Questioning the “markets” – part 1

Over the past three and a half years, I have had a ring-side view of the finance industry. I have been involved in developing a market risk-management software product targeted at banks. This product has now morphed into a far more mundane corporate treasury management software. In the process, I have developed a great distaste for financial modeling and all the elaborate math that goes into modern finance. I have come to question the role of the finance industry and its foundations – the currency, equity, credit and derivative markets. Note that I am not questioning the role of the finance industry in the recent “crisis” or any such thing; I am questioning the very existence of the finance industry in its current form; I am questioning the role of the finance industry in the free market system as such.

What led me to ask such fundamental questions? Here are some observations/experiences in no particular order.

Banks vs Corporates:

• It is a lot easier to make money in the finance industry by catering to banks.
• Banks are a lot less concerned with the accuracy or soundness of the results produced by our software.
• Banks are interested in far more complex analyses than corporates are. However, unlike the people at corporates, people at banks do not necessarily know what they are doing or how the analyses are to be interpreted.

Money:

• There is far more money to be made in the finance industry as compared to other industries.
• Many engineering graduates from IIT have some certification or the other related to finance (NCFM or some other acronyms that I don’t care to remember). These were unheard of when I graduated in 2006.

Math:

•  Highly sophisticated math is required for any non-trivial analysis. Very few people have the capacity to understand the math.
• A lot of the math is circular. Mathematical models are often calibrated to market prices of assets. The market is made by people who use mathematical models to price assets.
• A lot of the math is essentially unfounded. Correlation trumps causality because the causality is too complex to model mathematically.

It is clear to me that the finance industry is sick. What made it sick? How long has it been sick? Can it be cured? If so, how? I will consider these questions in future posts. (I have a history of starting a post with part 1 in the title and failing to follow up. This time however, I am sure there will be more posts on this theme.)

Book Review: Fooled by Randomness

I chanced upon Fooled by Randomness – The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb at a friend’s place and took the time to read it. Having a bit of a financial background – I work in a company that did some financial modeling before I joined it – I had heard of Taleb and was curious. Besides, I want to understand probability better than I currently do – I mean philosophically, not mathematically – and the title was attractive.

The book is divided in three parts. Part I starts off with a long and rather boring story of two traders – a rash, ignorant and over-confident John and a conservative Nero. John succeeds for a time – purely through luck – makes a lot of money and then blows up – market slang for losing more money than you thought possible. Nero remains risk-averse and makes a steady amount but suffers snubs from people like John before being vindicated. The reason for including this story is primarily to show how large a role randomness plays in the markets. Taleb also comments on the fact that Nero suffered emotionally from the snubs by people who made more money than him though he always knew himself to be better. Taleb says that this shows that the rational mind cannot prevent us from experiencing irrational emotions. Taleb then discusses an “accounting method” by which a dentist is much richer than a lottery winner. If one were to consider all the “paths” that the dentist’s life could take, there would not be much variation in the money he makes and the “average” would be close to what he makes in any particular “path”. If one considers all the paths that the lottery winner’s life could take, the average would be much lower than the money he makes on the winning path. This notion should seem familiar to anyone with a knowledge of Monte-Carlo simulations but I had not seen anyone putting it so explicitly. Taleb then goes on to discuss the difference between noise and significant information and how noise can affect perceptions in short timescales. He also discusses the dangers in fitting models to historical data. This is interrupted by an unexpected attack on Hegel’s pseudo-scientific philosophy that draws on Alan Sokal’s famous hoax. Taleb then talks of rare events, how their existence makes the difference between the median and the mean important and how most people including statisticians often unwittingly ignore this difference. He then talks briefly about Bacon, Hume and Popper in relation to the problem of induction and the difficulty of induction in the presence of rare events.

Part II deals with various biases in the perception and evaluation of events and outcomes in areas where randomness plays a major role. He draws on work by Kahneman and Tversky – which I am not even remotely familiar with – to claim that in dealing with uncertainty, our minds adopt certain heuristics/biases that are blind to reason (Prospect theory, Affect heuristic, Hindsight bias, Belief in the law of small numbers, Two systems of reasoning and Overconfidence). While it is easy to see how a person with no understanding of probability theory could be misled in the many examples Taleb gives, it is difficult to believe that people trained in probability would also be misled.

Part III deals with Taleb’s interpretation of stoicism as the solution to living in a world with so much uncertainty. Taleb writes that we should accept that we are incapable of making our emotions rational and attempt to behave with dignity in all circumstances. He writes that stoicism should not mean a stiff upper lip and a banishment of emotions but an acceptance of emotions and the uncertainties of life with the focus being on the process rather than the outcome. This part is titled Wax in my ears in a reference to the story of Odysseus and the Sirens. Taleb writes that he knows that he is not as great as Odysseus and instead of tying himself, he chooses to have wax in his ears. That is, he chooses to accept that his emotions will always be fooled by randomness and the only solution is to avoid situations where he might encounter such emotions (by not listening to the news or not tracking prices of assets on a moment-by-moment basis etc).

Overall, several anecdotes in the book are mildly entertaining, but intellectually, there is very little that I gained from the book. I agree with a lot of Taleb’s views on the role of luck in the markets and the inadequacy or even meaninglessness of most financial models, but I had already reached these views before reading Taleb and frankly I don’t think they merit a significant part of a book. These views can be easily expressed in a few pages – perhaps I will write a post myself. Taleb does not provide any definition of probability – something that I had hoped for – apart from the following excerpt. Taleb’s style is quite disconnected and the numerous back and forward references are irritating, especially since the references are hardly convincing. For example in the following excerpt he refers to something in Chapter 3, but there is no convincing arguement there, not even a hint.

Ask your local mathematician to define probability, he would most probably show you how to compute it. As we saw in Chapter 3 on probabilistic introspection, probability is not about the odds, but about the belief in the existence of an alternative outcome, cause, or motive. Recall that mathematics is a tool to meditate, not compute. Again, let us go back to the elders for more guidance – for probabilities were always considered by them as nothing beyond a subjective, and fluid, measure of beliefs.

The only thing that I got from the book is a reminder that I need to formulate more completely a proper alternative to Popper’s scepticism.