Archive for July, 2007

How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud

Thursday, July 5th, 2007

Today, we will continue from How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey and go deeper into the concept of the Bell curve. The ideas from this article comes from the book, The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb.Back in How the folks in the finance industry got the idea of ?risk? wrong!, we showed you the Bell curve:

The Bell curve

In Chapter 17 of his book, Nassim Nicholas Taleb, said that:

I only realised that Gaussian-trained [Bell curve-trained] finance professors were taking over business schools, and therefore MBA programs, and producing close to a hundred thousand students a year in the United States alone, all brainwashed by a phony portfolio theory. No empircal observation could halt the epidemic. It seemed better to teach students theory based on the Gaussian [Bell-curve] than to teach them no theory at all. It looked more ‘scientific’ than giving them what Robert C. Merton called the ‘anecdote.’

So the Gaussian [Bell curve] pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. If you read a mutual fund prospectus, or a description of a hedge fund’s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure ‘risk.’ That measure will be based on one of the above buzzwords derived from the bell curve and its kin. Today, for instance, pension funds’ investment policy and choice of funds are vetted by ‘consultants’ who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.

So, what is the idea behind the Bell curve?

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

The problem with mainstream thinking in today’s finance and economics industry is that the Bell curve is their cornerstone assumption. In other words, the Bell curve assumption is used extensively to model reality and derive conclusions and forecasts. Take that assumption away and all that is left is nothing but hot air, which is a devastating threat to the countless professions, businesses and vested interest of those in these industries!

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility. For example, as the book says,

If the world of finance were Gaussian [Bell curve], an episode such as the [1987] crash (more than twenty standard deviations) would take place every several billion lifetimes of the universe.

A quick look at the stock market history will show you that crashes do happen many times in the past century. Extreme events often do happen. Extreme wealth and poverty exists. We do not live in a world where everything reverts strongly to the mean. The Bell curve is an atrocious tool to model the world.

Yet, the finance and economics industry uses them as if they are the gospel truth. What is the consequences of all these? We will talk more about it in the next article of this series.

Example of a financial turkey: Australian Property Monitors

Tuesday, July 3rd, 2007
Sometimes, reading the mainstream news media is a source of great entertainment. Just yesterday, in How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey, we gave a parable of the turkey’s Black Swan event. Today, we can give you an example of a financial turkey from an article in the mainstream news media.

In Home prices set to surge again, fuelling debt crisis, it says:

Australian Property Monitors predicts that in the next decade many in the mortgage belt of “average Australia” will reach a point where they are unable to put food on the table because loan repayments swallow their incomes.

Now, let us compare the Australian Property Monitors’ ?prediction? with a turkey’s reasoning from our previous article:

Let?s say you are a turkey. Ever since you were born, humans had always fed you, took care of you and ensured that you were healthy and fat. In all your long life of 1000 days, humans were always your friend. Therefore, you forecast that the next 1000 days will be like the average of the past 1000 days?great care under the hands of your human friends. Life has always been good and you see no reason for otherwise in the futureā€¦

As the parable goes, by Thanksgiving Day, the turkey ended up being a meal on the table.

What is wrong with Australian Property Monitors’ forecast?

As we said before in Australian property good investment? Part 3?prospects of capital appreciation,

What drives capital appreciation of property? Traditionally, it is the rising income levels that drive property prices upwards over the years. Naturally, as people?s general income level increases, the prices paid for property will increase as well. Recently, we have another phenomena that drive property prices upwards?the sudden availability of easy credit and low interest rates, which are manifestations of monetary inflation (?printing? of money). The result is a short-term property price bubble, which is currently deflating slowly. Japan, on the other hand, had their property price bubble burst, which led to a long painful recession and continuous deflation of property prices for around 17 years.

Currently, with the Reserve Bank of Australia (RBA) worried about price inflation, it will be quick to pull the interest rate trigger the moment it sees any signs of ballooning wage rates fuelling the inflation fire. As empirical evidence shows, over the past several years, wage rate had not kept up with the rise in house price.

Now, with these two conditions in place:

  1. Housing is already generally unaffordable
  2. Any signs of wage inflation will be met with a response of interest rate rise

How can property prices continue to soar, even until 2016 as ?predicted? by Michael McNamara of Australian Property Monitors? The only way for property prices to rise further is for lending standards to fall to the point of recklessness i.e. mortgage lenders going berserk in a mindless lending orgy. If this happens, we can be sure that the current US sub-prime crisis (see Sub-prime fears return) will be a piece of cake compared to the mortgage crunch that will follow. When a mortgage crunch happens, there will be painful house prices deflation (see What can tip Australia into a downward property price spiral?), which makes Australian Property Monitors’ ?forecast? a load of nonsense.

Alas, there are too many financial turkeys around. And these turkeys are charging money for their ?research!?


How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey

Monday, July 2nd, 2007

Today, we will use the parable of the turkey from the book, The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb, to illustrate the concept of the Black Swan. In essence, this parable is a subtle criticism of the prevalent way of thinking among the mainstream in the finance/economics industry. You may want to read up on our previous article, Expect the unexpected with risk models that can?t anticipate the future, which mentioned the background thinking behind the Black Swan idea. Here goes the parable…

Let’s say you are a turkey. Ever since you were born, humans had always fed you, took care of you and ensured that you were healthy and fat. In all your long life of 1000 days, humans were always your friend. Therefore, you forecast that the next 1000 days will be like the average of the past 1000 days?great care under the hands of your human friends. Life has always been good and you see no reason for otherwise in the future…

Then on the 1001st day of your life, it was the eve of Thanksgiving Day. By Thanksgiving Day, you had became a meal for humans.

Sad story. But to that poor turkey, the eve of the Thanksgiving day is the day of the Black Swan event. A Black Swan event is one in which it is highly improbable but has colossal impact.

Next, we will talk about how the folks in the mainstream finance/economics industry are like the turkey. Keep in tune!

Using fear as a proxy for import controls?

Sunday, July 1st, 2007

Recently, MSNBC had this news report: Tainted Chinese goods could lead to trade war:

From tainted pet food to lead-painted toy trains, a string of recalled Chinese-made goods threatens to tarnish the Made in China label in the United States and intensify calls for trade protection.

But there are signs that China trade sentiment is souring: in Congress, on the editorial pages of U.S. newspapers, and even in a new advertisement criticizing retailer Wal-Mart Stores Inc. for its heavy reliance on Chinese imports.

As we said before in US shooting own foot with tariff on Chinese goods:

At present, the US Congress is simmering in antagonism against China for her trade surplus against the US. They see China as a convenient scapegoat for America?s economic woes, accusing her of misconducts that includes currency ?manipulation,? unfair trade practices and so on.

Regarding Congress temptation to label China as a currency manipulator, we find this the case of the pot calling the kettle black.

Further down the article, we said:

We doubt either side will be stupid enough to sabotage each other.

We could be wrong on that. If this carries on, the US may be the one to fire the first shot. The result will most likely be ugly for both sides.