Playing in the Sand Pile of History – Part I

             A problem in modern economics has been the unpredictability of things. A cacophony of voices have tried from the beginnings of civilization to predict the next big thing. Just imagine the problem an Egyptian stone mason had trying to figure out the next big pyramid job. How was he going to know what and when to order stone so the competition didn’t get the jump on the big contract. Mark Buchanan in his book Ubiquity Why Catastrophes Happen tackles the problem head on and in my mind with that single mindedness of the scientist convinced that there is a mathematical equation somewhere that will hold the answer to life, the universe and everything. Those who model these chaotic systems talk about complexity and the greater problem some call upheavability. Buchanan suggests that chaos is limited in its ability to explain extreme events (I would say Black Swans – you recognize that term) because many models do not generate upheavals.

             Buchanan is good enough to suggest that predicting the long-term future of any chaotic system is practically impossible. I will suggest that it is presently quite unlikely that current models and modeling techniques will successfully model financial and economic systems with any degree of success or accuracy. Further, what little successes we may have is inversely proportional to model time horizon and the complexity of the system.  We will tend to have limited modeling success in the short term with simplistic systems. However, Buchanan does have some interesting suggestions for looking at complex systems which I think may help in understanding both the complexity and the pitfalls inherent in economic and financial modeling. He uses the term critical state to suggest  a special kind of organization characterized by a tendency toward sudden changes, maybe radical changes. Using his physics background he suggests that instead of trying to find mathematical equations to describe these complex systems that an alternative is to use mathematical games, much simpler equations, to understand specific portions of complex systems. We are going to explore one of these modeling technique, the sand pile, in later blogs. Today we need to set some parameters.

             We need to look at some basic principles regarding modeling and models. I want to start with what Emanuel Derman and Paul Wilcott, financial quantitative analysts, term the Modelers’ Hippocratic Oath. Derman and Wilcott are considered part of the elite group of financial modelers and have been in the financial industry before, during and after the great recession of 2008. Many feel that quants as the financial modelers are known are responsible for the severity and length of the recession and its attendant losses. In many respects this is accurate. Derman and Wilcott’s Oath shows some of the problems inherent in trying to model complex financial systems that many people seem to forget. Models are tools – blunt, limited, and easily breakable.

 Modelers’ Hippocratic Oath

·       I will remember that I didn’t make the world, and it doesn’t satisfy my equations.
·       Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
·       I will never sacrifice reality for elegance without explaining why I have done so.
·       Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
·       I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.
 

             I have a copy of this hanging by my desk. Any time I encounter a financial or economic model or a discussion of one I look at the oath and attempt to see if the author / originator has applied all the points to his model and the information I have about it. If there is any part of the oath that I suspect the author did not consider or incorporate in his model I am immediately suspect of the model, its conclusions and most of all its recommendations. All financial and economic models are suspect, period. Always assume there are errors in the model. Errors in logic, in assumptions, in data points included and excluded, in the equations, and in conclusions. Once you have looked at a model in this light it can be reviewed and analyzed to see if there are portions that may have some value. If you get the sense that models are potential death traps to your financial health and to the forecasting of economic conditions, that is accurate. One doesn’t have to be able to break down models to their component parts but one does need to realize that every model has problems, many of them significant problems. What is a person to do, be very skeptical of the output of any financial or economic model and run away from anyone who says, “trust me, you don’t need to know what is in the ‘black box’ “. If the person can’t or won’t explain the black box (for example, a new financial product guaranteed to get you 25% return in today’s environment) you don’t want to be involved, ever. Remember the old adage, if it’s too good to be true it probably is.

             Next time, how to look at a sand pile –  what can we learn and how can we use it.

The Black Swan – Story Possibilities (Part IV)

             We have spent a few posts looking at Black Swans in economics and politics. Look at them as possible story lines or back story items. This can be either in world building or single situations. Can the reader see it if seen from the correct angle? For example, one can see a Black Swan if one is the Thanksgiving turkey (see Part I – Are We Unknowingly the Turkey) but there really isn’t any Black Swan from the farmers standpoint. The turkey is dumbfounded but the farmer is full and satisfied. Is the reader the turkey or the farmer?

             L.E. Modesitt, Jr.’s series titled The Ecolitan Matter consists of four books; The Ecolitan Operation, The Ecologic Secession, The Ecologic Envoy and The Ecolitan Enigma. These books explore economic, political and ecologic ideas and concepts. I highly recommend all four as a good example of economic and political ideas. The books were written from 1986 through 1997, during a time of several stock market crashes (1987, 1992 and 1997), political upheaval and a renewed concern for the environment. I will admit it is not hard to write books during times of stock market crashes since they tend to happen every four to eight years. Modesitt does a masterful job of including economic and political problems into his stories. I find Modesitt’s use of economic and political principles very well done and very true to form. Notice how he leaves much of the material as back story or world building materials but enough is in the stories to make it easy to follow and enjoy. He doesn’t burden the reader with too much detail.

             Remember, economics and social sciences are full of Black Swans. It is their very nature to be uncertain and unpredictable. Review The Black Swan’s Mask (Part II) to see how we rationalize our incorrect or missed predictions. Can a story be developed from looking backwards through our missed prediction to a situation (reverse the process by creating an outcome and looking backwards through a false prediction to the original situation- which may be incorrect). Remember every world is full of floods that happen only once in a 1,000 years. In The Black Swan – but I saw that Coming (Part III) we looked at the outlier and the uncertain or unknown nature of such.  Again, the most important point is that economics and political science are not true sciences in the way we think of science as being measurable and predictable. Both are full of Black Swans, the unknown and unknowable. Use that to your advantage.

The Black Swan – But I Saw That Coming (Part III)

           We have spent a couple of posts looking at the problem of the Black Swan – the impact of the highly improbable. We have discussed the turkey and the Thanksgiving feast in part 1 of this set. One doesn’t want to be a surprised turkey. We have looked at the problem of induction or inductive knowledge which includes how can we logically go from specific instances to reach general conclusions. According to Nassim Taleb there are traps built into any kind of knowledge gained from observation. He also suggests that those who believe in the unconditional benefits of past experience cannot project into the future. Remember back to our turkey example, was the farmer surprised by the outcome?

           Having made the above observation, I will say there are some situations where we can use past experiences to draw conclusions about future observations. Suppose you are asked to find the average height of the all men in the United States. You could take a sample of say 10,000 men and draw some fairly detailed conclusions. You would be able to take that data and make some conclusions regarding height of men in general. Now if you were to measure one more man from the population in general your estimate of his height would likely be within the parameters you had established. The same would be true for weight. Another way to state this is, one more observation will not significantly impact the predicted results. Now suppose you sample people who are worth more than $10 million. Let’s suppose that your sample does not include Bill Gates. Your sample size may be quite large, relatively speaking, but if it doesn’t include Bill Gates then as soon as Bill Gates is included in the analysis we have a Black Swan situation. A deviation so large that it blows up the study. So, you decide that Bill Gates must be an aberration… (sorry, let me be specific, in the data only), and toss that data point out. Then the next data point you sample includes Steve Job’s estate. The difference between sampling height and let’s say millionaires is one set of data follows a bell curve (predictable or regular) or a variation of such things and one doesn’t. Many who have studied this feel that economics and social sciences cannot be defined by bell curves and its like. Many in econometrics feel that the world can be defined by regular occurring events or activities. Taleb suggests that “a nerd is someone who thinks exceedingly inside the box” or is blind to Black Swans.

           Some other themes arise from our blindness to the Black Swan. Again I turn to Taleb and his book, The Black Swan the Impact of the Highly Improbable. He suggests the following ideas. We tend to focus on preselected segments of the seen and generalize from it to the unseen. We fool ourselves with stories that cater to our thirst for distinct patterns. We behave as if the Black Swan does not exist, human nature is not programmed for Black Swans. What we see is not necessarily all that is there. History hides Black Swans from us and gives us a mistaken idea about the odds of these events. We “tunnel”, that is we focus on a few well-defined sources of uncertainty at the expense of the others that do not easily come to mind.

           As you listen to the news and look at economic projections remember that economists and their associates are working in a world full of Black Swans or full of Bill Gates type situations. It is important to realize that studies done on how successful economists have been in their predictions have shown economists have an exceptionally poor track record of being able to predict things. Just because an economist is able to show past data to support his position may have little or no relationship to future events. It all depends on where the Black Swans are.

The passing of my father

Two weeks ago tomorrow our family laid my father to rest. He was buried with full military honors in Logan, Utah. He was 86 years old, a good age and had lived a good life. I have spent the last two weeks thinking about and reviewing his life and my own. It will be some time before the heartache of his loss subsides. I suspect it will never go away but will fade and will, in time, become just a dull pain. I am grateful for him, his teachings, his life and his example. I know many are also feeling his loss acutely. We can take comfort in knowing that God loves us and that families are in fact eternal. Life is good. My father knew this and I know it too.

My regular blogs will continue tomorrow. Thank you.

The Black Swan’s Mask (problems in induction) Part II

           The marvels (for me anyway) of technology and the benefits of a good internet connection make it possible for me to be in Arizona visiting my grandchildren and their parents. We spent the afternoon at Pima Air Museum where I listened to a marvelous docent, Mr. Miller, tell stories and share experiences from his time in the air service and relating stories of others from earlier times. I marvel again at the willingness of our service people to lay their lives on the line for our great country. I am grateful for their service and sacrifice. I was thinking how it must have felt to live during 1937 – 1939 and watch the world unfold. From our standpoint now in history we know that Germany was going to war, Italy and Japan were gearing up for war and the world was set for an awful time to come. I remember reading that the correspondent William L. Shirer who wrote what is considered by many to be one of the definitive works on Germany’s Third Reich, The Rise and Fall of the Third Reich, was living in Germany during much of the 1930s. If I remember correctly he said that even for those living during that time in Germany and who had a grasp of world events such as a print journalist like himself, didn’t fully grasp what was happening. He and his associates didn’t predict war any better than the others in government, economics or any other branch of science or social science. History tends to look back and say, how could you have missed that. All the signs were there?

           I experienced the lead up and the effects of the recession of 2007 – 2009 from a unique standpoint. I am directly involved in investment banking and many feel that this industry is a big part of the problems that caused that recession. I think the sentiment has some validity. However, most of the leaders or men of knowledge in economics and investment banking never saw it coming. Again, there are some who did see something and made a lot of money on the fact that they felt something was out of alignment in the economy. Again, if one looks at much of the literature on this recession we see individuals drawing conclusions and wondering how we could have missed it. I was in the thick of the information so to speak and I didn’t see it coming. Government leaders, economists, most investment bankers and Wall Street types didn’t see it. We now have Frank-Dodd legislation which runs into hundreds of thousands of words and is so convoluted that we as a people will never fully understand what it does nor do the writers of the legislation really understand its workings or impact. This is supposed to guarantee that we won’t have another financial situation like this happen again. Trust me on this one, it will happen again

           Let’s look at how we rationalize our incorrect prediction (or missed predictions). This is how we protect our self-esteem according to Taleb in his book The Black Swan, where he suggests four methods of rationalization. (1) Tell yourself that you were playing a different game. It is not your skills that are to blame. There is some hidden information or element that if you had known you would have been right. (2) You invoke the outlier. (This is what is generally used by the economists and math guys to explain the recession of 2007 – 2009.) Something happened that was outside the system. Given that it was not predictable you are not responsible. Hey, it was a 1,000 year flood, of course I couldn’t predict it. (3) The “almost right” defense. By looking backwards we assign values after the fact to ideas or events thus applying more or less importance to things, activities, happenings or events. After the fact we say this piece of information is important and this is not. (4) The hedgehog and the fox from Isaiah Berlin and Aesop’s Fables. The hedgehog knows only one thing and tends to exclude all other thoughts and ideas. It may be a single consequential but improbable event. This helps make us susceptible to Black Swans. The fox knows many things and is not married to one idea or course of action. The fox has an open mind (not empty but open) and tends not to get married to one idea. The fox knows history will be full of improbable events but just don’t know what the events will be.

           So, be a fox with an open mind.

Are We Unknowingly the Turkey (the problem of induction) - Part I

           The next couple of posts will explore the idea of how to learn from the turkey or the problem of induction or inductive knowledge as discussed by Nassim Nicholas Taleb in his book, The Black Swan The Impact of the Highly Improbable. I have referred to this book before as it has what I consider some highly insightful and provocative concepts, thoughts, and commentary relating directly to economics and finance. This problem also directly relates to the Black Swan phenomena as discussed by Taleb in his book mentioned above.

           The problem  of the turkey can be seen in the following story. Suppose you are a turkey and today the farmer comes to your pen and feeds you. Initially you think to yourself, this is interesting I wonder what is going to happen tomorrow? By the 14^th day of feeding you are thinking this is pretty good. By the 50^th day of the same activity you think this feeding thing is really great. I am going to brag to my friends about the farmer. By the 250^th day you have forgotten that you ever worried about food. By the 350^th day you feel you are entitled to being feed. You can look back on a long history of consistent feedings, it has always happened. No change, no difference. You expect tomorrow to be just the same as every other day, why wouldn’t it be? Tomorrow comes. The farmer has an ax- it is the day before Thanksgiving. You were not expecting that! The consequences of underestimating the impact is significant for you (the turkey). This is the problem of induction. Do past experiences or histories allow us to predict future events and activities? How do we know that what has been observed will be sufficient to enable us to figure out the properties of what we have been observing? Taleb poses several questions including; one, “how can we know the future, given knowledge of the past; or, more generally, how can we figure out properties of the unknown based on the known?”, two, “how can we logically go from specific instances to reach general conclusions?” and three, “How do we know what we know?”

           As I write this I am listening to the song “Russians” by Sting from Dream of the Blue Turtles album. The lyrics discuss the problem of believing what the Russians and President Regan say regarding the atomic bomb. At the time this was released in 1985 nuclear annihilation was a great concern. Both governments had the ability to destroy all humanity several times over. I remember being in school in the late 60’s and having air raid drills where we got under our desks. However, just four years after the song was released in 1989 the Berlin Wall was breached and by 1990 was torn down. By 1991, Mikhail Gorbachev had overseen the dissolution of the Soviet Union. Who predicted from past Soviet actions culminating in 1985 that six years later there would no longer be a Soviet Union, as such? No one. In 1973 I was studying military tactics in ROTC which included the most effective ways of destroying Russian tanks. In 2003 my son Daniel served an LDS church mission in Rostov, Russia, the place where they built the tanks I learned how to destroy in 1973. I never imagined in my wildest dreams in 1973 that one of my children would be in Russia on a religious assignment teaching the peaceable elements of Christianity in a former Communist country. This is a positive induction problem.

           Let’s further consider the problem of the turkey. Was the farmer suffering from a problem of induction? No, of course not. He knew exactly what was happening. Such problems can be very one-sided and it is critical which side we are on. In the following posts we will look at some specific examples of the problem of induction relating to recent financial and economic problems and some ideas for handling the problems. Additionally, I think there are some applications for world building that I hope will be interesting and helpful.

The bad dreams spawned by thinking about taxes and tax filing

I realized I haven’t done my taxes yet. Usually I have them done by now; the refund deposited and much of it spent. The reason for my procrastination is that I may owe something this year. I don’t know that but the thought makes me ill.I hate it with a passion reserved for few other things. I don’t think I would feel so strongly if I thought the Federal government would or even could use the funds wisely but having watched the latest shenanigans in Congress (even at our own state level) I just don’t have much confidence. We seem to lurch from one crisis to the next like a drunken sailor. Congress seems to careen from one short-term “solution” to the next, apologizing with a drunken smile at each injustice and injury but never thinking that the real solution might be to get sober. There is a good horror story here but I like horror stories to be fiction not true.

A new favorite author I have been enjoying is Nassim Nicholas Taleb. He writes The Black Swan, Fooled by Randomness and his new book, Antifragile. I have referred to some of his thoughts in previous blogs and will continue to do so in future blogs and comments. He has many comments on politicians and their actions. My own thinking tends to lean towards the thought that about the only way a politician seems to be able to justify his existence is by either spending money, creating a new program, increasing the welfare rolls, or creating a new regulation. One of my favorite examples is the TSA and airport security. A multi-billion dollar agency has been created to make a visible statement that something is being done. It doesn’t matter if the activity is helpful or hurtful, just that there is activity. What constitutes success here? The number of people embarrassed, the length of lines, the amount of money spent, the number of new Federal employees, the number of laptops stolen from the screening areas? The real hero here is the person who came up with the reinforced steel door for cockpits and the rule that pilots stay in the cockpit in any emergency situation. That person deserves a medal but will probably never be recognized and may not even be known. Dad tells a story that happened fairly soon after we had moved to Logan. Several of the neighbors thought it would be good to have street lights on our block. The families along to block got together, did the research to find what needed to be done and raised the money for the streetlights. The city people offered to install the lights because they had all the right equipment needed to do it correctly. When the job was done the local newspaper found out that a citizens group had improved their neighbor. As I remember the story a little ceremony was scheduled and who should show up but the local politician to be photographed and included in the story. He wasn’t involved in any other activity than the picture and story.

So in your writing, make your politicians believable. Whether that means a good guy or a bad guy depends on what you need. However, in my current frame of mind you are really going to have to work at making me believe a story with a good politician. Now, if you wanted to include one that didn’t do any work and only shows up for the ribbon cutting I have just the reference materials to help you.