(Published in the South China Morning Post on 26 August 2007)
It is hard to think of something to
say about the recent upheaval in world financial markets that hasn't already been
said either this time round or following previous crashes.
History is prone to repeat itself, especially
in the world of finance. This is because markets are the ultimate expression of
human nature on a mass scale, and human nature, with its predilections for
occasional irrational behaviour, remains con-
Stant.
Take humans out of markets and they
would be a dull affair. Were CNBC broadcasted on the planet Vulcan, for
example, correspondent Spock of Logical Securities would report: "Once
again, all stocks rose today by 0.03 per cent. This is the expected rate of
return and is fixed for all stocks as our perfect foresight means there is no
risk. "Like yesterday, and the day before that, today's earnings results were
all in line with expectations, not surprising really, given that we know exactly
what the future will bring and that we all behave totally rationally."
It is our innate irrationality that drives
markets. Much has been written about the role of computer algorithm traders,
known as quants, in the recent selloff. Surely if computers, devoid of emotion,
play more of a role in dishing out buy and sell instructions, markets should
become more rational, right?
Wrong. Computer models are, of course,
written by humans, and if they're all the same, which they are, herding becomes
even more in-
tense.
In fact, in many ways the sharp decline
in volatility and the attendant steady rise in markets in recent years were
synonymous with the hypothetical Vulcan stock market. The problem was that
everyone woke up one day and remembered that we lived on a planet called Earth
where it was humans who approve home mortgages to borrowers with no income,
humans who securitised and rated them and humans who bought them. Oh yes, and
it was humans who programmed computers.
Goldman Sachs chief executive David
Viniar, in a call to investors in its funds that had been damaged by their use
of computer modelling; said: "We are seeing 25 standard deviation events,
several days in a row." To put this into English, he was suggesting that
what had happened in markets was something that should only be expected to
happen every several trillion years.
Since this in itself is absurd, because
it did happen; what Mr Viniar was admitting was that the models were flawed.
In this case, the computer models are
not human enough. They do not take account of the impact on financial markets
of their buy and sell orders, also known as the feedback effect. Self-awareness
is a uniquely human trait and one that is impossible to build into computer
programs given our current programming skills and computer capabilities.
There is talk of artificial intelligence and non-linear neural networks that will address this issue, but for now
it remains just talk. And anyway, most of the time computer models work just
fine. It's just that their very existence will mean that we'll occasionally
have these increasingly-hard-to-understand ruptures in the financial markets.
It wasn't that long ago that it was the
bank managers who extended loans and they knew where to find you. But times
have changed and nowadays things are more complex. While this complexity on the
whole improves efficiency in the financial industry, it also means that the
occasional bout of panic gets amplified.
On the radio last week, a reporter asked
what has become a common question — whether the rating agencies should shoulder
some blame for not warning us of the imminent collapse of stock markets.
This is another absurd proposition,
as it suggests that we have the capability to panic in an orderly fashion. What
were the rating agencies to do? Say that everything will be fine and dandy as
long as we don't rush for the exit en masse?
The fact is that the warnings were there
for anyone who wanted to listen. But by then it was too late — our lemming-like
mentality had taken over.
The behaviour of the ratings agencies
is merely symptomatic of the problem, the root of which lies in the increased
complexity of financial instruments, which in turn lies in the increased demand
for risk management tools, which itself lies in our negative emotional response
to financial loss, which ultimately lies in human nature.
Get the gist?
This imperfection in our psychology
has been exacerbated by our desire to describe the world in a mechanistic,
Newtonian way, rather than qualitatively. Thanks to Harry Markowitz et al, we
have been wrongly persuaded that volatility is bad since it is synonymous with
risk. His idea that investors get rewarded for assuming more risk was a sound
one but his model required a quantitative measure of risk, for which he chose
the standard deviation — the volatility — of historic returns.
The fact is, the uncertainty associated with market crashes cannot be defined by the bell curve as his the sudden, unpredictable lurches in volatility like we had in the past month that presents true risk not the normal sweeping ups and downs.
The fact is, the uncertainty associated with market crashes cannot be defined by the bell curve as his the sudden, unpredictable lurches in volatility like we had in the past month that presents true risk not the normal sweeping ups and downs.
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