The Thought Refuse

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Posts Tagged ‘Stock Market

Study Supports Expert Bias

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ne of the more common logical mistakes we make is to turn to the expert bias, also known as the logical fallacy arguing from authority.  The logical error is committed by espousing expert credentials for sound logic, in order to make a logical argument.  A logical argument is founded on logic alone.  No amount of degrees or experience can supplant concrete logic.

Recently, a study was done on how expert advice affects the decision making part of the human brain, and lends physiological evidence that we are predisposed to experts over logic.  This has long been the contention of logical proponents, the most well known being Nicholas Nassim Taleb, who detailed in his New York Times best selling book, The Black Swan, just how detrimental and pervasive the expert bias can be.

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Written by huxbux

April 15, 2009 at 1:12 am

The Presidential Race Not Immune To Randomness

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I have sobering news for all of the political fanatics out there feverishly consuming every tidbit of news around the presidential race as confirmation or refutation for the support they’ve thrown beyond their respective candidate.  The presidential race will not be decided on the laundry list of pros and cons for each candidate that you’ve taken painstaking effort to lay out.  No, the presidential race will be decided by a randomness.

The presidential race of 2008 will be decided based on the crash of the housing market and the subsequent drop it caused in the nation’s economy.  For as much as the media and average citizens strive to transform the economic crisis into a politically derived problem, it is not.  I have previously made numerous posts concerning the reasons behind the economic crisis, and specifically attributed the error in management on the risk management models used by financial institutions.  The post illustrated how randomness poses a severe threat to these models.  The qualification for a random event is an event which cannot be predicted which precipitously qualifies the economic crisis as the consequence of a random event.

Just as the financial institutions risk management models did not predict a fall in home prices greater then 10%, political pundits could not predict the massive shift in the presidential race that the economic crisis would cause.  Prior to the first day the stock market plummeted nearly 800 points and the final realization that the economy was teetering, McCain was neck and neck with Obama.  Some polls showing McCain with a slight lead and others having McCain trailing by only a couple points.  Immediately after, McCain’s poll numbers began slipping, and as the nation became inundated with daily news that the economy was on life support, McCain’s numbers began to suffer from the war of attrition.

The economy became the center issue in the presidential race.  It thrusted itself to the forefront to become the deciding factor.  For political purposes, the affair was tailored by each candidate to suit their campaign in what amounted to an advertising campaign.  Voter perception leaned heavily towards Obama as being the one best suited to guiding the country back to economic health.  This voter acumen, as it turns out, resides without substance.

Considering risk management models bore the fertile blame for the financial catastrophe, how then can the politicization of the problem be justified?  It simply cannot.  However, it certainly has played a critical role in the shape of this presidential race.  Partisan advertising, voter ignorance, and media saturation loaned it the power necessary to become the deciding factor.

Barack Obama constructed an unwittingly genius advertising campaign while battling Hilary Clinton in the Democratic primary that was designed to link the presumptive Republican nominee to Bush’s economic policy.  Coupled with Obama echoing sentiments of economists, he painted a bleak economic picture.  In a speech earlier in the year, Obama said:

We are not standing on the brink of recession because of forces beyond our control.  This was not an inevitable part of the business cycle. It was a failure of leadership in Washington — a Washington where George Bush hands out billions of tax cuts to the wealthiest few for eight long years, and John McCain promises to make those same tax cuts permanent, embracing the central principle of the Bush economic program.

The Obama campaign as continued to connect the economic polices of George Bush as “failed” and inexorably tying McCain to those “failed” policies.  From a strategic standpoint, it stands as the center point for his presumed presidential victory.  Yet, it’s quite simply inaccurate in the sense that the term “failed” predicates that the economic policies of Bush/McCain caused the economic crisis.

The center of this recession and possible depression does not even remotely revolve around tax cuts.  Tax cuts putting money in the pockets of the poor, middle class, and rich has no bearing on sub prime lending practices or the flaws in statistical risk management models.  The concept is absurd.  In fact, it’s counter intuitive.  A middle class family receiving a tax cut would be more likely to take that money and use as a   on a home mortgage and would be less likely to enter into a sub prime, no down payment home loan.  Additionally, it’s clear that the wealthy, for whatever tax cut they might receive, are not consumers who are or were entering into sub prime mortgages.

The only credible accusation that can be made against Bush and his administration is government regulation.  But it’s difficult to conceive that the government, using the same risk management models and statistical information as the lending industry, would have been able to see what the financial sector could not.

Despite Obama’s inaccuracy, it was a strategic success due to voter ignorance.  Voters are not apt to critical thinking when examining the issues.  They display a preference for short and concise soundbites that can regurgitated on command.  We gravitate to linear paths and there is not a more straight path to making the connection between an administration that’s been entrenched for the last eight years, “failed” economic policies, and an economy entering a recession.  We are susceptible to the narrative fallacy and Obama beautifully catered to our ignorance for his own political gain.

The media onslaught that followed the stock market crash solidified Obama’s strategy.  There has not been a day in the last month that we have not heard more bad economic news.  Every time a voter read or watched a news piece on the economic crisis they made the connection in their mind between the state of the economy, those “failed” policies, and the message Obama has been preaching for months and months.

The fact of the matter is that no Republican or Democrat administration would have prevented the current economic crisis.  Short of the government heavily reducing the capitol requirements for lending and shifting the economy away from the debt based economy we have been operating on for nearly half a century, politicians were equal bystanders in the unfolding events that lead us to where we are.

So, it should be quite sobering to realize that if your voting for Obama or McCain primarily because you believe either candidate can bring the economy out by it’s bootstraps to know that you are casting your vote based on a random event.  It might even seem incomprehensible.

Randomness has the peculiar nature of being incomprehensible.  How can we understand that which we cannot predict, otherwise we would have already known it’s impending occurrence and been able to take steps to avoid said event.  Just as the statistical risk management models failed to predict the drop in housing prices, no one predicted that the decisive event in the presidential election would be, at it’s root, born from randomness.

How are we to feel knowing that the next leader of our country rode the wave of a random event into office?  I know I’ll be punching Obama’s name come November 4th for reasons divested of that random event, but it’s given me serious pause to come to terms with the fact that many other have been influenced by randomness knowing Obama’s poll numbers have reached double digits since the stock market crash.

Written by huxbux

October 17, 2008 at 6:33 pm

Attention Main Street: Don’t Panic

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With the Dow Jones Industrial average falling 369 points today and losing 3.6% of it’s value, plenty on Main Street might feel the urge to panic after taking a look at their 401k’s and modest portfolio’s.  Maybe Main Street has already started to panic after watching the stock market lose 1,100 points and 10% of it’s value over the course of one week.

But I want to tell Main Street – Don’t Panic.

I don’t want you to panic because you should know that the market hasn’t hit bottom yet, and your investments haven’t hit their low point.  In 1929 and 1987, the two largest market crashes in American history, it took 55 and 54 days respectively for the market to reach bottom from the Black Day.  We’re only about half way through if history is trying to repeat itself here.

So, you have time to shift your investments over to low yield, low risk bonds or even gold.  Take comfort in knowing that there’s alot more you could potentially lose of that retirement nest egg.  It could always be worse, and just might get plenty worse.  Just remember – Don’t Panic.

Written by huxbux

October 6, 2008 at 5:02 pm

Playing The Wrong Kind of Politics Dooms The Bailout Package

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Question.  What kind of recipe do you get when you have a Congressional election year, a financial crisis, and misinformed voter anger?  A recipe for disaster.

And now our politicians in Washington are, for all intensive purposes, are sitting on their hands by voting down the $700B bailout package in the House today.  In response the stock market had it’s worst day in history in points lost and it’s worst percentage drop since 1987.  All of this following on the heels of the beating Wall Street has suffered since September 18th.

We are witnessing a colossal tragedy unfolding if it continues.  What is occurring in Washington, alongside an angry populace fuming at the “greed” of Wall Street, is the equivalent of driving a car with your eyes closed down a winding mountain road.  There is a confluence of forces playing their part in this Shakespearean tragedy, none of which are constructive to our future economic health.

I expect when our elected officials to cast their vote on any bill, especially a bill that of such critical importance, to decide based on the merits of the bill.  Any other factors that enter into the decision making process are unacceptable.  Yet, today some House Republicans blamed “blamed Ms. Pelosi for a speech before the vote that disdained President Bush’s economic policies, and did so, in the opinion of the speaker’s critics, in too partisan a way,” to explain their nay votes.  Republican Jeb Hensarling said the bailout package would the nation on “the slippery slope to socialism,” and added that saddle taxpayers with “the mother of all debt.”

Democrats of course fingered Republicans in the typical partisan merry-go-round that has become standard practice.  In the end, all Washington accomplished today was politicizing the most important event of a generation.

Understanding why the vote became politicized is so perfectly simple, yet infuriatingly frustrating.  All it requires is a look at the vote roll.  Another reason opponents of the bailout package gave for voting no was that they had “encountered too much hostility for the bill among their constituents, and were worried that a vote in favor would be political suicide.”  Not surprisingly, in an election year, political suicide can be onset by taking action that might jeopardize your reelection.  Don’t rattle the cage too much.  People might get scared.

I came across the Robot Pirate Ninja blog today which had an interesting article on this very topic.  The post linked to FiveThirtyEight were political suicide is explained in the most simpliest of terms.  38 incumbent Congressman who are in tightly contested races voted on the bailout package.  Only 8 of the 30 voted in favor.  That’s a .211 average.  Of those not in a contested election race, 197 voted for and 198 voted against.  Almost a 50/50 split.  Is this just a statistical anamoly or did 30 elected Representatives decide their vote on what’s best for keeping them in Washington?  I’ll take the former and run with it.

Following the introduction of the bailout package by President Bush, a Gallup poll showed 78% of American’s supported some form of bailout package.  But only 22% of voters favored Bush’s proposal while 56% favored a different plan other then Bush’s.  Clearly, most American’s favor some form of a bailout package.

I contend that the 56% of voters who favored something other then the proposed plan responded on their deep distrust of Bush(note his 22% rating in polls), and a backlash reaction to the idea of using tax payer dollars to rescue Wall Street.  Bush sits as a lame duck President with an unbearable approval rating.  Any proposal he makes is going to be met with such ferocious backlash it’s destined to fight an uphill battle.  That hill has about a 78% incline.

Combine that with a misconception among the populace that the $700B in taxpayer money is going straight into the pockets of corrupt, greed driven corporations, it creates an irrational fear that the bailout package is the epitome of Wall Street excess and irresponsibility.  It’s an emotional reaction, and these types of reactions incite a disregard for analysis.  Logic bows in the face of feverish passion.  I have read so many blogs that are a mouthpiece for a blinding rage pointed at Wall Street.  I’ve talked to many people who ardently contend that they should not be spending their dollars to save money hungry con artists.  The bailout package has become something deeply personal for many people.

Times of crisis are one of the few times our elected officials start taking the pulse of their constituents.  They have almost assuredly taken note of the wrath that’s resonating throughout our country.  They are certainly not going to poke an angry bear.  It just might bite.

Some of this would be alleviated by an American populace that viewed the bailout with less theatrics and with more understanding of the economic implication in having a massive bank failure in this country.  What we face is not a singular, isolated event.  There is a cascade of dominos that follow if we allow banks to crumple.

Banks holding trillions of dollars in illiquid assets amass massive debt.  Without capitol reserves, banks drastically reduce corporate loans.  Corporate entities unable to raise needed capitol investment scale back their production.  The supply and demand equilibrium becomes unbalanced and price delfation sets in.  Existing assets lose their value sending businesses scrambling to stabilize their capitol reserves.  Lacking necessary capitol reserves and unable to sustain operations, some businesses shut down completely.  Existing business hoard capitol reserves and make severe cut backs.  The unemployment rate spikes upwards.  Lost home income translates into a plummet in consumer spending.  Supply and demand ratios become more imbalanced and deflation continues.  With reduced loans, banks start calling in their loans.  Borrowers, already struggling to meet their own capitol needs, default further reducing existing banks ability to lend.  Squeezed with minimal capitol reserves and debt either are unable to pay their loans.  A further string of bank closing occur.

The vicious cycle that unfolds goes on and on.  This sort of cycle has taken place once before in this country and that was the Great Depression.  Understand that bailing out the financial institutions that are now treading water is to put a stop to the falling domino’s – to stop this country from experiencing a massive bank failure and the subsequent evaporation of the necessary capitol to keep the economy functioning.  $700B is a small amount of money to potentially to minimize a catastrophic risk.

Handcuffed by political preservation, the gears have ground to a halt.  Let us all hope that there are enough of our elected officials in Washington who aren’t driven by partisan politicization, and can hash out a needed bailout package.  In the end, I do believe some sort of package will go through.  Yes, our tax payer dollar will go to corporate America.  And yes, it’s going to save them from running aground.  But it’s also going to save our jobs, our health insurance, and our retirement benefits.

This isn’t the first time the government has had to save the free market.  It happened once before but not before plenty of foot dragging.  In if helps, last time this happened the government came out recouping our tax dollars and then some.

Written by huxbux

September 30, 2008 at 12:24 am

Financial Risk Management: The Problem With Applying Statistical Models To A Random System

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Having digested more then my fair share of reasons behind the market crash from television to radio to print to the blogosphere, I’ve been saturated by the common theme of corporate greed and corruption.  I don’t buy it as anything other then a compulsory and secondary component to a free market economy.  This is, of course, beyond obvious.

Add to the equation profitable longevity, and the greed/corruption arguement becomes less credible.  If I gave you the option of taking $5000 right now or $1000 for the next ten years which option would you take?  Profitable longevity is not a difficult concept to understand, yet it seems lost on the relentless pounding being doled out on anyone remotely associated with the market crash – market traders, business executives, and government officials.

While there are certainly businesses that run counter to profitable longevity, i.e. Enron, this is not an isolated incident of a single lending institution engaging in suicidal greed.  The problem spans entire business sectors including lending institutions and trading firms.  From a logical perspective, it’s difficult to assume that two entire business sectors concurrently decided to knowingly engage in practices fueled by excess at the cost of self-destruction.

The need to balance profit and longevity within the financial sector following the Great Depression, the concept of stock and bond risk management was born.  By the 1950s, financial risk management evolved from a concept into a full fledged theory centered around mathematical diversification.  A decade later risk management theory adopted stochastic calculus in order to better account for the inherent randomness involved in stock trading.  Today the financial corporations are littered with what are known as quantitative analysts, otherwise known as quants.

The role of a quant is to develop sophisiticated mathematical and statistical models designed to simulate stochastic processes and it’s potential impact against illiquid products.  Uneffected by supply-and-demand price fluctuations, illiquid asset management depends entirely on these quant models to determine value.  Another tool employed by quants is the process of statistical arbitrage that relies on quantitative data mining in order to determine the expected value of an asset.  These two quant instruments are the foundation for the risk management techniques finicial corporations employ today.

Stochastic calculus attempts to deal with multiple outcomes and given an array of possible initial values, marks the possible outcomes for multiple initial conditions.  While it accounts for a wide possibility of paths, it determines which paths are more probable and which ones are more improbable based on the probability of the initial conditions being present(whose sheer numbers can be exponentially mindnumbing).  Statistical arbitrage relies heavily on gathering statistics over time, in order to create a computational value based on the expected outcome where multiple outcomes exist.

These two systems are attempting to deal with and account for rogue events.  It is in trying to deal with events which have never occurred previously that a fundamental flaw becomes apparent.  These two systems, particularly statistical arbitrage, relies almost exclusively on the collection of event data.  These statistical models derive their accuracy from the amount of data collected.  Hence, the more finite a time data is mined, the less accurate the model becomes.  In order for either of these models to be bulletproof, it would require an infinite amount of time to aggregate data.

Here we have two systems employed by the financial sector to determine the improbability of events and conditions which have never occurred.  The problem exacerbates itself when you consider how the data that is amassed is disseminated.

In order to map these probable and improbable events, statistical analysis employs the use of the Gaussian curve.  It’s a bell curved shaped graph illustrating the probability density of all potential values.  The Gaussian curve bends downwards at it’s edges towards improbable events and upwards towards the probable.  The width of the curve correlates to the weight of those probable events against those improbable ones.  Basically, it charts the normal distribution for events, and giving an indication of which events are more probable then others.

The Gaussian curve is essentially a median value for all possible events.  And that is where it fails.  A model cannot really account for and give the proper value to a rogue event, the most improbable of occurrences, when it gives greater value to standard, the most probable of events.  It fails in calculating the impact of heavy swings against the normal distribution value.  A singular, yet improbable event, will hardly impact the height or width of the curve against the statistical weight of a multitude of those that are likely.

To better illustrate this take 100 middle class American households, and calculate the average income.  Now put every name of every adult in the United States, and put them in a hat.  Randomly draw one name from the hat.  Now take that persons household income and recalculate our income average.  99% of the time you would have selected someone close to the median US household income of $40k.  The average will not make an appreciable movement upwards or downwards.  You could have selected the poorest household in America and the number would hardly have budged.  Let’s say you draw from the hat again, but this time you pick out someone in the top 1% income bracket out of the hat with an improbability factor of 298,128,548 to 1.  Recalculate the average again.  A massive swing upwards in the average will occur.  An event that has a 0.01% chance of occurring will appreciable change our end value, where as 99.99% of possible events will not.

One singular, blip on the Gaussian curve can drastically effect our end value.  But the curve itself doesn’t properly adjust for that highly improbable, rogue event.  Combine this massive swing due to random events with quant statistical models that are ineffectual in mapping these Gaussian blips, and you can begin to see where the problem might lie.

Let’s throw these inadequate models in bed with profit longevity, and it becomes a sticky situation.  Financial corporations have a tricky balancing act to perform.  Faced with reams of data pointing at the normal distribution of the Gaussian curve coupled with the blind spots for events which have never occurred in stochastic calculus and statistical arbitrage, conclusions have to be made as to which path to follow.

Taking the path of improbability would severely limit potential profits.  Under performing profit margins threat longevity.  Following the road towards the probable, gives some assurance in profits and promotes company longevity.  The decision making process cannot even account for rogue events which the statistical models fail in forecasting.

The historical housing market rise and fall would, at it’s very least, qualify, as an most improbable event.  A case could be made that it was a rogue event incapable of being calculated by the quants models.  Instead of tossing around the idea that corporate greed was at the center of the economic crisis our country now faces, let’s consider that, at best, the financial sector was presented with misrepresented data by a fundamentally flawed model.  And, at worst, their models simply were not able to account for never before seen event chain.

Either way, the quant risk management system might be to blame, and desperately needs to be reexamined to better account for those improbably catastrophic occurrences.  No amount of money infusion will turn failing statistical financial models into pinpoint accurate prediction machines – if that’s even possible.  Or maybe we should just learn to accept certain levels of risk that randomness carries with it rather then constantly acquiescing to the fat cat blame game.

McCain’s Perfect Storm

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Prior to the collapse of Wall Street that began on September 15th, John McCain held a 2% point lead over Barack Obama according to a Gallup Poll.  A lead McCain has held to varying degrees following the Republic National Convention.  McCain’s convention bump was considerable and noted by a Gallup study:

While the increased vote share a candidate receives following his convention usually diminishes, candidates who lead after the second convention usually remain the leader a month after the convention. This is based on a review of historical Gallup data since 1964 — the first year for which Gallup could reliably measure convention bounces. The only possible exception to this general pattern occurred in 1980, when Jimmy Carter had a slim one-point advantage after the Democratic National Convention but he and Ronald Reagan were exactly tied one month after Carter was nominated for a second term.

However, following the market collapse the opinion polls began to take a turn.  This can be directly attributed to McCain’s handling following the stock market fallout.  Most are familiar with McCain’s perceived gaffe at proclaiming that the fundamentals of our economy are strong.” While not a technical error, it was a lingual mistake that resonated to the public that McCain is a man out of touch with what was transpiring.  McCain was also lambasted by the media for at first criticizing the bailout package presented by Treasury Secretary Hank Paulson in a speech, and then later saying he supported the package in a 60 minutes interview.

Considering McCain’s comments in total, he doesn’t come off as indecisive or clueless.  But in the political arena, where soundbites and snippets are king, McCain commited a serious err.  The combination of an economic collapse coupled with the political mishandling on McCain’s part may very well thrust Obama into the White House.  According to an ABC poll, American’s have considerably more faith in Obama’s ability to handle the economy then McCain.  In conjunction with the economy now the most important topic to voters, the economic fall out is shaping up to the perfect storm for McCain, and the sole reason we may be electing Barack Obama into office come November.

Written by huxbux

September 24, 2008 at 10:56 pm

Pin The Tail On The Stock Market

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The recent fall out on Wall Street highlights the fundamental problem with the stock market.  It’s a pure guessing game more akin to the children’s game Pin the Tail on the Donkey then a sort of statistical evaluation of the nation’s economic state.  We are told that the stock market is a complex value estimation of the countries businesses present and future.  An army of economists armed with countless ledgers and spreadsheets deliver authoritative analysis on the future value of stocks, and direct us where to invest in order to maximize our returns.  These professional economists, alongside their financial adviser compatriots, are nothing more then best guess givers, and horrible ones at that.

I once heard a jaw dropping statistic that the stock market, over the course of it’s life, has gained or lost nearly half it’s value in only 50 days of trading.  It begs the question – how can a market guarded by so many professed experts be prone to such wild shifts in value?  Two immediate answers jump out at me.  One, the stock market is driven by such large, random events that massive swings in value are uncontrollable.  And two, that economists tend to gradually overvalue stock prices and occasionally are forced to make massive adjustments downward due to critical mass evidence.

Both of these don’t speak kindly to the prowess in skill of economists.  The first indicates that a market under the guise of extreme randomness cannot be estimated.  Any expert economist offering up investor advice is more like a mentalist masquerading as a psychic feeding his customers with information irregardless of it’s accuracy.  The fact that it’s delivered is of prime importance to the economist.  However, supplying certain data based on a fundamentally uncertain system is ethically suspect.  Or it’s just another opportunity to generate income for the individual.

If not the first then let’s settle for the second conclusion that we are simply optimistic estimators.  Everyone has noticed the cycle of the stock market.  It will gradually rise in value without any major upticks in value, and every once in awhile takes a terrible tumble.  I attribute this to our penchant for overestimation in all aspects of life.  It serves as a natural self defense system against mental and emotional degradation.  It’s only when confronted with undeniably definitive information that the bottom falls off, and a drastic correction in stock value occurs.

An analogous comparison I’ve encountered is that of the Hollywood Stock Exchange.  It’s a fun little game where players buy and trade movie and star stocks.  Traders speculate what a movie will make at the box office, and following a movie’s opening weekend, the appropriate movie stock will adjust up or down based on it’s actual earnings.  On average, movie stocks adjust roughly 33% following an opening weekend, and the vast majority of stocks adjust downwards in value.  So, traders overestimate by nearly 1/3rd the value of a movie’s opening box office.

The stock market, despite what all the experts will tell you, is an random and uncertain playing field.  It’s a best guess game, and even our best guesses are not particularly good.  It’s one glaring fault is that it’s littered with experts spewing statistical probabilities against improbable trends to anyone with a dollar to invest in the market.  Economists collect extravagant salaries to advise corporations with their unflappable numbers.  Traders gouge investors with commissions offering up best guess investments moves.  These experts have the pin in their hands and are optimistically yet blindly moving closer to the donkey confident they will land on their target.  Except when their eyes open and that pin is two feet off center, it’s the spectators that end up footing the bill for such failing expertise.

Written by huxbux

September 23, 2008 at 12:57 pm

Posted in Business

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