In the latest American Economic Journal, Pindyck and Wang work out what financial prices and their fluctuations suggest about what speculators believe to be the chances of big economic catastrophes. Bottom line
Those are trading markets. Tail risks are priced with the assumption that they can bail out before it hits (trader's overconfidence, so to speak).
There seems a conflict between this miniscule estimate of existential risk and Robin's (belated) embrace of the doomsday argument (after Katja Grace rebutted the self-indication dodge). Did Robin really "update" after reading Katja's thesis?
I can't access the paper, but listed put option prices indicate *way* higher risk-neutral probabilities than what's presented in the paper. Several orders of magnitude at least.
Risk aversion can explain maybe a 100-200% premium, but a 10,000% premium risk aversion premium is just ridiculous.
I can't access the paper, but it seems more likely that the extreme numbers are from a mis-specified model rather than market participants putting such ridiculously low P-values on large capital wipeouts.
Taleb is a charlatan and an idiot, who isn't respected by anyone serious in finance.
Buying out of the money put options is historically a terrible investment strategy. Options are systematically overpriced because there's a lot more natural buyers of insurance than sellers. You'll get big intermittent gains, but those will be more than offset by the rise in option premium following the crash. (Like how re-insurance premiums rise following hurricanes).
There's an ETF that's basically perpetually long out of the money put options, it's called VXX. In under five years it's lose 96.93%.
You still have counterparty risk. If the entity you buy the options from isn't around to honor them after catastrophe strikes, you don't make money.
That's a parasitic strategy that only works as long as no more than a few people use it. Then again, if you're living off of the stock market you've already decided that working for a living isn't for you...
Indeed, people shouldn't just assume directly proportional and linear risk aversion. Partly because in human psychology loss hurts more than profit excites and because there is no stock market safety net (you're screwed if you lose your fortune, the fact that your investment strategy had positive expected return, and still does, on average, and that the average of the stock market is still going up doesn't help the individual who lost his fortune).
Buy out of the money put options on stocks. This is Nicholas Nassim Taleb's Empirica hedge fund's strategy (and, indeed, how Taleb made his 'F _ _k you' money in the crash of October, 1987.
Much (most?) capital these days is in intangibles and could only be destroyed if knowledge of it were destroyed, yet it is probably more likely the ownership is destroyed than the knowledge itself. Capital itself has a high depreciation and a short half life unless regenerated between patent expiration and product displacement. The return is only the return after this regeneration and a sudden loss of capital would be followed by suddenly higher returns for those remaining.
The model includes strong risk aversion, so it isn't clear to me that the prices you quote are inconsistent with the model.
But the power law begs the question raised by proponents of "existential risk." Their claims are tantamount to denying the power-law's applicability. The point is trivial (isn't it?) that extrapolating based on a power law from small disasters (or expectations regarding them) will give you a miniscule probability for hyper-disasters.
Most people think there was a significant probability of nuclear war during the Cuban missile crisis. The power law doesn't seem to apply to eliminate this possibility. Why?
You've discussed this: power laws don't apply within classes of explosions. Explosions are rare but not so rare as the power laws would suggest.
During the height of the cold war, mutually assured destruction created nuclear peace. No one seriously contemplated a limited nuclear war. The onset of nuclear war would be (probably) explosive. At least that was the assumption. (Otherwise, it would be too tempting for Washington to obliterate Moscow or St. Petersburg and say oops!)
To discount (explosive) existential risk, you can't legitimately assume a power law applies.
[Added 11/3.] Maybe I should be more explicit. The "event class" is nuclear war. If you conditionalize on nuclear war, you don't get a power law--far from it: keeping the catastrophe minor is unlikely. (Or if you disagree empirically, then you might still concede that a world where this is true isn't far from ours--there's no fundamental reason to think total annihilation wouldn't be the result of nuclear war.)
This would seem to indicate that the estimate provided by extrapolation is far, far from the right "ballpark."
Forgive me if this was mentioned somewhere and I missed it, but in regard to "if you disagree you should expect to profit by buying options that pay off mainly in the case of huge disasters" can you give an example of such an investment, especially if it would be both practical and available to a person of ordinary means?
"over two centuries, speculators see only a 1.6 in a hundred thousand chance of a shock that destroys over half of capital. And a shock destroying 80% or more of capital has only a one in a hundred trillion chance" ... "So why aren’t you buying?"
I don't buy because the prices I see bear no resemblance to that. I just looked at puts on the S&P 500 expiring in December 2015. It would cost me $0.65 to get an option that would pay $124 if the S&P 500 dropped 90% in that time (a strike price of 300).
Eric Falkenstein's work suggests that there might be some speculator behavior that that is consistent with the crazy numbers you mention, but if it isn't being arbitraged to lower S&P 500 put prices, why should I believe I can exploit it?
I'm honestly confused about how to reconcile this
> if you disagree you should expect to profit by buying options that pay off mainly in the case of huge disasters. So why aren’t you buying?
> This model OVER-estimates the chances of disaster if investors lose because of theft of property, rather than its destruction
If it's generally thought that there will be no protected property right in the scenario that 80% of value is destroyed, then no one will buy options that pay off mainly in the case of huge disasters. Won't then the probability of such a disaster inferred from the market be much lower than the actual probability? (Sorry for such a basic question.)
It would certainly be interesting to see the analysis redone with an added parameter to represent a focus on relative returns.
I was going to mention your own theory of asset prices & risk before I saw your name pop up here. I'm surprised you didn't bring it up. My recollection is that you think people are concerned with relative wealth. And if a "common shock" damages most portfolios, you won't look that bad relatively speaking, so that risk will not be incorporated into the price. A catastrophic shock sounds like the sort of thing your theory would predict is ignored by asset prices.