Saturday, March 19, 2011

Rationality #Fail

Odds of a nuclear core meltdown are estimated by scientists to be 1 in every 10,000 years. That’s very interesting especially in light of the fact that we have had 3 at least partial core meltdowns in just the last 50 years. This is the kind of statistic that makes us shake our head at such mathematical estimates based on a purely rational approach. Of course anyone in our profession will instantly see the parallel between the utter failure of the scientific estimate regarding potential nuclear disasters and the utter failure of the estimated risk of financial meltdown in 2007. Statistically both were nearly impossible and incredibly unlikely. And both are occuring in a very regular time-line. What becomes very clear is that complex systems defy rational mathematical estimates of risk.

We were pondering these thoughts last week when our intelligent friend Alex recommended reading Richard Bookstaber’s A Demon of our Own Design. Fantastic book — here are a few quotes:

“I believe the markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have. Just because you can turn some cash flow into a tradable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so. Well, in the efficient market paradigm it does. . .But in the world of normal accidents and primal risk, limitless trading possiblities might cause more harm than good. Each innovation adds layers of increasing complexity and tight coupling. And these cannot be easily disarmed through oversight or regulation. If anything, attempts at regulating a complex system just makes matters worse….Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.

Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets. These modifications will lead to a financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But, like the coarse response mechanism of the cockroach, when faced with the inevitable march of events that we cannot even contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable”