Overcoming Bias

Modern Depressions

To make you extra thankful today, an excellent summary of what a depression today would look like:

The lines wouldn't be outside soup kitchens but at emergency rooms, and rather than itinerant farmers we could see waves of laid-off office workers leaving homes to foreclosure and heading for areas of the country where there's more work - or just a relative with a free room over the garage.  Already hollowed-out manufacturing cities could be all but deserted, and suburban neighborhoods left checkerboarded, with abandoned houses next to overcrowded ones. ... The flickering glow of millions of televisions glimpsed through living room windows, as the nation's unemployed sit at home filling their days with the cheapest form of distraction available. ...

Diamond Palace Survive?

The November National Geographic has spectacular picts of a gypsum cave found in a Mexico lead/silver mine:

If such a cave were found like this but made of diamonds, would it be revealed or secretly destroyed?  Tourist revenue from a preserved cave would be tiny relative to the revenue from carving it into diamonds for sale. 

Hanging Out My Speaker's Shingle

I was recently invited to give a talk on heuristics and biases at Jane Street Capital, one of the top proprietary trading firms ("proprietary" = they trade their own money).  When I got back home, I realized that (a) I'd successfully managed to work through the trip, and (b) it'd been very pleasant mentally, a nice change of pace.  (One of these days I have to blog about what I discovered at Jane Street - it turns out they've got their own rationalist subculture going.)

So I've decided to hang out my shingle as a speaker at financial companies.

You may be thinking:  "Perhaps, Eliezer, this is not the best of times."

Well... I do have hopes that, among the firms interested in having me as a speaker, a higher-than-usual percentage will have come out of the crash okay.  I checked recently to see if this were the case for Jane Street Capital, and it was.

But more importantly - your competitors are learning the secrets of rationality!  Are you? 

Or maybe I should frame it as:  "Not doing too well this year?  Drop the expensive big-name speakers.  I can give a fascinating and useful talk and I won't charge you as much."

And just to offer a bit of a carrot - if I can monetize by speaking, I'm much less likely to try charging for access to my future writings.  No promises, but something to keep in mind.  So do recommend me to your friends as well.

Beware the Prescient

I was watching Robin's speech at O'Reilly open source convention, and he highlights the usefulness of accumulating track records.  I want to highlight a curious bias to those successfully calling improbable events.  I am talking here about events that have no cross section, so we can not calibrate them in our lifetimes (eg,  when something has a 1% chance of happening ever year, as opposed to something like death rates that have a small probability but a wide cross section).  As Allan Greenspan noted in his Congressional testimony a couple weeks ago on the financial crisis:

the fact that there are a lot of people who raised issues about problems emerging. But there are always a lot of people raising issues, and half the time they are wrong. And the question is, what do you do?

Indeed, there are always people predicting imminent financial disaster and they are usually wrong (see Ravi Batra).   That is, from a Bayesian perspective, given a small probability of say 2% of X, and many (but proportionately few) forecasting X, when X happens, should their opinions be upgraded to a probability of 4%?  If 4%, is that sufficiently large that we should make massive adjustments to incorporate their logic? What if this just reminds us they are outliers, emphasizing 2% events?  What if X happened, but it was because of Y, and not Z as they argued ex ante?

Trust Us!

Few experts in our society could pull off saying:

Emergency!!!  We will suffer terribly if you don't spend a trillion dollars right now overpaying for stuff from our friends!  No, you don't have time to study the problem, nor will we present an analysis for your review.  No, other experts in our field cannot actually see this problem, and there will never be data showing the problem really existed.  You just have to trust us and give us the trillion right now!!

US military experts said something similar on Iraq weapons of mass destruction, but at least they admitted we'd eventually be able to see if they were wrong (as they were).  Medical experts implicitly say something similar about the health value of the second half of medical spending that costs a trillion dollars a year, even when our best data show little value, but this is a steady problem not a sudden new problem.  Global warming experts have been trying, so far without much success, to get us to spend similar amounts on their problem, even though other experts can supposedly verify it.

Given how much less respect and deference economists get on most policy topics, relative to docs, physicists, or generals, I'm surprised to see some economists just got away with this sort of thing.  The US has given top government economists, such as Paulson and Bernanke, well over a trillion in mostly blank checks to spend saving their Wall Street friends from ruin, supposedly to prevent another great depression.  But it seems economists looking today at the data available then just can't find clear evidence a massive buyout was needed.

Traditional Capitalist Values

Followup to:  Are Your Enemies Innately Evil?, Policy Debates Should Not Appear One-Sided

"The financial crisis is not the crisis of capitalism.  It is the crisis of a system that has distanced itself from the most fundamental values of capitalism, which betrayed the spirit of capitalism."
        -- Nicolas Sarkozy

During the current crisis, I've more than once heard someone remarking that financial-firm CEOs who take huge bonuses during the good years and then run away when their black-swan bets blow up, are only exercising the usual capitalist values of "grab all the money you can get".

I think that a fair amount of the enmity in the world, to say nothing of confusion on the Internet, stems from people refusing to contemplate the real values of the opposition as the opposition sees it.  This is something I've remarked upon before, with respect to "the terrorists hate our freedom" or "the suicide hijackers were cowards" (statements that are sheerly silly).

Real value systems - as opposed to pretend demoniacal value systems - are phrased to generate warm fuzzies in their users, not to be easily mocked.  They will sound noble at least to the people who believe them.

Whether anyone actually lives up to that value system, or should, and whether the results are what they are claimed to be; if there are hidden gotchas in the warm fuzzy parts - sure, you can have that debate.  But first you should be clear about how your opposition sees itself - a fact which has not carefully optimized to make your side feel good about its opposition - otherwise you're not engaging the real issues.

So here are the traditional values of capitalism as seen by those who regard it as noble - the sort of Way spoken of by Paul Graham, or P. T. Barnum (who did not say "There's a sucker born every minute"), or Warren Buffett:

Grateful For Bad News

Speculators were blamed for rising oil prices a few months back, but not for recent falling oil prices.  Short-selling speculators were recently blamed for falling stock prices, and actually banned for a few weeks, but no one proposed banning buying speculators two years ago when stocks were rising.  Now Steven Pearlstein of the Post wants to close financial markets for a week:

What we need to do is to stop making things worse by continuing to over-rely on financial markets and financial institutions that have proven to be incapable of performing their core missions: getting capital to where it needs to go and pricing that capital in a way that reflects the risks and underlying economic values. We have to stop digging. Another week like this one, and there won't be much left to rescue. 

To begin, the markets could use a timeout just about now, something that lasts longer than a weekend and gives policymakers around the world the chance to get a good nice sleep and evaluate their options without feeling like they have to respond to every movement flashing across their Bloomberg screens.  It would allow some time for passions to cool and for real investors to regain control of markets now dominated by the computerized short-term trading strategies of hedge funds and hot-shot money managers desperate to recoup some of their losses.

I can't imagine Pearlstein suggesting closing newspapers for a week, or banning them from printing bad finance news for a few weeks.  So Pearlstein doesn't get it:  financial markets are news institutions, just like newspapers!  The fact that newspapers report a lot less news on this crisis on weekends shows that most crisis news now comes via financial markets.  Don't blame the messenger for telling you bad news; blame those who caused the bad news, and who keep you from learning sooner.

The Hope Premium

It is a strange fact that for many professions, the odds of success are extremely low, and so is the average pay.  For example, many people have dreams about getting into acting, but I’ve seen estimates that only 5% of people who call themselves actors make a living acting, as opposed waiting tables and whatnot.  Similar odds exist for would-be novelists, musicians.  There are the high profile people one thinks of for the categories that act like lotto jackpots, a focal point that overwhelms objective odds. It is somewhat unrealistic, if not cruel, to tell people that chasing their dreams is a waste of time.  People like to dream, and after all, ‘the experts’ are often wrong.  Yet I think this phenomenon suggests that perhaps people accept low average ‘return’, in exchange for the dreams these professions present. 

The inequality in these fields, where incomes have a power law distribution, is not bug, it’s a feature.  The presence of superstars, whose income and status is so high, is the offsetting basis of the dreams for those in the industry, why they are willing to accept less 'on average'.  In dreams without such opportunities, you need security, or some other offset to compensate. If this is true, it suggests there is a general hope premium in industries, and even assets.  Many financial assets that have the highest volatilities have below average returns, if not negative returns: out-of-the-money call options, Junk bonds, highly volatile stocks, extreme-odds at the racetrack.  We pay to dream, and it can be frivolous, as with the $1 I recently spent on a $206MM lotto ticket Saturday (odds: 1 in 130 million, I did not win), but it can also be a significant part of one’s investment portfolio (not wise, in my opinion, but real). 

People take risk based on hope, and hope is a function of one’s dreams.  In 1961 Walter Gutman wrote a book You only have to get rich once, and noted that "growth stocks might better be called dream stocks", and that 'dreams are real--we have them every day.  It's a big mistake to think dreams are unreal and what is called real life is real'.   This is a simple, profound, model of the value effect, where stodgy, low beta firms without much upside generate a higher return than stocks that can be classified by some as the next ‘Yahoo!’ Dreams, in moderation of course, are paradoxically as real as anything, and assets that embolden dreams have extra value for investors, and they are willing to accept a lower ‘average’ return because in taking risk, because they are already ignoring the skepticism of the consensus.

Jonathan Alter recently wrote that we should perhaps pay teachers more, and pay their superstars a lot.  I think the data suggest that if we start paying really large salaries for superstar teachers, we could pay a few of them more, but pay them in aggregate less.  That is, we would have just as much supply if we offered them the hope of become very wealthy, with a lower average pay, than our current system, which pays them a rather solid pay but with very limited upside.  No one with really large ambitions goes into education precisely because they top has a low ceiling.  Hope is worth something, in terms of a higher price, and thus lower  return.

White Swans Painted Black

Nassim Taleb has an article related to the current financial crisis. While much of what he says is true, he misleads when he implies that the recent collapse of financial companies resulted from a Black Swan. He claims:

use of probabilistic methods for the estimation of risks did just blow up the banking system

Ban the Bear

I applaud the SEC's courageous move to ban short selling.  Isn't that brilliant?  I wonder why they didn't think of that during the Great Depression.

However, I feel that this valiant effort does not go far enough.

All selling of stocks should be banned.  Once you buy a stock, you have to hold it forever.

Sure, this might make the market a little less liquid.  But once stock prices can only go up, we'll all be rich!

Or maybe we should just try something simpler: pass a law making it illegal for stock prices to go down.