Category Archives: Finance

Seek Superstar Slavery

The latest Review of Economic Studies has a great article (ungated here) by Marko Tervio.  I'll summarize.

CEOs, actors, directors, musicians, authors, and athletes make big bucks because:

  1. Desired abilities are rare and lasting.
  2. It is very expensive to try someone new.
  3. Everyone can see which trials worked or not.
  4. Winners are free to demand more money or walk.

Given these conditions, a few proven winners make big bucks, and few new folks get tried.  After all, a new trial who wins will soon demand as much as other winners.  Here winners avoid retirement to keep milking their gravy train, and small biases in weak signals on new guys to try can magnify into great social injustice. 

Condition 4 is crucial.  When long term deals are allowed, more folks are tried, because a few successes can pay for lots of failures.  Folks being tried get paid more, and there are more better winners who retire earlier and are paid less even when free to walk.  Distorted signals about who to try matter less.  Such long term deal gains were realized, for example, in the US movie studio system of the 1920-40s, the old US American baseball club system, and even now via exclusive long-term music album deals.

Over the last century, however, legislatures and courts have consistently moved to limit and prohibit such long term contracts, thereby increasing inequality and decreasing productivity.  France even forbids artists from selling the full value of their paintings.  The key tipping factor here seems to me to be a public displeased by seeing gains by admired musicians, actors, athletes, artists etc. going to less admired others.  The word "slavery" is often invoked. For example, music fans can be outraged to see their favorite musicians shackled to ungenerous album deals. 

So our vast wage inequality of superstar CEOs, artists, athletes, etc. is caused not by a lack of sensible regulation to limit random cruelties of unfettered markets, but by a public preferring its heroes unshackled, even if those heros had preferred otherwise. Now maybe insuring heroes against financial variations imposes a negative externality on wider admiring publics, one large enough to justify preventing long term deals.  But for now count me as skeptical; I'd rather allow CEO and other superhero "slavery," for their good and ours. 

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Near-Far Like Drunk Darts?

From a recent book review:

Jonah Lehrer's mission in The Decisive Moment is to help us determine when to override our instincts and when to let them run. … One of Lehrer's interesting recommendations [is]: trust your emotions in situations where you have had a lot of experience, since this is when [your brain is] … best equipped to warn you of any deviations from their established patterns. In novel situations, on the other hand, such as when playing a new game or considering a risk to your health, it is a good idea to take a step back and do the maths, even though your emotional brain will tell you it knows better.

Macroeconomists have seen lots of precedents for this economic crisis; this isn't too far out of line from what they've seen before elsewhere. I've heard some macro folk complain that bigshot macroeconomist advice for us-now differs substantially from what they've written about there-then, i.e., about how others should have dealt with similar problems at other times.  Apparently they give different advice when a crisis is seen as "near" versus "far."  Which advice is better?

The quote above suggests this is like asking if you should drink before competing in a darts championship. If you've always practiced darts while drunk, you may be better at darts when drunk than sober; in which case you should compete drunk. Similarly, if macroeconomists have developed most of their expertise while considering events in far mode, they might give better advice when in far than near mode.  In which case we are getting bad advice.

Perhaps macroeconomists would give even better advice if they had trained in a near mode, just as you might compete better at darts if you'd trained sober.  (At least they might if my far-image near-decision speculation is correct.)  But once the training mode has been chosen, and it is time to act, that option may be no longer available.

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Markets are Anti-Inductive

I suspect there's a Pons Asinorum of probability between the bettor who thinks that you make money on horse races by betting on the horse you think will win, and the bettor who realizes that you can only make money on horse races if you find horses whose odds seem poorly calibrated relative to superior probabilistic guesses.

There is, I think, a second Pons Asinorum associated with more advanced finance, and it is the concept that markets are an anti-inductive environment.

Let's say you see me flipping a coin.  It is not necessarily a fair coin.  It's a biased coin, and you don't know the bias.  I flip the coin nine times, and the coin comes up "heads" each time.  I flip the coin a tenth time.  What is the probability that it comes up heads?

If you answered "ten-elevenths, by Laplace's Rule of Succession", you are a fine scientist in ordinary environments, but you will lose money in finance.

In finance the correct reply is, "Well… if everyone else also saw the coin coming up heads… then by now the odds are probably back to fifty-fifty."

Recently on Hacker News I saw a commenter insisting that stock prices had nowhere to go but down, because the economy was in such awful shape.  If stock prices have nowhere to go but down, and everyone knows it, then trades won't clear – remember, for every seller there must be a buyer – until prices have gone down far enough that there is once again a possibility of prices going up.

So you can see the bizarreness of someone saying, "Real estate prices have gone up by 10% a year for the last N years, and we've never seen a drop."  This treats the market like it was the mass of an electron or something.  Markets are anti-inductive.  If, historically, real estate prices have always gone up, they will keep rising until they can go down.

Continue reading "Markets are Anti-Inductive" »

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On Not Having an Advance Abyssal Plan

"Even though he could foresee the problem then, we can see it equally well now.  Therefore, if he could foresee the solution then, we should be able to see it now.  After all, Seldon was not a magician.  There are no trick methods of escaping a dilemma that he can see and we can't."
        — Salvor Hardin

Years ago at the Singularity Institute, the Board was entertaining a proposal to expand somewhat.  I wasn't sure our funding was able to support the expansion, so I insisted that – if we started running out of money – we decide in advance who got fired and what got shut down, in what order.

Even over the electronic aether, you could hear the uncomfortable silence.

"Why can't we decide that at the time, if the worst happens?" they said, or something along those lines.

"For the same reason that when you're buying a stock you think will go up, you decide how far it has to decline before it means you were wrong," I said, or something along those lines; this being far back enough in time that I would still have used stock-trading in a rationality example.  "If we can make that decision during a crisis, we ought to be able to make it now.  And if I can't trust that we can make this decision in a crisis, I can't trust this to go forward."

People are really, really reluctant to plan in advance for the abyss.  But what good reason is there not to?  How can you be worse off from knowing in advance what you'll do in the worse cases?

I have been trying fairly hard to keep my mouth shut about the current economic crisis.  But still –

Why didn't various governments create and publish a plan for what they would do in the event of various forms of financial collapse, before it actually happened?

Continue reading "On Not Having an Advance Abyssal Plan" »

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Who Are Macro Experts?

I never learned much macro-econ; they didn't respect it at Caltech where I got my Ph.D.  So while my econ colleagues blog 24/7 about the macro crisis, I've mostly kept quiet.  But I can speak on this issue: who are the real "experts"?

During this crisis, politicians and reporters have been eager to cite "economists" in support of their causes.  For example, Obama:

What I've said is what other economists have said across the political spectrum, which is that, if you delay acting on an economy of this severity, then you potentially create a negative spiral that becomes much more difficult for us to get out of. 

The Post:

While economists remain divided on the role of government generally, an overwhelming number from both parties are saying that a government stimulus package — even a flawed one — is urgently needed to help prevent a steeper slide in the economy. 

So who are these "economists"?  While Bryan reports "almost none of the economic `experts' pontificating [in the media] on Obama's economic plan are actually [degreed] economists", Obama and the Post were probably talking about standard "prestigious" economists, i.e., those holding top positions in prestigious institutions.  But are these really the most accurate sources for macro policy advice?  What is the best way to identify "experts" on such topics anyway? 

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Investing for the Long Slump

I have no crystal ball with which to predict the Future, a confession that comes as a surprise to some journalists who interview me.  Still less do I think I have the ability to out-predict markets.  On every occasion when I've considered betting against a prediction market – most recently, betting against Barack Obama as President – I've been glad that I didn't.  I admit that I was concerned in advance about the recent complexity crash, but then I've been concerned about it since 1994, which isn't very good market timing.

I say all this so that no one panics when I ask:

Suppose that the whole global economy goes the way of Japan (which, by the Nikkei 225, has now lost two decades).

Suppose the global economy is still in the Long Slump in 2039.

Most market participants seem to think this scenario is extremely implausible.  Is there a simple way to bet on it at a very low price?

If most traders act as if this scenario has a probability of 1%, is there a simple bet, executable using an ordinary brokerage account, that pays off 100 to 1?

Why do I ask?  Well… in general, it seems to me that other people are not pessimistic enough; they prefer not to stare overlong or overhard into the dark; and they attach too little probability to things operating in a mode outside their past experience.

But in this particular case, the question is motivated by my thinking, "Conditioning on the proposition that the Earth as we know it is still here in 2040, what might have happened during the preceding thirty years?"

Continue reading "Investing for the Long Slump" »

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Bad News Predictor Jailed

The Economist a month ago:

Back in September a message appeared on an online bulletin board owned by Daum, the most popular web host in a country, South Korea, with a huge internet culture. Written by someone called "Minerva," it predicted the imminent collapse of Lehman Brothers, a now-defunct investment bank.

Wild speculation is normally disregarded, but when it proved to be right just five days later, a prophet was born. Word raced through the "netizen" community, and when Minerva went on to predict that the Korean won would fall against the dollar by around 50 won a day in the first half of the week of October 6th, his followers began to watch the currency markets in anticipation. The won did indeed fall by about that much over the next three days.

Minerva became an internet phenomenon, with 40m-odd hits to date. Web-users combed through previous posts, looking for prognostications, and clues about his identity. Sharp comments on the state of the Korean economy and government policy only increased his standing. … It came as little surprise when the finance minister, Kang Man-soo, admitted that officials had attempted to uncover the blogger's identity.

Today's news:

South Korea set a rare and controversial example over the weekend by arresting a popular blogger who was accused of undermining the financial markets but worshipped by many Koreans as an online guru.

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Entrepreneurs Are Not Overconfident

Not too long ago, the well-known economist Robert Hall presented this paper (co-authored with Susan E. Woodward) at my place of work.  Here is the abstract:

In the standard venture capital contract, entrepreneurs have a large fraction of equity ownership in the companies they found and are paid a sub-market salary by the investors who provide the money to develop the idea.  The big rewards come only to those whose companies go public or are acquired on favorable terms, forcing entrepreneurs to bear a substantial burden of idiosyncratic risk.  We study this burden in the case of high-tech companies funded by venture capital.  Over the past 20 years, the typical venture-backed entrepreneur earned an average of $4.4 million from companies that succeeded in attracting venture funding.  Entrepreneurs with a coefficient of relative risk aversion of two and with less than $0.7 million would be better off in a salaried position than in a startup, despite the prospect of an average personal payoff of $4.4 million and the possibility of payoffs over $1 billion.  We conclude that startups attract entrepreneurs with lower risk aversion, higher initial assets, preferences for entrepreneurship over employment, and optimistic beliefs about the payoffs from their products.

During the seminar it occurred to me that these results, assuming they are correct, are evidence of an absence of overconfidence, at least among the kinds of people who leave good jobs to form high-tech startups.  The reason is that if potential entrepreneurs were massively overconfident, one would expect to see lots of entry of startups based on weak ideas, which would lead to an expected payoff so low that forming a startup would be a losing proposition for the potential entrepreneur unless he/she started out extremely wealthy and/or had very low risk-aversion.  But what the authors actually find is that forming a startup with an average-quality idea* is a break-even proposition for a potential entrepreneur with quite modest wealth and with a more-or-less standard degree of risk-aversion.

After the talk, I asked Professor Hall if he agreed with this interpretation (he seemed to), and if he would object to my posting about it on OB (he didn't).  But I will make him aware of this post, and invite him to comment if he would like, and correct any mistakes that I might have made.

*The authors have no way to distinguish the quality of an idea, so there is an implicit assumption that the marginal quality of the idea is equal to the average quality of all ideas that actually get implemented.
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Trade With The Future

Richard Chappell rises to my challenge:

We're not doing the world any favours by populating the future with our primitive 20th(-21st) century minds. … So cryonicists must assume that it is better to extend an existing life than to create a new one. … Many people are (quite reasonably!) wedded to the particularities of their life and situation, … insofar as this newly awakened person would be enculturated into a new society, acquiring new values and life projects, they are effectively becoming a new and different person. But … then revival is unjustified: a better new life could be created 'from scratch', so to speak.  So cryonics is (at best) only justified for people whose central concerns and life projects could continue to be fruitfully pursued upon revival in a transhuman society.

Imagine a volcano is about to destroy an island and we go to local villages telling the natives boats are waiting at the shore, and urging people to leave without delay.  It would be odd to object saying their lives somewhere else will be different enough to make them different people, and so the world would be better off just raising new people to live in those other places.  Perhaps you just want us to remind people that maybe they would really rather just die than live such a different life, but even that seems a bit odd.

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Gas Arbitrage

When I bought my Miata the dealer told me to use premium gas, but my wife recently suggested I try regular.  At which point I considered midgrade gas, and noticed: one is better off mixing regular and premium than buying midgrade!  For regular, midgrade, premium, the $/gal. prices were 1.77, 1.92, 2.02 , while the octane ratings were 87, 89, 93.  So the first jump gives you 2 octane points for $0.15, while the second jump gives you 4 octane points for only $0.10.  Since mixing gas averages the octane ratings, if you mix 2/3 regular with 1/3 premium, you make your own midgrade gas for only 1.85, saving 0.07.  I then went searching and found this Feb ’08 paper:

Regular octane remains the product of choice for most consumers with an 82.2% market share in 2006.  Midgrade is a mature product with a 2006 market share of 9.3%. Premium’s market share ranks last at 8.4% in 2006. … Midgrade is a redundant product offering, easily and almost costlessly replicated by mixing existing regular and premium products. Indeed, this redundancy is widely known and exploited by … just-in-time mixing at the retail pump from separate underground regular and premium storage tanks. … It is rare to see a consumer create a midgrade by buying from two retail feedstocks at a single retail gas station. This is true despite the overwhelming evidence that consumer midgrade mixing is almost uniformly the least costly way to buy retail midgrade. …

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