This page covers various reviews which i feel like writing from time to time.
Owing to the limitation on the "page" format of blogger, i can't publish each of these as a separate post. The following list includes the names of all the books and movies covered in the below page.
1. Book review - Thinking, Fast and Slow
2. Book review - Stumbling on Happiness
3. Book review - When Genius Failed
2. Book review - Stumbling on Happiness
3. Book review - When Genius Failed
4. Movie review - Rashomon
Book Review - Thinking, Fast and Slow
The book is split in four sections - dealing with system 1 and 2 of our decision making mind, overconfidence we have in our decisions, the process of making choices and lastly the existence of two selves (the experiencing self and the remembering self). Through each section the reader gets to see systematically how we err in our judgment and how we are inconsistent in our choices.
I wholeheartedly agreed with the author. However, even if i were not to, the arguments are generally quite plausible and based on real experiments. There is of course the usual critique which can be applied here as well - the experiments can always be designed with an expected outcome to be liklier than others. However, if one carefully thinks about the experiments described in the book, it is hard to believe that they were open to manipulation. I have personally tended to believe aftersome scrutiny most results. Going beyond the experimental accuracy, there is a more subtle potential issue - many conclusions are drawn in the context of a given theory and its expectations. It might be that some variables might be subtly correlated and not accounted for by the proposed theory. For example, if we track the accident rates of various types of cars we might be tempted to declare on the basis of data that SUVs are more likely to be in accidents than sedans (not true, i am just taking a hypothetical example). The issue however is that we might be assuming implicitly something which is incorrect - that the buyers of all vehicles in general are similar including those of the sedans and SUVs. If it is observed that the buyers of SUVs are anyway aggressive drivers, that might have more to do with the accident rate. The correct methodology to read the data would be to then see the data for a country which does not have any SUVs (for cost, regulatory or availability reasons) and try to control for people's score on the aggression paramters if possible.
The subtler issues aside, the book's central theme is highly relevant - and very disappointingly left out in most textbooks and mainstream economic courses. Our decision making framework is at the heart of all of economics and ignoring a very important, directly challenging to the mainstream and adequately supported by experiment construct like behavioral economics should be given equal if more weightage in the study of economics.
On the whole, a must read for anyone interested in human decision making process. For the better informed, this can almost be a high-end self-help book. For students of economics, a highly relevant read even if one has no direct interest in the field of behavioral economics. For finance professionals, very relevant again, however, they can skip to section on over-confidence and prospect theory if pressed for time. For anyone grappling with the question of happiness and purpose et al in life, the last section is highly relevant.
Book Review - Stumbling on Happiness
I recently finished reading the book "Stumbling on Happiness" by Daniel Gilbert (psychology prof in Harvard). The title is a little misleading - in that it sounds like a self-help book. In a way it is - but for the very scientific and left-brain sort of reader. In that sense, it might put off a lot of intelligent reader. I thought ten times before buying it myself (but then read a couple of pages to make sure).
The book makes two starting points
1. We feel happy about thinking about the future and controlling our path to future
2. Our happiness is independent of the destination we reach
Of this the first is assumed to be an agreed on hypothesis. The second is explained through the book. The idea is that we don’t know what makes us happy. However we continue to believe that we do. The first of this – that we don’t know what makes us happy is due to the following
1. The limitations of imagination – filling in details in our picture of the future, without us consciously knowing it; and more importantly leaving out details without us consciously knowing it
2. The tendency of human mind to construct the view of the future in the light of the present.
3. The ignorance of human mind of its own strength to rationalize – which makes a person suffer less than expected due to a negative event
The author then goes on to claim with supporting evidence from experiments that human beings are very unlikely to learn from their own experience – since memory is a very unreliable guide to how one “felt” in each event.
The final recommendation from the author’s side then is to rely on the experience of others who are currently in the state that we are expecting to be in future. Adequate explanation is given to deal with the claims of uniqueness of human experience (we are not really that different from each other).
There is a small excursion into why we continue to believe in the eternal truths of more wealth being better and children being a source of joy. This is quite important. The theory of super-replicators in the domain of ideas/beliefs is the same as that of suitable genes in the domain of biological evolution. The simple idea is that false beliefs can last long and grow in societies since these make those societies as a whole stable, prosperous and long lasting. At the individual level though, these beliefs may not be (and often are not) happiness-maximizing.
Very interesting book to say the least. Definitely worth a read - almost without break if possible; so that the arguments stay connected in one's head. The book opens a lot of ideas but does not necessarily close any. This at once may be the asset or liability. Liability because the book has no solid recommendations - there is one weak reco at the end. But nothing of the sort say a weight loss book might tell you about losing weight. Asset because in this domain any "recommendation" is likely to fall on deaf ears. It is then for the reader to dig deeper. I have tried some of this in my post on this blog itself. Each reader should of course construct her own version!
Book review - When Genius Failed
This book on the LTCM debacle is by no means either new or contemporary. I just happened to dig it out from Landmark one evening and finished reading it today.
LTCM i.e. Long Term Capital Management, was a hedge fund promoted by a clutch of bond traders on Wall Street along with a few academicians (including Scholes and Merton of Black-Scholes-Merton fame). At its peak it had equity capital of more than $ 4 bn and assets of more than $ 100 bn.
The book covers the rise and fall of LTCM in great detail - in a very human rather than analytical way. It is written for lay persons and that shows. A good read for lay persons for sure, but also for the practitioners of modern finance, all the more so in emerging economies like India's. It is not implausible to expect an LTCM like debacle in India within next 5 years. As the complexity of the financial system grows, crises of LTCM variety are more and more likely to occur.
So what exactly happened? LTCM started out as purely a bond arbitrage portfolio with $ 1.5 bn in capital. It borrowed about 25 times that and invested in bonds of various types. It was not a directional bet on the bond prices though. It dealt in what is called convergence trades i.e. narrowing of spreads between two bonds. For whatever reasons if the spreads between two bonds are out of whac with the usual levels, an opportunity to make relatively low risk return arises. One needs to short the costlier bond and long the cheaper one. Over time, as the spreads do narrow, one squares off both the positions and makes a tidy profit. This is market neutral trade since absolute price levels of either of the two positions is not relevant for the profit and loss of the trade. Only the spreads matter.
LTCM did good business in first four years of its operation. However, its success prompted many others to enter the bond arbitrage business. This put the firm in a quandary. It was getting more investors but fewer opportunities. The firm reacted by diversifying into newer areas of convergence trade - including merger arbitrage, volatility spreads and so on. This however was a much more tricky turf than bond arbitrage. Owing to a blind faith in the validity of their lognormal price models and a financial storm precipitated by the Russian bond default of the 1998, LTCM found that the spreads in most of its trades were diverging rather than converging. Owing to its excessive leverage, this proved to be far too much for it to handle. The fund had to be rescued by a consortium of investment banks.
The efficient market hypothesis has turned out to be more a neat modeling tool rather than reliable predictive framework. The book repeatedly refers to fat tails and the ridiculous implicit expectation in normal distribution models that events of 1998 should occur no more than once in the lifetime of the universe! In reality, such events happen once in 25-50 years; and are occuring more frequently in recent decades.
An interesting meta-inference i could draw was as follows. The accuracy of the efficient market hypothesis itself is a market dependent variable. Think of it as the volatility of the volatility. During normal times, the normal distribution (no pun intended) holds much more accurately than during turbulent times. I recall my lessons as an aerospace engineer. In fluid mechanics we always specified whether our models were dealing with laminar flow or turbulent flow (when you open a tap just a little, its water stream is laminar, if you open it fully and the water pressure is good, it becomes turbulent). The models, one would guess, differed significantly. Something similar should apply to the financial world as well. The laminar models are already in place. The turbulent ones need to be developed. (Jump diffusion for option pricing is an interesting start.)
Movie review - Rashomon
Holiday season is upon us and I thought I would take a little break from the world of finance and economics to wander off into some interesting territories. I had bought this collection of Akira Kurosawa movies. Of this I finally got around to watching Rashomon. It is a great movie no doubt. Here's a humble attempt to analyse it.
The movie is narrated by a wood-cutter to a common man who has come to share a shelter named Rashomon during a heavy downpour. There is a priest as well. It transpires that the woodcutter and the priest had come to testify in a court for a crime of rape and murder by a bandit against a samurai and his wife. The woodcutter however recounts (from what he hears at the court as told by the witnesses) three different stories to the commoner - each of which are different in their reasons and details. These are accounts of the crime as told by the bandit, the wife and the samurai. The starting set-up, ending state and some of the major chunks of events are same in each story. The motives and specific actions by each of the three however are quite different.
Just as they are wondering which of the stories is correct, the woodcutter goes further to narrate his version of the story as well - supposedly the closest to the truth. As it turns out, the best availble version of the 'truth' has its own flaws as well. The commoner represents the utterly cynical worldview while the priest stands for the idealist variant. The woodcutter seems quite disturbed by his observation of the limitations of human nature.
The central theme of the movie is quite disturbingly accurate of the limits of the truth available to human beings. For one, it focuses on how truth gets deformed by the individual agendas and aspirations the observer has. This is shown through the three stories of the bandit, the samurai and the wife. Secondly the movie goes into the more disturbing exploration of whether there is any absolute truth whatsoever which is without any coloring by the observer. This is brought out in the slightly distorted version of the events produced by a supposedly unbiased woodcutter. One is almost tempted to revisit the principle of quantum mechanics that the observer invariably influences the observed and thus can never provide the accurate description of "things as they are". Rashomon seems to bring out a similar intertwining of the observer and observed in the moral plane.
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