that the premise is not correct in describing the events occuring in the market.

Lord Blagger said...

Part of the problem is the premise is wrong.

Many want to maximise risk. ie. I can't afford a retirement unless I win big. Quite common

Laxmi said...

"Part of the problem is the premise is wrong.

Many want to maximise risk. ie. I can't afford a retirement unless I win big. Quite common"

Is it?

Thai said...

Laxmi, There is certainly a ton of what you say I completely agree with yet I'm a little confused as to why you are frustrated with this post?

Further, I don't see how you answered your own question, namely: "Does the attempt really morph and come back to hit us?". For giving examples of how it all seemed to work out is not proof thing went for the best as we really don't know what would otherwise have happened. The ability to see alternate realities/futures Is beyond at least everyone I seem know.

... Though I guess you are a lawyer so I may be forgetting how you and your colleagues always seems to posess this unique skill when in front of a jury/judge in a courtroom. ;-)


Be well



I certainly see how prudent

Lord Blagger said...

It may be a UK centric comment.

There is a standard con by finiancial advisors.

Save 100 pounds a month, and after 40 years you will have hundreds of thousands. People get 'convinced', but it is baloney. Inflation eats most of it.

That then means that many resort to higher risks to get the return they 'require'. ie. It's low contributions that drive high risk seeking.

ie. For the larger part its driven by high taxation. People don't have enough to save sensibly, so increase risk.

Now, MPT is quite clear. If your investment is low then you should increase risk.

Debra said...

Laxmi, I may be making a blanket statement, but I hold firm to that blanket statement.
Now... I did not say that in order to EXPERIENCE vital risk, it HAD to be experienced IN THE STOCK MARKET for example.
It can be experienced elsewhere.
And VITAL risk does not necessarily mean putting your life at stake either.
It means.... ENGAGING yourself in something that you believe in without knowing in advance how it is going to pan out. Confronting uncertainty in your life. Not denying it, or trying to pretend it will go away all the time.
Once again, this is a metaphysical question.
But it would seem that you don't know my Smithsonian Zoo parable.
Two years ago I saw a sign in front of the lion's cage in the Smithsonian Zoo that said :
"you may think that our lions are unhappy in their cage ( a luxurious compound much nicer than the cages of death row prisoners), but where would YOU rather be, in this nice cage where you get your din din brought to you on a silver platter every night, the vet worries over your every scratch, and you play with your ball when you get bored, or... in the wild, where you don't know IF you will have a next meal, and every scratch COULD BE FATAL."

The... weltanschauen (world view) behind this sign gives a good idea of what is at stake in the retirement game, and in the stock market.

How to achieve the delicate balance between turning us all into mindless domesticated animals, with reduced brains, reduced neurons, and starving to death from crop failure, or exposure to the elements.
Lots of middle ground in there, I think.
And we have moved a little far towards the first half of the equation in my book.
Now... maybe that's a GOOD thing in certain people's heads. But.. I STILL maintain that it has its disadvantages, living this way...

Debra said...

and, of course, not all of us are mindless domesticated animals everywhere, thank God, and maybe we will be saved because I am a domesticated animal in an area where YOU are not, for example...
Who knows ?

Debra said...

"Most people attempt to totally remove risk from their existence". Most "reasonable" people."
That is a blanket statement. It is more than a generalization, it is a sort of prejudice, an assumption.
"Our ancestors removed the risk of starving by agriculture"......
That is really interesting. I'm sure that many of our ancestors DIED while resorting to agriculture, and the 19th century potato famine shows just how risk free agriculture REALLY IS...
If there is anything that really is NOT RISK FREE, it is agriculture.
Our collective reaction to the Haïti earthquake, a repeat performance of our collective reaction to the Lisbon earthquake in the 1700's shows that we go along, cahin caha, under the illusion that we have ELIMINATED the risk that Mother Nature regularly throws in our paths.
That our society has constructed elaborate risk "eliminating" social strategies to dull our collective mind to the idea that we could disappear tomorrow in an earthquake too.
And we have... caged ourselves with these strategies, I believe. And since we are STILL WILD ANIMALS SOMEWHERE DOWN THERE (dixit Darwin, at least...), well, we feel a little cheated by our puny tactics. I believe...
Of course, this is all my personal speculation. (Although there must be other people out there saying this, I'm not THAT exceptional...)
But.. is it necessarily ANY LESS VALID than the algorithms, etc of our economic high priests ?
Why ?

OkieLawyer said...

Food for thought:

Simon Johnson: Greece and the Fatal Flaw in an IMF Rescue

Debra said...

American "think" and American "putting a price tag on everything that moves (and a lot that doesn't...) IS REALLY GETTING ME DOWN.
It's... DEPRESSING...

Debra said...

AND... for what it's WORTH..
I ALSO think it's bringing the world down with America.
Too bad. The world is/could be SO BEAUTIFUL without a price tag on everything...