Posts
Too often people phrase an opinion as a statement of a fact. When we do that we polarize1 the minds of those listening. It’s a great way to end a dialogue and begin an argument.
People frequently do the same with what are in reality conclusions2. This again is a great way to end a dialogue and begin an argument.
Adding “in my view” keeps those minds and dialogues open. We don’t need a bi-polar society3.
1. By this I mean that the listeners immediately react in conformity with their prior convictions and cease further analysis. Those that agree see the “statement of fact” as confirmation of their belief and we know how confirmation bias then affects them. Those that hold a contrary belief see the expression of the “fact” as contrary to their belief and then affected also by confirmation bias, discard the “fact” without further consideration.
2. As a tip off, it is not uncommon to see “judgmental” modifiers included in the statement.
3. The analogy is not apt; this last sentence is an example of what I was discussing.
Friday, November 18, 2011
Thursday, November 10, 2011
Football and Politics
Several years ago I wrote an Observation that given recent developments bears repeating. I reproduce it here and give an update.
• Demigod (Demon)
Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process of deification goes on constantly, often the result of actions by their subordinates.
We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.
We should overcome the temptation to do so.
- 07/07/2008
• Football(Coaches) and Politics(Candidates)
Sometimes the folks placed in positions of power come to believe that the deification process is justified. Such beliefs can be manifested by actions which demonstrate “I know better” or “the rules don’t apply to me” attitudes. I guess it takes a level head to resist that temptation.
We don’t help matters when we go along with this.
• Demigod (Demon)
Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process of deification goes on constantly, often the result of actions by their subordinates.
We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.
We should overcome the temptation to do so.
- 07/07/2008
• Football(Coaches) and Politics(Candidates)
Sometimes the folks placed in positions of power come to believe that the deification process is justified. Such beliefs can be manifested by actions which demonstrate “I know better” or “the rules don’t apply to me” attitudes. I guess it takes a level head to resist that temptation.
We don’t help matters when we go along with this.
Wednesday, October 12, 2011
Overcomming Confirmation Bias
Confirmation Bias1 is a real and material problem for us as individuals and as a society. It destroys our ability to make intelligent and informed decisions. Although it occurs subconsciously and reflexively the bias is not impossible to overcome.
The best way to overcome it is to take an assertion or opinion and try to prove that it is false.
For example -
A money manager says that he or she adds value by selling stocks that have declined by 20 percent.
Try and prove that the assertion (value is added) is false by asking:
How did the “sold” stocks do after they were sold?
Another example –
A consulting firm tells you it achieves superior results by firing underperforming money managers.
Test the assertion (that they achieve superior results) by asking for data on the performance of those “fired” managers after they were fired.
Finally-
If you think you are a good stock picker, then take a look at three groups of stocks.
Those you own.
Those you have already sold.
Those you thought about buying but ultimately didn’t.
In deep east Texas they don’t say “you’re right.” They say “you ain’t wrong.” Who would have thought that the Deep East Texans would even know about the scientific method? Bubba Newton? Or maybe Billy Ray Bob Bacon.
1. In an earlier Observation I discussed Confirmation Bias. You can find that Observation at: http://gregtevis.blogspot.com/2011/08/why-impasse.html
The best way to overcome it is to take an assertion or opinion and try to prove that it is false.
For example -
A money manager says that he or she adds value by selling stocks that have declined by 20 percent.
Try and prove that the assertion (value is added) is false by asking:
How did the “sold” stocks do after they were sold?
Another example –
A consulting firm tells you it achieves superior results by firing underperforming money managers.
Test the assertion (that they achieve superior results) by asking for data on the performance of those “fired” managers after they were fired.
Finally-
If you think you are a good stock picker, then take a look at three groups of stocks.
Those you own.
Those you have already sold.
Those you thought about buying but ultimately didn’t.
In deep east Texas they don’t say “you’re right.” They say “you ain’t wrong.” Who would have thought that the Deep East Texans would even know about the scientific method? Bubba Newton? Or maybe Billy Ray Bob Bacon.
1. In an earlier Observation I discussed Confirmation Bias. You can find that Observation at: http://gregtevis.blogspot.com/2011/08/why-impasse.html
Friday, September 2, 2011
Moral Hazard
I am not politically inclined but I distinctly recall which politicians were screaming about the financial bailout, wailing about the moral hazard. I distinctly recall which politicians were and are so enthusiastic about tort reform. The same ones.
In economic theory, moral hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk.
In economic theory, moral hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk.
Many of you may recall that I was on the commuter train that crashed head on into a freight train in Chatsworth California
I thought I might relay my subsequent experience with “Tort Reform” and moral hazard.
I didn’t sue anyone - but I got sued. Sure enough in Federal Court even and by the very people that were responsible for the crash. Why you might ask.
There is a federal statute enacted as tort reform that caps single train crash damages. Those that caused the crash had the cap amount in insurance coverage so they filed a lawsuit (interpleader) to dispose of this mess once and for all, deposited the insurance proceeds in the cap amount with the court, sued me and the other unfortunates as defendants and said essentially, judge: “let us go and let‘em fight over the cap money between themselves.” The judge followed the law, absolved the culprits of any further financial responsibility wherever and whenever it was sought and assigned another judge as the “Decider” in allocating the funds between the unfortunates. Each unfortunate was assigned an allocation of damages hearing before the Decider. By the time the Decider got to me, I was ready1. Ready to tell him I didn’t want any money that would otherwise go to the other unfortunates. I did want, however, to make sure none of it went back to the people that caused the wreck.
I didn’t get the chance to say that, in fact I didn’t get to say much at all. Out of the box the Decider tells me there isn’t enough to go around even for those seriously injured. My hearing wasn’t fun, but as every lawyer knows some times in court you have to keep your mouth shut and let the judge verbally beat the crap out of you about something that you didn’t do2.
The Decider turned out to be a pretty smart person. He issued a stunningly descriptive opinion (the description starts on page 5) and I recommend that you read it. I provide the link to it below. Not for nothing but I “withdrew” my “claim”.
So at the end of the day this Tort Reform law transferred all of the realized risk caused by the people who caused the crash to the pocket books and broken bodies of the unfortunates. Is there moral hazard in that? I don’t know. Read the Decider’s opinion. It should be entitled “The foreseeable consequences of driving a locomotive while texting on your cell phone.”
- The lawyer for one of the culprit/plaintiffs actually filed a brief in opposition for my hearing stating that I had not proved I was on the commuter train and in the crash. This is so despite listing me as a passenger in his complaint and specifically naming me as a defendant/passenger in the Interpleader action and then having me (as opposed to some other Greg Tevis) personally served with the lawsuit. As Bill Murray in Caddie Shack says “so I got that going for me [at the hearing] which is nice.”
- The Judge was troubled that I had not initiated a lawsuit against the culprits contending that such a failure deprived him of jurisdiction over me. This was so notwithstanding the fact that the plaintiffs specifically admitted in their pleadings that I had a “claim” and that the Federal Judge transferred the claims to the Decider’s court for the claim allocation process. Given the Decider’s expression of immense frustration over the lack of adequate funds for those truly in need, I didn’t think that it was beneficial for me to point out among other things, that his court (a California state trial court) was a court of general jurisdiction and if nothing else the parties could be deemed to be subject to its jurisdiction by consent (we were present and had not filed objections to the court’s jurisdiction). So as I say above I kept my mouth shut while he talked. I knew I was going to try and get my “claim” “withdrawn.”
Friday, August 26, 2011
The Yearn to Confirm
A human condition, which operates subconsciously and compulsively - called “confirmation bias” by psychologists - may help explain the impasse we see in ongoing political debate. It has been confirmed to cloud economic decisions and probably has a significant effect on people who decide the outcome of trials and arbitrations.
In short people tend to search for or interpret new information in a way that confirms their existing opinions or beliefs. They avoid information and interpretations which contradict their opinions or beliefs.
Some quotes from Tolstoy on this subject
"I know that most men, including those at ease with problems of the greatest complexity, can seldom accept the simplest and most obvious truth if it be such as would oblige them to admit the falsity of conclusions which they have proudly taught to others, and which they have woven, thread by thread, into the fabrics of their life"
"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”
A quote from Francis Bacon
“The human understanding when it has once adopted an opinion ... draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects or despises, or else by some distinction sets aside or rejects.”
Google “confirmation bias” if you want to research this phenomena. Wikipedia has a good piece with substantial footnotes on the psychological studies which identified or discussed this bias.
In short people tend to search for or interpret new information in a way that confirms their existing opinions or beliefs. They avoid information and interpretations which contradict their opinions or beliefs.
Some quotes from Tolstoy on this subject
"I know that most men, including those at ease with problems of the greatest complexity, can seldom accept the simplest and most obvious truth if it be such as would oblige them to admit the falsity of conclusions which they have proudly taught to others, and which they have woven, thread by thread, into the fabrics of their life"
"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”
A quote from Francis Bacon
“The human understanding when it has once adopted an opinion ... draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects or despises, or else by some distinction sets aside or rejects.”
Google “confirmation bias” if you want to research this phenomena. Wikipedia has a good piece with substantial footnotes on the psychological studies which identified or discussed this bias.
Thursday, August 4, 2011
People Overreact to News both Good and Bad
When we are asked to recall a list of items in any order (free recall), we tend to begin recall with the end of the list, recalling those items best (the “recency effect”).
People tend to place far too much emphasis on recently announced “news.” Rather than placing the appropriate emphasis on more salient but “distant” information, we emphasize what we can recall and the easier it is to recall (some might say “fresher or vivid in our minds”) the more importance we place on that information.
The foregoing phenomenon helps explain the sudden swings in our financial markets.
People tend to place far too much emphasis on recently announced “news.” Rather than placing the appropriate emphasis on more salient but “distant” information, we emphasize what we can recall and the easier it is to recall (some might say “fresher or vivid in our minds”) the more importance we place on that information.
The foregoing phenomenon helps explain the sudden swings in our financial markets.
Thursday, June 30, 2011
As For Me - a Message for July 4th
Politics is a lot like economics. Take for instance free enterprise or for that matter freedom in general. Most participants in human endeavor talk the talk but don’t walk the walk. We as Americans do and we need to remind our children that we do and how hard this is to do so. As we approach July 4th we should remember that we are in the minority. Most participants talk about freedom but wish for a system that is rigged in their favor.
Last year I directed your attention to the words of our national anthem.
This year I direct you to words uttered on March 23, 1775. I believe it does our souls good to read these words and recognize they reflect what we are. To read them visit
http://www.law.ou.edu/ushistory/henry.shtml
As for me..... I think the gentleman was correct.
Last year I directed your attention to the words of our national anthem.
This year I direct you to words uttered on March 23, 1775. I believe it does our souls good to read these words and recognize they reflect what we are. To read them visit
http://www.law.ou.edu/ushistory/henry.shtml
As for me..... I think the gentleman was correct.
Friday, June 3, 2011
Congressional Idiots - part two
If you want to make certain that a statement you make in response to a personal question is not believed - equivocate.
Thursday, May 19, 2011
Educated guesses are the best we can do
"Suppose you were an idiot, and suppose you were a member of congress; but I repeat myself.”
- Mark Twain
Economics is, at best, an uncertain science. No one - not even Nobel prize winning economists - “ knows” the economic effect of any activity, effort or event. Yet members of congress (from both parties) constantly pontificate as if they do. Any one of them who makes a statement like that is an idiot. But I repeat myself.
Consider this in the coming debate.
- Mark Twain
Economics is, at best, an uncertain science. No one - not even Nobel prize winning economists - “ knows” the economic effect of any activity, effort or event. Yet members of congress (from both parties) constantly pontificate as if they do. Any one of them who makes a statement like that is an idiot. But I repeat myself.
Consider this in the coming debate.
Friday, April 15, 2011
A Temptation that is Terrible
Even when a risk is real sacrificing due process of law is terribly tempting but also tempting something terrible. Yet even in this country we see it urged upon us from time to time. Like the dogs of war, once you begin to trade liberty for safety….
Friday, March 18, 2011
The Distinction between a question of if and a question of when
I was listening to the evening news last night when I heard Brian Williams say “the Japanese government is using helicopters, fire trucks and water cannon to try and contain the nuclear disaster at the Fukushima Daiichi power plant.”
Helicopters, fire trucks and water cannon are the tools we are reduced to using to solve a disaster at a plant over which billions of dollars were spent in its design and construction. Presumably some of that money was spent with safety in mind.
So let me see if I have this straight (think back to your high school geometry training):
1. Japan and its east coast in particular sit at the center of earthquake universe.
2. The location of the major fault and the structure of the ocean floor off the east coast of Japan are well known and make it certain that a tsunami will occur after an earthquake there.
3. Tsunamis are giant ocean waves followed by a flood.
4. You build your nuclear plant on the coast right where the tsunami will strike if an earthquake happens.
5. It isn’t a question of if an earthquake will happen it’s a question of when.
6. Pumping water into the reactors is the critical and only method of averting a meltdown disaster.
7. The pumps require power to operate.
8. After billions of dollars in design you put the backup power systems right on sea level at the plant and even put them between the reactors and the seashore. As Jon Stewart would say – at the seashore, on sea level, right where the tsunami is going to strike.
9. If the power to the pumps goes out the rest of the design safety doesn’t make any difference.
Well then you had better make sure you keep the helicopters, fire trucks and water cannon nearby but for heaven sake don’t put them in the same spot you put the back up power supply – on the seashore, at sea level, right where the tsunami will strike.
Because remember it is not a question of if, it is a question of when.
And another thing, remember when I said we are not stupid, well forget that.
Will Rogers, where are you man?
Helicopters, fire trucks and water cannon are the tools we are reduced to using to solve a disaster at a plant over which billions of dollars were spent in its design and construction. Presumably some of that money was spent with safety in mind.
So let me see if I have this straight (think back to your high school geometry training):
1. Japan and its east coast in particular sit at the center of earthquake universe.
2. The location of the major fault and the structure of the ocean floor off the east coast of Japan are well known and make it certain that a tsunami will occur after an earthquake there.
3. Tsunamis are giant ocean waves followed by a flood.
4. You build your nuclear plant on the coast right where the tsunami will strike if an earthquake happens.
5. It isn’t a question of if an earthquake will happen it’s a question of when.
6. Pumping water into the reactors is the critical and only method of averting a meltdown disaster.
7. The pumps require power to operate.
8. After billions of dollars in design you put the backup power systems right on sea level at the plant and even put them between the reactors and the seashore. As Jon Stewart would say – at the seashore, on sea level, right where the tsunami is going to strike.
9. If the power to the pumps goes out the rest of the design safety doesn’t make any difference.
Well then you had better make sure you keep the helicopters, fire trucks and water cannon nearby but for heaven sake don’t put them in the same spot you put the back up power supply – on the seashore, at sea level, right where the tsunami will strike.
Because remember it is not a question of if, it is a question of when.
And another thing, remember when I said we are not stupid, well forget that.
Will Rogers, where are you man?
Wednesday, February 9, 2011
Will Rogers was correct
Recently I read Michael Lewis’ book The Big Short. I have read several books which attempt to explain or at least describe the financial collapse we experienced several years ago. Mr. Lewis’ book is by far the best and I recommend it for those interested in this subject. His book is not without short comings however. One is its failure to adequately address what is addressed in a terrific article by Felix Salmon in Wired Magazine, “Recipe for Disaster: The Formula that Destroyed Wall Street.” Here is the link to the article:
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1
The article describes the “Gaussian copula function” or formula. This is in essence a mathematical function (equation) developed by a PhD mathematician in the 1990s and used by wall street "Quants" (financial wizards with mathematical backgrounds) to determine the risk of CDOs composed of residential mortgages. The formula did not depend on historical information to determine risk but instead used market data about the prices of credit default swaps. Say what? - but that is my point in this Observation. The upshot is that our Quants took this formula and ran with it. I know at this juncture you don’t understand and frankly after reading the article I still don’t understand what the Quants saw and how they concluded that they had things figured out on the risk of these CDOs. But that in fact is what they thought and they convinced everyone else that mattered (including Wall Street CEOs and people at the rating firms) that they, the Quants, had successfully quantified the risk on these esoteric financial products. The article places a great deal of emphasis on the fact that although the formula was fine as an intellectual exercise (that is it worked when you placed close restrictive parameters on the values that could be given to the variables in the equation), for practical real world application (where those parameters did not exist) the equation was fatally flawed. On that precise point no one (including the Quants or the people who either didn't inquire or gave up trying to understand and just assumed the Quants were too smart to be wrong) had figured this out until it was too late. The use of the formula permitted and justified the development and dramatic (suicidal) expansion of the market for CDOs and related products (such as Credit Default Swaps on CDOs which consisted of subprime residential mortgages). The rest is described in Mr. Lewis’ book. Looking back over 2007-2009 I went over some of my Observations from that period that relate to the points I have raised here. I have reproduced them below with an added [editorial comment].
• Separating the truth from fiction
“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.”
Charles Mackay – Scottish Philosopher
If you don’t understand something ask for an explanation. If the explanation doesn’t make sense ask for clarification. If it still doesn’t make sense the problem is not you or your capacity to understand. It’s that “it” doesn’t make sense.
Implying that people who “don’t understand” are dense is a common persuasive tactic of people who themselves don’t actually understand (or worse).
The problems we often encounter are not caused by our lack of mental capacity, but by our willingness to go along with such an implication.
-03/24/2008
• Demigod (Demon)
Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process goes on constantly, often the result of actions by their subordinates.
We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.
We should overcome the temptation to do so.
- 07/07/2008
• What happened (11/05/2007)
Here is my take:
People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence and a lack of perception of the amount of risk they are undertaking in making financial decisions. This in turn tends to burn them from time to time and it kick starts the law of unintended consequences hurting others.
10/01/2008 Supplement: Senior executives in financial firms, quasi governmental entities (Fannie, Freddie), and regulatory authorities listened to and accepted the explanation (by senior but subordinate experts) of the “risks incurred” for various proposed offerings and undertakings. The senior executives and those making a proposal were far too confident that the analysis of the risk/reward balance on the proposal was based on accurate and complete underlying data. That is a classic and oft repeated mistake. This led to tragic overconfidence and the assumption of a level of risk that was unknown and unprecedented sending the law of unintended consequences off on a gallop.
But make no mistake we all had a hand in this. Whining that it was someone else’s fault isn’t going to help.
-09/29/2008
• Never again! Really? The Devil you say.
Last week I was asked to explain one comment in my Observation. That comment was that “we all had a hand in it.” By “it” of course I meant the present economic conundrum. By “we” I meant to include the population at large.
I was then asked to explain my reasoning.1 I gave the following explanation:
We are all subject to human imperfection. I have discussed many of those imperfections (cognitive biases) in my Observations because they do impact our business and our lives in general. One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is:
People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis (remember my Observation about Chicken Little -03/17/2008). They are then unpleasantly surprised when the “trend” ends and things revert to the mean. Hence the following previous Observation:
• Yes but this time it’s different
It never is.
Why do you think they named it the “mean?”
Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it.
- 06/18/2007
Ok how does all of the foregoing apply to our present situation? When real estate began to “take off” (late 90’s) and that market condition continued until then general public perceived it as a trend this “cognitive bias”, called recency or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the possibility of making a large profit comes in the room a cognitive bias causes probability to head for an exit -05/27/2008).
Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans. Yes that’s how far logic strayed. All of us were aware of what was transpiring.2 We simply did not perceive how short the trend would last and how far and extensive the damage would be.
Then the trend ended and now -
We know how mean the mean is.
Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on.
People say that we should learn from this and never let it happen again. Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions. Our shortcomings are embedded in our DNA.
The best strategy in my view is to remember our shortcomings as human beings and do our best with those in mind to avoid repeating our economic mistakes.3
Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation) is no doubt going to have a field day with these peccadilloes.
1. There is no truth to the rumor that it was someone running for political office (no not the one you are thinking) that asked me.
2. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.”
3. In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People how to learn. The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome. In order to keep history from repeating itself we need instead to focus on the one thing we had and will have control over and that is our own conduct. That is why in my previous observation I said “Whining that it was someone else’s fault isn’t going to help.”
-10/06/2008
• Prognostication is a four letter word (and so is overconfidence)
I was all set with a different Observation for today but then a financial guru testified before Congress on Thursday. I read a transcript of part of his testimony and I just could not resist.
What he said was:
"It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."
What he meant was:
They thought they had it figured out but they didn’t and it turned out to bite everyone on the....*
*reminds me of when I was young and used to set off firecrackers with my buddies. Once we set off several hundred in a row without a failure. Then one of didn’t go off after being lit. Georgie Wade stuck his head over the darn thing; it flared up and burnt his eyebrows off.
-10/27/2008
• A lesson we all should learn
“It isn't what we don't know that gives us trouble; it's what we know that ain't so.”
- Will Rogers
An earlier Observation on behavioral economics bears repeating.
Risk taken by individuals and businesses often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption.
How does this happen?
• By overconfidence that the information one is going to base a decision on is (i) complete and (ii) accurate.
• By overconfidence in one’s ability to analyze the information that is available.
--------
You see what the Quants ultimately used the Gaussian Copula function for was to assess the likelihood (risk) that one ninja loan contained in a CDO would go bad at or about the same time another ninja loan in the same CDO had gone bad. In plain English, were the two events related or to use statistical language “correlated.” If the answer was no and you put a lot of those ninja loans in the CDO then the risk of the CDO itself going bad was reduced to next to nothing. The assessment was that there was no correlation (the formula assumed the correlation stayed the same) and presto you could conclude with mathematical certainty that you could rate a CDO crammed entirely with Ninja loans as “AAA.” No one stopped to consider a general real estate decline (because that was not a factor considered in the Gaussian Copula function) and hence a situation where the loans would act the same at the same time. The relationship (or rather lack of one) between loan outcomes was considered to be or remain constant.
In truth during good economic times there is no relationship between the outcome from one residential loan to another. So the correlation is zero and no risk to a ninja CDO. But in bad times the relationship starts to exist and gets stronger the worse times get until there is a direct relationship and a ninja CDO has sufficient defaults in its compiled ninja loans that the value of the CDO goes from par to zero itself. Poof.
Now someone like Will Rogers with a great deal of main street common sense would have stepped back from the fray and said to the Quants - “your idea doesn’t make sense and I am not buying your explanation.”
Unfortunately Mr. Rogers isn’t with us. Just remember it’s what you know that ain’t so...that really hurts you. Oh and you’re not stupid - if it doesn’t make sense it’s because “it” doesn’t make sense.
-01/10/2009
[There – now I feel better.]
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1
The article describes the “Gaussian copula function” or formula. This is in essence a mathematical function (equation) developed by a PhD mathematician in the 1990s and used by wall street "Quants" (financial wizards with mathematical backgrounds) to determine the risk of CDOs composed of residential mortgages. The formula did not depend on historical information to determine risk but instead used market data about the prices of credit default swaps. Say what? - but that is my point in this Observation. The upshot is that our Quants took this formula and ran with it. I know at this juncture you don’t understand and frankly after reading the article I still don’t understand what the Quants saw and how they concluded that they had things figured out on the risk of these CDOs. But that in fact is what they thought and they convinced everyone else that mattered (including Wall Street CEOs and people at the rating firms) that they, the Quants, had successfully quantified the risk on these esoteric financial products. The article places a great deal of emphasis on the fact that although the formula was fine as an intellectual exercise (that is it worked when you placed close restrictive parameters on the values that could be given to the variables in the equation), for practical real world application (where those parameters did not exist) the equation was fatally flawed. On that precise point no one (including the Quants or the people who either didn't inquire or gave up trying to understand and just assumed the Quants were too smart to be wrong) had figured this out until it was too late. The use of the formula permitted and justified the development and dramatic (suicidal) expansion of the market for CDOs and related products (such as Credit Default Swaps on CDOs which consisted of subprime residential mortgages). The rest is described in Mr. Lewis’ book. Looking back over 2007-2009 I went over some of my Observations from that period that relate to the points I have raised here. I have reproduced them below with an added [editorial comment].
• Separating the truth from fiction
“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.”
Charles Mackay – Scottish Philosopher
If you don’t understand something ask for an explanation. If the explanation doesn’t make sense ask for clarification. If it still doesn’t make sense the problem is not you or your capacity to understand. It’s that “it” doesn’t make sense.
Implying that people who “don’t understand” are dense is a common persuasive tactic of people who themselves don’t actually understand (or worse).
The problems we often encounter are not caused by our lack of mental capacity, but by our willingness to go along with such an implication.
-03/24/2008
• Demigod (Demon)
Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process goes on constantly, often the result of actions by their subordinates.
We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.
We should overcome the temptation to do so.
- 07/07/2008
• What happened (11/05/2007)
Here is my take:
People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence and a lack of perception of the amount of risk they are undertaking in making financial decisions. This in turn tends to burn them from time to time and it kick starts the law of unintended consequences hurting others.
10/01/2008 Supplement: Senior executives in financial firms, quasi governmental entities (Fannie, Freddie), and regulatory authorities listened to and accepted the explanation (by senior but subordinate experts) of the “risks incurred” for various proposed offerings and undertakings. The senior executives and those making a proposal were far too confident that the analysis of the risk/reward balance on the proposal was based on accurate and complete underlying data. That is a classic and oft repeated mistake. This led to tragic overconfidence and the assumption of a level of risk that was unknown and unprecedented sending the law of unintended consequences off on a gallop.
But make no mistake we all had a hand in this. Whining that it was someone else’s fault isn’t going to help.
-09/29/2008
• Never again! Really? The Devil you say.
Last week I was asked to explain one comment in my Observation. That comment was that “we all had a hand in it.” By “it” of course I meant the present economic conundrum. By “we” I meant to include the population at large.
I was then asked to explain my reasoning.1 I gave the following explanation:
We are all subject to human imperfection. I have discussed many of those imperfections (cognitive biases) in my Observations because they do impact our business and our lives in general. One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is:
People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis (remember my Observation about Chicken Little -03/17/2008). They are then unpleasantly surprised when the “trend” ends and things revert to the mean. Hence the following previous Observation:
• Yes but this time it’s different
It never is.
Why do you think they named it the “mean?”
Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it.
- 06/18/2007
Ok how does all of the foregoing apply to our present situation? When real estate began to “take off” (late 90’s) and that market condition continued until then general public perceived it as a trend this “cognitive bias”, called recency or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the possibility of making a large profit comes in the room a cognitive bias causes probability to head for an exit -05/27/2008).
Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans. Yes that’s how far logic strayed. All of us were aware of what was transpiring.2 We simply did not perceive how short the trend would last and how far and extensive the damage would be.
Then the trend ended and now -
We know how mean the mean is.
Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on.
People say that we should learn from this and never let it happen again. Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions. Our shortcomings are embedded in our DNA.
The best strategy in my view is to remember our shortcomings as human beings and do our best with those in mind to avoid repeating our economic mistakes.3
Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation) is no doubt going to have a field day with these peccadilloes.
1. There is no truth to the rumor that it was someone running for political office (no not the one you are thinking) that asked me.
2. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.”
3. In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People how to learn. The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome. In order to keep history from repeating itself we need instead to focus on the one thing we had and will have control over and that is our own conduct. That is why in my previous observation I said “Whining that it was someone else’s fault isn’t going to help.”
-10/06/2008
• Prognostication is a four letter word (and so is overconfidence)
I was all set with a different Observation for today but then a financial guru testified before Congress on Thursday. I read a transcript of part of his testimony and I just could not resist.
What he said was:
"It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."
What he meant was:
They thought they had it figured out but they didn’t and it turned out to bite everyone on the....*
*reminds me of when I was young and used to set off firecrackers with my buddies. Once we set off several hundred in a row without a failure. Then one of didn’t go off after being lit. Georgie Wade stuck his head over the darn thing; it flared up and burnt his eyebrows off.
-10/27/2008
• A lesson we all should learn
“It isn't what we don't know that gives us trouble; it's what we know that ain't so.”
- Will Rogers
An earlier Observation on behavioral economics bears repeating.
Risk taken by individuals and businesses often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption.
How does this happen?
• By overconfidence that the information one is going to base a decision on is (i) complete and (ii) accurate.
• By overconfidence in one’s ability to analyze the information that is available.
--------
You see what the Quants ultimately used the Gaussian Copula function for was to assess the likelihood (risk) that one ninja loan contained in a CDO would go bad at or about the same time another ninja loan in the same CDO had gone bad. In plain English, were the two events related or to use statistical language “correlated.” If the answer was no and you put a lot of those ninja loans in the CDO then the risk of the CDO itself going bad was reduced to next to nothing. The assessment was that there was no correlation (the formula assumed the correlation stayed the same) and presto you could conclude with mathematical certainty that you could rate a CDO crammed entirely with Ninja loans as “AAA.” No one stopped to consider a general real estate decline (because that was not a factor considered in the Gaussian Copula function) and hence a situation where the loans would act the same at the same time. The relationship (or rather lack of one) between loan outcomes was considered to be or remain constant.
In truth during good economic times there is no relationship between the outcome from one residential loan to another. So the correlation is zero and no risk to a ninja CDO. But in bad times the relationship starts to exist and gets stronger the worse times get until there is a direct relationship and a ninja CDO has sufficient defaults in its compiled ninja loans that the value of the CDO goes from par to zero itself. Poof.
Now someone like Will Rogers with a great deal of main street common sense would have stepped back from the fray and said to the Quants - “your idea doesn’t make sense and I am not buying your explanation.”
Unfortunately Mr. Rogers isn’t with us. Just remember it’s what you know that ain’t so...that really hurts you. Oh and you’re not stupid - if it doesn’t make sense it’s because “it” doesn’t make sense.
-01/10/2009
[There – now I feel better.]
Tuesday, January 25, 2011
Risk to Others - The Risk Remains
Recently I observed something that reminded me of two observations I made in a former life
· I sincerely wish the following were not true but it is:
When someone ignores a rule, regulation or law in our business they affect the lives of other people.
-08//14/2006
· Exceptions
Requests for exceptions should be considered in the context that they will exist. The risk will remain long after the goal is achieved. -09/12/2006
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