Category Archives: Risk and Uncertainty

Michael Mauboussin rocks!

From Knowledge@Wharton: “How do we know which of our successes and failures can be attributed to either skill or luck? That is the question that investment strategist Michael J. Mauboussin explores in his book “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing“. Wharton management professor Adam M. Grant recently sat down with Mauboussin to talk about the paradox of skill, the conditions for luck and how to mitigate against overconfidence.”

I also recommend Mauboussin’s book entitled “Think Twice: Harnessing the Power of Counterintuition“. Mauboussin does a wonderful job explaining how to use modern social science findings (particularly behavioral finance) to become a better decision-maker when facing risk and uncertainty.

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Are You Brilliant, or Just Lucky?

Are You Brilliant, or Just Lucky? –

This article applies insights from Michael Mauboussin’s new book entitled “The Success Equation: Untangling Skill and Luck in Business, Sports and Investing” to investment decision-making. I particularly like the author’s description of a classic experiment in which “… people guessed the outcome of a coin toss. When told they got the first four tosses correct, they concluded on average that they would be able to guess 54 of the next 100 coin flips.” In other words, people often fool themselves into attributing skill to pure luck.

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We Already Went Over the Fiscal Cliff

We Already Went Over the Fiscal Cliff | The American Conservative.

It’s Paul Krugman vs. Paul Krugman.  Paul Krugman v.2 says there’s nothing to worry about, whereas a previous incarnation of Paul Krugman (from a decade ago – let’s call him Paul Krugman v.1) says that there is plenty to worry about…  Hat tip to my Baylor colleague economist Dave VanHoose for pointing this article out to me…

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The political economy of “All cribs now must pass tough new safety rules”

Last week, the Chicago Tribune published a story entitled “All cribs now must pass tough new safety rules” which describes in some detail new regulatory crib safety standards that have been promulgated by the Consumer Products Safety Commission (CPSC).  While crib deaths are obviously incredibly tragic, they are also very rare events.  Here, I call attention to some potentially deadly (and unsavory) “unintended” consequences associated with the proposed policy changes.  I’ll do this through the lens of George Stigler’s theory of regulatory capture.

The Wikipedia definition for regulatory capture is as follows: “…regulatory capture occurs when a… regulatory agency created to act in the public interest instead advances the commercial or special interests that dominate the industry or sector it is charged with regulating.”  A good place to start in this particular case is by thinking carefully about the underlying interest group politics behind this new federal regulatory initiative. The above referenced Chicago Tribune article notes, among other things, that “federal regulators recommend that families that can afford to do so buy new cribs and destroy their old ones (italics added for emphasis).” Think of the market consequences if everyone followed the CPSC’s “advice” – all of a sudden, you would have a sharp reduction in the supply of used cribs; furthermore, without the presence of a viably competitive used crib market, this means that the primary demand for baby cribs will likely be met by manufacturers whose products comply with the new regulations. Given this adverse supply shock while holding demand constant can only mean one thing – higher prices for baby cribs.  The next obvious question is, who is likely to benefit financially from these new regulations?  Baby crib manufacturers who can produce new cribs which are fully compliant with the new regulations obviously stand to benefit, particularly if the effect of the regulations is to create entry barriers (in the form of regulatory fixed costs) to this industry (hat tip to my Baylor colleague Dave VanHoose for pointing this aspect of regulatory capture out to me).  I can’t help but wonder whether the Juvenile Products Manufacturers Association has been actively lobbying for these new regulations for these very reasons.

Another interest group which stands to benefit is the plaintiffs bar who can be expected, in the wake of this change in regulatory policy, to pursue quite aggressively products liability cases against companies whose baby cribs at the time of manufacture were not fully compliant with the new safety regulations.  That it is possible to successfully litigate cases under such circumstances came as somewhat of a surprise to me, until I read Peter Huber’s book entitled Liability a number of years ago and more recently, a Supreme Court decision which seems to have established a precedent that full compliance with federal safety regulations at time of manufacture does not necessarily grant manufacturers immunity from liability after the fact (e.g., see “Supreme Court allows lawsuits over seat belts”, Reuters, February 23, 2011). It will be interesting to see whether this new regulatory initiative emboldens the plaintiffs bar to also pursue formal certification of pending baby crib lawsuits as class actions (if they haven’t already done so!). Of course, the additional legal cost will quickly become reflected in the price of new baby cribs, which will in turn make lawsuits all the more profitable to pursue (since payments to attorneys in such cases are largely based upon contingency fees) and baby cribs less affordable.

In the meantime, parents who can’t afford the sharply higher prices (due to higher direct and indirect regulatory and liability costs) for baby cribs will either violate regulatory policy outright by buying cribs off eBay and from garage sales; other parents will simply improvise their own sleeping solutions for their babies, which will likely be far more hazardous for babies than the cribs that the CPSC is currently in the process of outlawing. What a mess!

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Fibonacci numbers in nature and in finance

My favorite econ blogger, George Mason University’s Russ Roberts, posted the following (short, less than 4 minutes) video called “nature by numbers” yesterday on Cafe Hayek.  This video provides a remarkable and beautiful presentation concerning how Fibonacci numbers appear in nature. 

For more information concerning the math used in this video, go here.  Peter Bernstein (author of the worldwide best seller “Against the Gods: The Remarkable Story of Risk”) traces the origins of risk theory and finance back to a 13th century Italian mathematician by the name of Leonardo Pisano, who was known for most of his life as Fibonacci (see pages 23–26 from Bernstein’s book for historical context on the Fibonacci number series).  For some examples of applications of Fibonacci numbers in finance, go here.

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“Fat Tails” and implications for risk management

Yale mathematician and emeritus professor Benoît Mandelbrot passed away last week at the ripe old age of 85. Mandelbrot was most famous for his seminal work in the field of fractal geometry, but is also considered by many (e.g., Nassim Nicholas Taleb, the author of Fooled by Randomness and The Black Swan) as the “intellectual father” behind critiques of efficient markets models. Mandelbrot’s critique of efficient market theory was centered on the notion that actual return distributions are more “fat tailed” than would be implied by the normal distribution. Taleb provocatively argues in chapter 15 of his book The Black Swan that the bell curve (normal distribution), when applied to financial markets, is a “great intellectual fraud”. Taleb has also recently argued that “… the Nobel Prize for Economics (specifically, the 1990 awards to Harry Markowitz, Merton Miller and William Sharpe for their work on portfolio theory and asset-pricing models and the 1997 awards to Myron Scholes and Robert Merton for their work on option pricing theory) has conferred legitimacy on risk models that caused investors’ losses and taxpayer-funded bailouts…”, and that “investors who lost money in the financial crisis should sue the Swedish Central Bank for awarding the Nobel Prize to economists whose theories he said brought down the global economy” (see “`Black Swan’ Author Says Investors Should Sue Nobel for Crisis“).

While there is no question that Dr. Taleb’s narrative is brash and provocative, I am not convinced. Of course, he would argue that people like me who received their graduate training in finance during the past 2-3 decades have a vested interest in defending orthodoxy for its own sake. However, it’s only fair to also recognize that Dr. Taleb has a vested interested in defending heterodoxy for its own sake. It seems that Taleb seeks to discredit pretty much anyone who happens to disagree with him, not on the strength of the arguments that they marshall on behalf of “orthodoxy”, but rather on the basis of ad hominem arguments about how they can’t be taken seriously because they are intellectually biased a priori in favor of efficient markets orthodoxy.

I couldn’t have explained the implications of Benoit Mandelbrot’s research for financial markets any better than Dr. Ewan Kirk, who is Chief Executive for Cantab Capital Partners in Cambridge, UK, so I quote directly from Dr. Kirk’s letter to the Financial Times entitled “How Mandelbrot Caused Confusion“: “It is true that markets are very difficult to model precisely. Indeed, even after this simple transformation, there continue to be significant non normal features to markets and of course there are always “unknown unknowns” and “black swan” events. However, these issues are considerably more subtle than just presenting the 100-year unscaled daily returns of the stock market and implying that foolish theoreticians and practitioners are modeling the returns as a stationary Gaussian or normal distribution.” Also, the essay by Bob Gillespie entitled “Black Swans and Absurdistan” is worth reading.

In closing, I would like to point out two interesting videos from The first video, “Inefficient markets and Mandelbrot“, features a debate concerning whether the impact of Mandelbrot’s legacy has been overstated. The other video, “Why ‘efficient markets’ collapse” is an interview with Mandelbrot recorded last year in which Mandelbrot explains his more than 40-year old critique of the “efficient markets” hypothesis and why new (i.e., Mandelbrotian) theories on price movement discontinuities are needed in light of the financial crisis of 2007-????.”

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Assorted Links (7/2/2010)

Here’s a list of articles that I have been reading lately:

Scientists Discover Keys to Long Life –

“By analyzing the DNA of the world’s oldest people, Boston University scientists said Thursday they have discovered a genetic signature of longevity. They expect soon to offer a test that could let people learn whether they have the constitution to live to a very old age.”

Charles Krauthammer – Terror — and candor in describing the Islamist ideology behind it

“The administration’s refusal to identify terrorists reflects a dangerous cowardice.”

Brad Greenberg: How Missionaries Lost Their Chariots of Fire and Why They Should Add the Gospel Back

“In The Wall Street Journal’s Houses of Worship column, Brad Greenberg says that over the past century, Protestant mission workers have moved from spreading the Gospel to do doing good works, and says that they should be doing both.”

Paul H. Rubin: Why Is the Gulf Cleanup So Slow? –

“In the Wall Street Journal, Paul Rubin writes that there are obvious actions to speed up the Gulf oil spill, but the government oddly resists taking them.”

Kim Strassel: The Obama Trade Games –

“In the Wall Street Journal, Potomac Watch columnist Kimberley Strassel writes that free trade is making a convenient comeback in the Obama administration.”

E.J. McMahon: The Empire State’s Stimulus Addiction –

“In The Wall Street Journal, E.J. McMahon writes that New York will never get its budget under control as long as Washington feeds its spending habit.”

Daily Kos Founder Says Polling Data Was Faked – The Numbers Guy – WSJ

“In an unusually public rift, a prominent left-wing political Web site is renouncing polling it had commissioned and published and is suing its former pollster.”

Short-term insurance buyers in Massachusetts

“Further evidence on how consumers in the real world “game” insurance mandates – this is a cautionary tale for Obamacare, given that ObamaCare is in essence a nationwide implementation of RomneyCare…”

Keynes vs. Alesina. Alesina Who? – BusinessWeek

“Economist Alberto Alesina argues that austerity triggers growth.”

The Problem With Food Aid – Freakonomics Blog –

“Planet Money and Frontline report on the distorting effects of foreign food aid on local food economies, particularly in Haiti. People don’t buy rice when they can get it for free.”

It Depends on What the Definition of ‘Austerity’ Is

“Paul Krugman says we are in a ‘new era of austerity.’ When will government spending be enough? … In the last ten years, the private sector has, on average, grown 1.2 percent annually, while the government has, on average, grown 3.5 percent annually.”

John B. Taylor: The Dodd-Frank Financial Fiasco –

“In The Wall Street Journal, Stanford University economist John B. Taylor says the Congressional financial reform bill all but guarantees bailouts as far as the eye can see, while failing to address real problems like Fan and Fred and our outdated bankruptcy code.”

No Way to Help Small Business

“The need of many small businesses to raise money has led to several proposals to give small businesses more access to credit. Will they work?”

Menace to Mobility

“Comparing the administration’s new transportation plan to a Soviet ‘five-year plan’ would be unfair to the Soviets.”

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