IAFE 2010 Annual Conference - Talk: Physics envy may be hazardous to your wealth

Physics envy may be hazardous to your wealth...YES, but how?
http://web.mit.edu/alo/www/Papers/physics8.pdf



This talk was quite interesting, delivered with quiet passion and confidence that was not obnoxious, or as one would say in Chinese 自信但不骄傲.

He proposed a thought provoking taxonomy for classifying various levels of risk and uncertainty

Taxonomy of Risk & Uncertainty:
Level 1: Complete Certainty i.e no randomness, as in physics, all parameters are deterministic;
Level 2: Risk without Uncertainty, i.e randomness but coming fully random variables whose law and parameters are completely identified;
Level 3: Fully Reducible Uncertainty;
With sufficient data, using existing statistical estimation methods, we can get to level 2.
Level 4: Partially Reducible Uncertainty
Parameters of random variables estimated as in Level 3may vary unpredictably
Level 5: Irreducible Uncertainty: Total uncertainty as to the nature and random variables driving observed data that can be improved with even more data.

Technical criticism:
At the very least,Level 2 & 3 should be merged. There is really no real life situation, except in controlled experiments, where the law of the random variable is written on the wall. You always have to estimate it. 4& 5 could be more tightly put together, so that really there are only 3 levels: No randomness, randomness with a precisely defined law and and randomness with a law that is not fully known.
Each of the last two levels creates the need for potentially redundant hedges.

(From memory 8 days later) One example he uses in the talk but that is not in the paper online and that caught my attention is the example of the Drawing of an urn containing let's say 100 balls colored black or white.

In the first example we know there are 50 white balls and 50 black balls.The question much one would pay to take part in a game where if one guesses correctly the color of the ball taken out of the urn, one receives let's say $100.

The conclusion here appears to be that one should pay $50.

In the second case we do not know how many black or red balls there are in the urn. Using iterative reasoning that boils down to what is known in information theory as a maximum entropy inference, it also appears one should pay $50.

He notes there is a psychological bias for red.

This leads me to my practical criticism of the paper

Practical Criticism:

This was an analysis of uncertainty from the viewpoint of a statistician/econometrician rather than from the viewpoint of a Risk Manager that is still prey to the mindset of a physicist in its analysis.

As I explained in my article in the Investment Professional last summer "BICs, the PPIP and the fallacies of expectations based risk management", the correct answer of what one should be willing to pay in the example he gives really is: "it all depends..."

Curiously, he refers admiringly in his online paper to Taleb's Black Swans without really addressing issues of hedging robustness that are the risk management dual correspondent of uncertainty issues.

References:

Smoke and Mirrors - BICS, the PPIP, and the Fallacies of Expectations-Based Risk Management

http://www.iafe.org/html/06182010.php

http://web.mit.edu/alo/www/Papers/physics8.pdf

http://www.newyorker.com/online/blogs/currents/2010/06/new-yorker-currents-nassim-taleb-on-risk-and-robustness.html

IAFE 2010 Annual Conference - Keynote Speech: The Possible Misdiagnosis of a Crisis

A few words on some of the talks at the 2010 International Association of Financial Engineers meeting.
Let's start with the Keynote Speech: "The Possible Misdiagnosis of a Crisis" by Richard Roll,Japan Chair of Finance, UCLA & 2009 IAFE/SunGard Financial Engineer of the Year Winner
* The recent global financial crisis has been blamed on several factors
* Elementary principles of finance suggest that none of these explanations are likely
* There is an alternative diagnosis consistent with financial principles
* The current treatment may be exacerbating the symptoms

In his talk he used 3 hypotheses to conclude that the current crisis is due to the government's increased share of national wealth in the US economy at the expense of the private sector:
H1. The some of all assets equals the sum of liabilities on a balance sheet.
H2. Merkets are forward looking
H3. Total wealth in an economy decreases as the share of government ownership increases. As a way of benchmark he put forward the statistic that a 20% increase in total wealth by the government results in a 50% decrease in aggregate wealth.


H1 is axiomatic; H2 is reasonable. H3??? Well...

From these hypotheses he reasoned that the total loss of wealth in the US Economy caused by the real estate bust was due to an increase ownership of the government in the US economy.He stated that this was a fact that had been observed in many other countries including China India, Brazil. The more government retreated from the economy the more aggregate wealth increased.

First of all I have to tip my hat to him for sticking his neck out there and saying something that stirred strong emotions.

However, I was really surprised that such an eminent and seasoned scholar would make such an extraordinary dubious claim as in H3 and back it with such little evidence in a keynote speech.

The most compelling evidence to disprove this argument is a comparison of loss of wealth in the US during the dot com bust and the real estate bust. The dot com bust occurred in an environment where more laiseez faire, welfare reform arguments were the dominant philosophy with the repeal of the Glass–Steagall Act, the incoming republican administration and all that.The real estate bust in 2007 triggered a more aggressive government interventionist posture in the real economy. For a comparison, I turn to Jeffrey D. Benson of the blog American MacroEconomic Dynamism:

"How much wealth has actually been destroyed in the current housing decline versus the 2001 tech burst? According to the Case Shiller Indices (the most accurate housing guage available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion. So is this decline in value a direct hit to the Net Worth of the United States. Absolutely. If the value of liabilities declined proportionally to asset price then the answer would be no, but they clearly do not. The United States has significantly overstated it's wealth. Sound familiar?

In 2001 the Dot.com bubble was another significant overstatement of wealth. The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. Comprising all Nasdaq-listed common stocks, it is the most commonly used index for tracking the Nasdaq. The Dow Jones Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. No other index comes close to offering its comprehensiveness. For comparison, the NASDAQ listed securities compose 19% of the 5000 Total Market Index. The Market Capitalization of the Dow Jones Wilshire 5000 Full Cap was $16.7 Trillion as of April 30, 2008. Comparatively, the market cap at the end of Q1 in 2000 was approximately $16 trillion (only slightly smaller). However, between 2000 Q1 and Q1 2003 the index lost a stunning 43% of its valuation. In other words, $7.1 Trillion of wealth was lost."

In order to make a statement on China, the proxy by which a comparison would be made is India. Here again In China, we have state capitalism and a government controlled economy. India has a more liberal democratic tradition. So far China has outperformed India year after year for the past 3 decades.

In Russia, the failure of liberalization policies of the early 1990s led to the strong state reassertion and state capitalism under Putin with popular support.

In Africa in the late 80s and 1990s, the IMF liberal orthodoxy led to the crumbling of national welfare in so many economies...

And on and on and on....

How could such a respected scholar and from all appearances a nice and sound minded person make such a claim, I am still scratching my head...


As I have made the case many times before in my BICs book and Knol collection and blogs, the role of government is bound to increase as population density increase, and this is due to what I have called the holistic theorem.



References:
The 2010 IAFE Annual Conference

Housing Bubble vs. Tech Bubble Loss of Wealth in Dollars denominated terms by Jeffrey D. Benson of the blog American MacroEconomic Dynamism