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Incorporating Human Behavior Into Wall Street Mathematical Models

Soulskill posted more than 5 years ago | from the fear-and-greed dept.

Math 300

After watching the stock market struggle for the past year, financial experts from Wall Street and academia are putting more effort into bringing behavioral modeling into their complex financial calculations. "The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic." Analysts are looking at research from other fields to supplement the hard mathematics of risk assessment. "Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets." Another avenue they're exploring is how we react to the spread of disease. Jon M. Kleinberg, a computer scientist at Cornell, said, "The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets."

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Such as? (4, Funny)

siloko (1133863) | more than 5 years ago | (#29405985)

Incorporating Human Behavior Into Wall Street Mathematical Models

What? Like morality?

Re:Such as? (4, Insightful)

Anonymous Coward | more than 5 years ago | (#29406007)

What? Like morality?

Like irrationality. (What was that sound? Oh yeah, it's the collapse of every economic philosophy proposed over the last few centuries as people realize there's no such thing as a rational actor!)

Re:Such as? (1, Insightful)

Anonymous Coward | more than 5 years ago | (#29406045)

>irrationality
I can model all your irrational behaviour to 98% given enough data. What appears to be a greater concern is simple-minded, animal, territorial, and greedy behaviour that isn't in tune with Game Theory; which says that it makes sense for people (and mathematical entities) to cooperate for mutual profit. It's when one entity tries to grab more than their equal share that the trouble starts. People can become ingeniously self-destructive when motivated by anything but altruism and solidarity.

Re:Such as? (2, Informative)

wizardforce (1005805) | more than 5 years ago | (#29406107)

nonsense. what happened was people acted in their own rational [so they thought] interest... few people want to intentionally harm themselves... the system was such that people acting to defend themselves from economic decline caused an avalanche of others doing the same. If someone believes that it is in their best interests to sell their stock it would be irrational of them to just sit there and watch their wealth erode away... but it would also mean that if they did sell their stock under incomplete information conditions the entire system becomes comparatively irrational...

Re:Such as? (3, Interesting)

Helpadingoatemybaby (629248) | more than 5 years ago | (#29406261)

"nonsense. what happened was people acted in their own rational [so they thought] interest..."

.

Whether people think they're rational doesn't make their acts rational. Professors Daniel Kahneman and Vernon Smith challenged the old Libertarian thought that people act in their own self-interest. "human decisions, rather than being based on a full analysis of the situation, often rely on shortcuts or rules of thumb. The studies developed the idea of representativeness, in which people are too quick to see patterns in data that are actually random."

.

http://www.independent.co.uk/news/business/news/irrational-studies-lead-to-nobel-prize-for-us-economists-613675.html [independent.co.uk]

.

They won a Nobel prize in economics for this.

If someone believes that it is in their best interests to sell their stock it would be irrational of them to just sit there and watch their wealth erode away... but it would also mean that if they did sell their stock under incomplete information conditions the entire system becomes comparatively irrational... Again, no. Your premise is wrong that they are acting in their own self-interest, your premise is also wrong that they are acting rationally, and your presumption that the entire system becomes irrational because people act on incomplete information is... well, incomplete. This is behavioral finance.

Re:Such as? (1)

jonbryce (703250) | more than 5 years ago | (#29406289)

I'm not so sure. We had a real estate bubble, the 2nd most recent in a long sucession of bubbles. Bubbles happen when people are behaving irrationally, and they burst when people start being rational again.

Re:Such as? (0, Troll)

benjamindees (441808) | more than 5 years ago | (#29406365)

Bubbles happen when people are behaving irrationally, and they burst when people start being rational again.

Bubbles happen when governments steal from rational people in order to give to irrational people.

Re:Such as? (1)

OeLeWaPpErKe (412765) | more than 5 years ago | (#29406451)

Exactly. Not that this (or any other) administration is about to stop doing that.

Re:Such as? (1)

OeLeWaPpErKe (412765) | more than 5 years ago | (#29406441)

What exactly was irrational about investing in houses between, oh, 1944 and 2008 ? Inquiring minds want to know.

For the record, I think people just aren't rational. People copy one another. It's rather easy to see that leads to bubbles (no matter what economical system you use btw, I think bubbles existed literally within villages in the stone age, and even before), and therefore I think bubbles are here to stay.

The more you know about the concept rationality btw, the more problems you can point out with actually using rationality, and the more insurmountable those problems become (summary : it's theoretically impossible to behave completely rational, and practically it's impossible to behave even vaguely rational. If you succeed in making 1 tiny modification of your behavior to make it slightly more rational yearly, you've done quite well). And yes I think that means that distributed decision making will beat the crap out of centralization until Kingdom come. And no, I don't expect obama to take that into account any time soon. I get the strong impression he "feels" he is sooo much smarter than the rest of us.

Re:Such as? (1)

wizardforce (1005805) | more than 5 years ago | (#29406627)

Don't forget that the bubbles exist only because the cheap credit allowed them to exist. Take a look at the major bubbles and their collapse. what preceeded them was cheap credit doled out by the federal reserve followed by a constriction.

Re:Such as? (1)

benjamindees (441808) | more than 5 years ago | (#29406213)

This is such a stupid distraction to claim that Wall Street's models should take "irrationality" into account.

The market already takes irrationality into account. Irrational actors fail. Instead of robbing taxpayers in order to reward irrational investors, a just government would let them fail.

Any rational Wall Street firm would invest in overthrowing an unjust government that robs from it in order to prop up it's competitors rather than investing in any more ridiculous computer models that attempt to make human irrationality an quantifiable concept.

"Only two things are infinite, the universe and human stupidity, and I'm not sure about the former." -you know who

Re:Such as? (1)

osu-neko (2604) | more than 5 years ago | (#29406745)

The market already takes irrationality into account. Irrational actors fail. Instead of robbing taxpayers in order to reward irrational investors, a just government would let them fail.

Ah, if only this were true. The fact is, it's just not that simple. Irrational actors often succeed, and rational actors often fail when they're deluded into thinking the market will act rationally.

Re:Such as? (2, Insightful)

wizardforce (1005805) | more than 5 years ago | (#29406049)

if conditions exist that favor making money through "immoral behavior" then that is what will happen. people didn't magically become depraved sociopaths who inevitably caused the recession- the conditions which favored that behavior did. The models were not sophisticated enough to model human behavior rational or not under these conditions.

Not a level/transparent/open playing field (2, Informative)

FriendlyLurker (50431) | more than 5 years ago | (#29406117)

if conditions exist that favor making money through "immoral behavior" then that is what will happen.

Some point to (substantial) evidence that the playing field itself could be called as you say, "immoral": http://www.chrismartenson.com/crashcourse/chapter-15-bubbles [chrismartenson.com] (ch16 and 17 as well) and some related news: http://www.google.com/search?q=audit+the+fed [google.com]

Re:Not a level/transparent/open playing field (1)

wizardforce (1005805) | more than 5 years ago | (#29406303)

I would say you're right about the system its self being immoral as it creates these bubbles of credit in the first place. Instead of shorter less severe bubble/collapses we have longer drawn out bubbles and subsequent collases as credit is distorted by the feds in order to create short term stability at the cost of these large bubble/collapse cycles.

Re:Such as? (1)

jo42 (227475) | more than 5 years ago | (#29406055)

The Greed Factor.

Re:Such as? (1)

Korbeau (913903) | more than 5 years ago | (#29406235)

What? Like morality?

Naw, I think they are trying to make a 1-ton replica of Jim Cramer's brain :)

Re:Such as? (0)

Anonymous Coward | more than 5 years ago | (#29406405)

WTF? We're talking -human- personality here.

So like... greed and fear.

Re:Such as? (0)

Anonymous Coward | more than 5 years ago | (#29406633)

somany wack ideas in this economic science. these peoplelive behind the moon or at least somewhere 100 years ago

Re:Such as? (1)

bhima (46039) | more than 5 years ago | (#29406645)

No. Remember they're talking about Wall Street.

On a more serious note, Nature Magazine has had several very interesting articles on economic & climatic modeling in the past few months... but I'm sure all of them are behind the Nature.com pay wall.

Re:Such as? (1)

Tablizer (95088) | more than 5 years ago | (#29406687)

Incorporating Human Behavior Into Wall Street Mathematical Models

What? Like morality?

Yeah, they forgot to remove it from their models.
   

Slight mistake (0)

Anonymous Coward | more than 5 years ago | (#29405993)

Financial markets ... are anti-social networks

There, fixed that for ya.

Who Would Have Thought (0)

Anonymous Coward | more than 5 years ago | (#29406009)

But I thought financial markets were an independent entity, not influenced by human social conditions.

The October syndrome (1)

mangu (126918) | more than 5 years ago | (#29406295)

Stock markets usually drop during the month of October. People in Europe and the US get back from their summer vacations and have to sell some stock in order to get their bank accounts in the black. This causes stock prices to fall in September, then people get worried and the general gloom of approaching winter does the rest during October.

Re:The October syndrome (0)

Anonymous Coward | more than 5 years ago | (#29406491)

But other major stock market crashes have occurred in April-May.

My human gut instinct says.... (1)

ducomputergeek (595742) | more than 5 years ago | (#29406051)

....somehow this isn't going to end well.

Re:My human gut instinct says.... (1)

taddyhatty (1037918) | more than 5 years ago | (#29406193)

Creating consolidated finantial statement of exchange of securities on internet market, almost 80% transactions may be meaningless.

"Myth : Stallman may ba a democratist, if he respect to "invent" not "inventry""

Re:My human gut instinct says.... (1)

berwiki (989827) | more than 5 years ago | (#29406251)

somehow this isn't going to end well.

yea, no kidding, the only reason they want to build these models is to dump all their cash while it maintains its maximum value.
do you really think this will help the stock market stay UP? It will simply allow the rich to pawn their stocks immediately, while the rest of us get shit on, watching our fortunes collapse, and they'll take all their protected money and reinvest it back into the market when it has bottomed out. Hooray.

I foresee... (1, Interesting)

Anonymous Coward | more than 5 years ago | (#29406053)

... more miserable failure. Sorry folks, interdisciplinary research does not work. The people who build the financial models will never understand psychological theories; the people doing psychology will not understand (nor care) about financial models. Moreover, what "behavioral models" we are talking about here? I would very much like to see one that actually has predictive power. Alas, most of this so-called research in, say, "web social networks" is merely a collection of useless results designed to get published and raise the academic status of the researcher. Academia is a fraud... la-la-la *blasphemy*

Am I bitter? Yeah.. please, someone prove that I am wrong. I would like to be wrong on this one.

Re:I foresee... (2, Funny)

gznork26 (1195943) | more than 5 years ago | (#29406167)

A predictive model of human behavior? Sure. If I recall, Harvard Law states that under carefully controlled conditions, human beings will do what they damn well please.

+ + +

Read "Terrifying Vindication" at http://klurgsheld.wordpress.com/ [wordpress.com]

Either we had the wrong algorithm (1)

Perp Atuitie (919967) | more than 5 years ago | (#29406069)

or we burnt the wrong animal at the sacrifice. But let us take this setback as a call to redouble our faith: Soon the saucer will land.

Wrong Direction (2, Interesting)

benjamindees (441808) | more than 5 years ago | (#29406073)

Personally I think this is a terrible sign. Irrational investors should be discouraged from gambling in the markets instead of coddled and encouraged through tax breaks and an extensive regime of inconsistent regulation. Governments and the fraudulent investment advisors they subsidize and fail to regulate have done us all a disservice by suckering the average person into investing in derivatives markets like the stock exchanges. And now instead of letting the market correct the problem all sides are dragging us further down the path of government interference and command economy. They actually have the brazen stupidity to think that a command economy will work if only they can come up with some better computer models of market behaviour.

Re:Wrong Direction (1)

edremy (36408) | more than 5 years ago | (#29406387)

Hate to tell you this, but *all* investors are irrational at some point. It's human nature. We're in this mess in large part because a bunch of economists convinced themselves that the market is always perfectly rational and prices things correctly. They continued to think this despite the endless strings of bubbles and panics in the markets for centuries. Huge events like the bankruptcy of LTCM and the NASDAQ tech crash didn't seem to bother them in the least. They needed no regulation at all- after all, the market was perfect, never made mistakes and they understood risk perfectly.

How much more irrational can you get?

I must admit I'm a bit confused why you think the government is at fault here- the folks running all those sophisticated models were private investors. If someone in the government had had the balls to actually restrain them we wouldn't be here.

Re:Wrong Direction (1)

benjamindees (441808) | more than 5 years ago | (#29406795)

We're in this mess in large part because a bunch of economists convinced themselves that the market is always perfectly rational and prices things correctly.

I hate to break it to you, but no one actually believes this. No one cares whether the market "prices things correctly" as long as the losers are allowed to fail.

I must admit I'm a bit confused why you think the government is at fault here- the folks running all those sophisticated models were private investors.

If you are not aware of the history of Fannie Mae and Freddie Mac, the largest mortgage underwriters in the world, that were chartered by the US government and recently re-nationalized at taxpayer expense, along with the Fed's market manipulation by lowering interest rates and robbing from savers in order to stimulate irrational lending, as well as the myriad government regulations that forced lenders to make sub-prime loans to otherwise unqualified borrowers (that they then had find creative ways to pawn off on others), then I suggest you inform yourself.

If someone in the government had had the balls to actually restrain them we wouldn't be here.

Yes but we also wouldn't be here if government had the balls to let the losers fail and let the courts sort through the remains. What we have is the worst of both worlds, and it will get worse by trying to control every tiny aspect of the market through Congress and regulation rather than allowing the free market to function as designed.

Re:Wrong Direction (1)

TerribleNews (1195393) | more than 5 years ago | (#29406525)

I don't think you quite understand who works for whom, here. If the goal is to vacuum as money out of The Masses' wallets and into the pockets of the rich, then obviously the incentives should be for "investing".

And this is not some kind of conspiracy, here, this is simply a lot of people trying to act in their own best interests and, in the case of Wall St and Washington, succeeding. Unfortuately, because of the way our financial system is set up, that is at the direct expense of Joe Six-pack. Until your average person becomes a little more savvy and realizes that more than half The Economy is a Ponzi scheme, this will continue. Sadlly, it is likely that by the time Joe Six-pack gets wise, Wall St and Washington will have moved on to bigger and better money vacuums.

Re:Wrong Direction (0)

Anonymous Coward | more than 5 years ago | (#29406601)

"And now instead of letting the market correct the problem all sides are dragging us further down the path of government interference"

Blind faith in "the market" is arguably part of what got us here in the first place. "Letting the market correct itself" might as well be a euphemism for "the complete collapse of a nation" in some cases. And seeing every major bank fail at the same time would have triggered one of the really really big catastrophes; as it was, we were already seeing perfectly viable normal responsible businesses starting to struggle as the flow of money ground to a halt. Do we really want to play economy jenga, and see how many pieces we can yank out of the tower before the whole thing collapses? Not really; it's happened to other places and it wasn't pretty.

Re:Wrong Direction (0)

Anonymous Coward | more than 5 years ago | (#29406673)

A "perfectly viable normal responsible businesses" that is dependent upon a "flow of money" from an irresponsible bank or government subsidy is neither viable nor responsible.

Voodoo (3, Insightful)

Weedhopper (168515) | more than 5 years ago | (#29406075)

Why is it that these people insist on trying to apply a veneer of respectability to this shit?

Financial engineering is not engineering.
Economics is not a real science.
Finance is not real math.

Re:Voodoo (1)

TJ_Phazerhacki (520002) | more than 5 years ago | (#29406101)

Because there is a grain of respectability and truth to the pure quantitative analysis. So engineers/smart people pursue it. And the people with money who want to make more will leverage whatever small advantage the quants can generate.

Smarts can be a liability. (1)

NoYob (1630681) | more than 5 years ago | (#29406619)

So engineers/smart people pursue it.

Really? Engineers are the easiest people to dupe with financial numbers. Why, you ask?

Engineers come from a background where the numbers are based upon physical laws - the numbers mean something tangible in the end. Whereas in accounting and in business in general, the can be and usually are several correct answers, and in some cases, the incorrect numbers look more reasonable. Many times, the numbers are assumptions. Numbers that are assumptions are pulled from one's ass; hence assumptions.

Re:Voodoo (1)

gestalt_n_pepper (991155) | more than 5 years ago | (#29406249)

But *boy* was there money to be made.

Human behavior again!

Sorry: Giving up not the appropriate response (2, Interesting)

BigSlowTarget (325940) | more than 5 years ago | (#29406377)

Human behavior is the core of all economic thinking. It either directly or indirectly is the basis of every model and every theory. The problem might be that the behavior assumed is over simplified to 'greed and fear of risk' when it should include something more, but that's nothing new.

This doesn't mean the right thing to do is give up on modeling risk and simply give up and go back to simply letting the king (or the five year plan) decide what is worth funding. Venture capital and stock markets are capitalism's attempt to estimate what technologies and businesses are the most promising and most efficient. Is it wrong? Often. But its wrong less often than other methods.

So, is financial engineering really engineering? It depends how you define both the terms. Marketing guys that add 'engineering' to something to make it sound trustworthy are not, but I'd say that the forecasts financial analysts and economists make can be as legitimate in approach and method as the forecasts civil engineers make about traffic flow, water needs, sewage requirements and infrastructure development. Both are mathematical forecasts of what human behavior will be in the future and both can have good or bad underlying assumptions that drive results. Both can be right or wrong based on the math or the assumptions.

Re:Voodoo (-1, Flamebait)

Anonymous Coward | more than 5 years ago | (#29406381)

Right. In fact, modern economic theories can be viewed as an equivalent of theology in 18th century (and before) monarchies: complex enough that some people will enjoy studying it and even believe the dogmas, and thus will honestly try to enforce it (today's laissez-faire yes-men, basically, with popes such as Milton Friedmann). But of course the really powerful (billionaires, big CEOs,...) don't usually really believe the baloney (neither did some Popes or kings, btw), they just subsidize educated slaves (such as Friedmann) because it serves their interests to keep enough gullible people in the "true faith" (name your favorite short-sighted political trend here).

Re:Voodoo (0)

Anonymous Coward | more than 5 years ago | (#29406725)

Certainly not, it's just a bunch of numbers, and what has that got to do with math?

Re:Voodoo (1)

Tablizer (95088) | more than 5 years ago | (#29406807)

You should probably lump "software engineering" into there also, if ignoring the machine performance aspects. Society is increasingly relying on "soft science" disciplines where traditional scientific experiments cannot be practically done.

There's too many factors to tame and too many issues, such as cost, scale, and ethics, that keep a researcher from performing the necessary research in a clinical way.

This problem itself perhaps needs it's own branch of researchers. What kind of name can we give it? Fuzzitology?
       

Incorporating Human Behavior Into Wall Street Math (1)

omar.sahal (687649) | more than 5 years ago | (#29406079)

Another avenue they're exploring is how we react to the spread of disease

Prevention is better than cure! It can be averted by less risky behaviour!

Re:Incorporating Human Behavior Into Wall Street M (2, Informative)

wizardforce (1005805) | more than 5 years ago | (#29406185)

often times it was closer to being fraudulent than risky... the current system allows companies to leverage far more capital than they have in assets [fractional reserve banking] that is very dependant on the stability of the money supply... consequently when there are monetary expansions followed by monetary restrictions by the federal reserve we observe a collapse of the system catalysed by panic.

NO! Not again! (2, Insightful)

QuoteMstr (55051) | more than 5 years ago | (#29406085)

Between these revived, yet still pernicious models and Wall Street's darling new death bonds [businessweek.com] , we look poised to blow another bubble, destroy another decade of growth, and funnel more money into the hands of the obscenely wealthy when the system flies apart.

We cannot allow that to happen. Finance needs to be returned to a staid utility that forms a relatively minor part of our economy. We need to be deeply skeptical of innovation in the financial sector: it's been around for a long time, and we've already explored most of the beneficial ideas. What remains is deception and fraud.

Wrong link (4, Insightful)

QuoteMstr (55051) | more than 5 years ago | (#29406115)

Corret one [nytimes.com] .

The bankers plan to buy "life settlements," life insurance policies that ill and elderly people sell for cash -- $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to "securitize" these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return -- though if people live longer than expected, investors could get poor returns or even lose money.

Keep in mind that these things will be securitized, tranched, and then the pieces will be securitized and tranched, greatly magnifying the risk. On top of that, there will be a new, brisk trade in various hedges on these instruments, including the infamous credit default swaps. In this way, a tiny diseases market can metastasize throughout the economy.

Death Insurance gambling (1)

Zerth (26112) | more than 5 years ago | (#29406271)

Damn, didn't people learn how stupid this was back when they did it to AIDS patients?

Investing in life insurance scams is plain gambling. No wealth is created and the insurance company generally is smart enough to set itself up as "the house". And the house always wins.

So either you lose, or you're taking death benefits from the elderly. Not a position I'd want to be in when somebody decides to do a news piece on it.

Re:NO! Not again! (1)

jonbryce (703250) | more than 5 years ago | (#29406329)

It mentions Keydata Investments in England, but doesn't mention that they were shut down for tax evasion, and subsequently it has been discovered a lot of investors' money has been lost in fraud as well.

How is daytrading not gambling? (1)

MartinSchou (1360093) | more than 5 years ago | (#29406089)

I'm yet to hear a decent explanation on how day trading isn't gambling while poker is.

Both are working on limited information
Both involve you making money off of other people's mistakes
Neither creates wealth and merely shifts it around
Both can cost you fortunes even though you did nothing wrong

Re:How is daytrading not gambling? (1)

Repossessed (1117929) | more than 5 years ago | (#29406187)

The market isn't zero sum or negative sum (well, usually). When the economy is good (which used to be most of the time), almost everyone wins. A good investor will make money consistently even when the market is down (if maybe not when its in freefall like the last couple years).

Re:How is daytrading not gambling? (1)

moon3 (1530265) | more than 5 years ago | (#29406217)

Most of business is kind of gambling only with variable risk factors. Even if you create something of a real value -- like when GM produces a car, that doesn't mean cost of production and other factors will not drive them into red numbers.

Re:How is daytrading not gambling? (1)

Brewmeister_Z (1246424) | more than 5 years ago | (#29406453)

But a business that produces something of value can act upon variable risks as they appear or have a plan that considers what might happen to provide a bit of a safety net. To do so in gambling (cheating of some sort) or daytrading (inside information) will get you arrested, roughed up, or killed if caught.

The businesses that tend fail due to risk are run by scum that takes the short-term gains and bail before the long-term loss. This could also lead to being arrested, roughed up, or killed if caught. So you are correct, but businesses vary and the business structure and management style will ultimately determine risks that would be closer to gambling.

Re:How is daytrading not gambling? (1)

wizardforce (1005805) | more than 5 years ago | (#29406223)

you act like both have the same amount of randomness... if you make a bet at a poker table it is likely to be significantly more risky than investing in say mcdonalds. one is mostly random and the other is a company unlikely to collapse any time soon. one involves risk and concealment, the other involves risk and possible wealth creation. big difference.

Re:How is daytrading not gambling? (1)

behemoth64 (1576441) | more than 5 years ago | (#29406389)

It's your third point where you go wrong,

Neither creates wealth and merely shifts it around

more daytraders means more participants in the market place, more participants means more liquidity and more liquidity means a better functioning market place. A market with no liquidity, is a market that is not trading, ie the 2008 market, where bids and offers are worlds apart, this is bad for ALL the participants from big institutions to small retail guy, much like you I presume... Hence daytraders, while you may not realize it are providing a service for the market place at their own risk and are compensated accordingly.

Austrian Economics, anyone? (5, Informative)

dark_requiem (806308) | more than 5 years ago | (#29406105)

Human behavior is the basis for the Austrian school of economic thought. Has been from its roots. Ludwig von Mises, one of the founders of Austrian economics, titled his magnum open "Human Action". The basic idea of Austrian economics is that the study of economics is an a priori discipline. In other words, you can't implement, from both a practical and ethical standpoint, experiments to study economics on a useful scale. Instead, economics must be viewed as a study of human behavior. Humans are the principle actors in an economic system, so their behavior and drives must be the primary focus of economic study. The study of economics can therefore be viewed as a study of groups of self-interested participants working for their own betterment.

Incidentally, Austrian economics also posits that interference with the operations of markets produces a boom-bust business cycle, by promoting misallocation of scarce resources. It's worth noting that many Austrian economists were predicting our current economic crisis well before it occurred, when the more mainstream Keynesians were still calling it a golden age of economic development.

What is being proposed here is to continue to view markets as purely mathematically modelable phenomena. Economic decisions occur on the most local of levels, the individual level. No model accounts for the variability of the individual. For a Keynesian-style planned economy to function requires omniscience.

Re:Austrian Economics, anyone? (1)

xs650 (741277) | more than 5 years ago | (#29406253)

"The study of economics can therefore be viewed as a study of groups of self-interested participants working for their own betterment."

That could also describe a study of crime families and drug gangs.

Re:Austrian Economics, anyone? (3, Informative)

benjamindees (441808) | more than 5 years ago | (#29406461)

Crime families and drug gangs are economic phenomena.

Both usually comprise an underground economy of immigrants (people outside the normal purview of government) working to avoid government regulation of business activity.

Re:Austrian Economics, anyone? (1)

oldhack (1037484) | more than 5 years ago | (#29406373)

Point to "Austrians" for recognizing the social nature of economics, but their prescription thereafter is an ideology rather than science. As far as ideologies go, not the worst one I've came across, but an ideology nevertheless.

Re:Austrian Economics, anyone? (3, Interesting)

Trepidity (597) | more than 5 years ago | (#29406495)

It's true that the Austrian school of economics correctly realizes that human behavior is the central component of economics. But they base their entire subsequent theory on an absurd model of human behavior with no scientific support:

The study of economics can therefore be viewed as a study of groups of self-interested participants working for their own betterment.

This is making a pretty huge assumption about human behavior that most scientific studies of human behavior, in any field, don't bear out.

Re:Austrian Economics, anyone? (1)

Tablizer (95088) | more than 5 years ago | (#29406741)

Indeed. Psychology is often called a "soft science" because it's hard to isolate specific factors for experiments, let alone repeat them; and so educated guesses are the main mode. Software engineering (beyond machine performance) may also fall into this type of problem.

Re:Austrian Economics, anyone? (0)

Anonymous Coward | more than 5 years ago | (#29406675)

Astrian economics makes two fundamentally wrong assumptions about the world:

1. That humans are "rational actors".
2. That those "rational actors" have access to "perfect information".

Please don't. (4, Insightful)

Shihar (153932) | more than 5 years ago | (#29406111)

I really wish wall street would get off their 'risk models' fetish. The financial systems of the world are wildly complex beyond all comprehension. "Risk models" make three, very shitty assumptions and, as a rule, eventually always fail. As we saw with the latest blow up, some times they fail with epic spectaularity. The three shitty assumptions are:

1) That the model has enough information to make predictions in this infinitely complex system
2) The system doesn't change.
3) We will see nothing in the future we have not seen in the past.

It is like watching someone try and figure out a way to predict the winner of a game where the rule book takes a library to hold AND the rule books are constantly being swapped out for new rule books. Everyone likes to blame the current recession on greed, evil bankers, and corporate corruption. While all of those things exists, they are not what caused the melt down. What cause the melt down was that a bunch of morons were using a 'risk' model that basically predicted that what happenend could NEVER possibly happen, so don't worry about it. Based upon this bad information, people made some very awesomely bad 'safe' bets. When the "impossible" (as the risk "models called them) happened, those very bad but "safe" bets imploded and you saw the wide spread destruction that happened as a result.

Re:Please don't. (1)

oldhack (1037484) | more than 5 years ago | (#29406349)

Can't you cut the Wall St. Assholes a break? You don't think they bleed black pus when cut like the rest of us?

Re:Please don't. (1)

hibiki_r (649814) | more than 5 years ago | (#29406403)

It's harder than that. What a speculator does is try to guess what other people think the majority will find popular. Read about the Keynesian beauty contest: It shows why the market, while somewhat based in fundamentals, is inherently unstable.

it wont work (3, Insightful)

Iamthecheese (1264298) | more than 5 years ago | (#29406123)

to steal a quote, markets can remain irrational long after a rational trader becomes insolivant. This includes rational predictions about human behavior.

Re:it wont work (1)

Shikaku (1129753) | more than 5 years ago | (#29406517)

So you are trying to rationalize irrational rationalization of rational human behavior?

Sign me up... (3, Interesting)

Paul Fernhout (109597) | more than 5 years ago | (#29406135)

High math and analytical GRE scores, a degree in psychology, previous work in the speech group at IBM Research, lots of programming and simulation knowledge... :-)

Might as well make a little money out of the market before post-scarcity issues obsolete it. :-)
    http://www.pdfernhout.net/post-scarcity-princeton.html [pdfernhout.net]

Widespread panic not the only thing left out (1)

aztektum (170569) | more than 5 years ago | (#29406141)

What about widespread greed?

Greed? yes + dishonesty (1)

KwKSilver (857599) | more than 5 years ago | (#29406415)

To say nothing of plain old dishonesty.

The *real* formula (0)

Anonymous Coward | more than 5 years ago | (#29406143)

( (bunch of lazy quants using numerical recipes in c) * (offshored IT in large banks) / greedy rampant bankers) % ineffectual regulators - backstop of wage slave tax payers = fucked economy > big bank bonuses.

Seriously though - the modelling used in most cases is hopelessly crap, as it only models things in a perfect situation, where we assume we know all variables within certain tolerances, at that given time, and no extraordinary event will take place, and people will be rational, and the market knows best, and such like. Utter rubbish, and I write trading systems that have to use these "models" for pricing, risk and valuations.

 

Consumer based ecomomies must consider social elem (2, Interesting)

Brewmeister_Z (1246424) | more than 5 years ago | (#29406207)

The biggest problem with some economic models is that they don't consider the irrationality of a consumer. This is fine when an economy is based on manufacturing or processing/export of natural resources since that follows more rational processes.

The US economic meltdown was long overdue since the writing was on the wall with housing screaming up in value while any job that could be outsourced overseas was sent regardless of the quality and logistics issues it may create.

A consumer-based economy with jobs for the consumers disappearing is going to fail unless money is being pumped in elsewhere (AKA government welfare through various programs such as low-income assistance, subsidies, stimulus checks, etc.). This itself cannot be sustained and now our government looks for more loans from the countries we made wealthy by sending most of our manufacturing jobs (China).

Increasing taxes for the wealthy and businesses will force people to leave the US or find other ways to evade taxes. This means the middle class will bear more of the tax burden over time. There is a good analogy of beer drink buddies of various incomes splitting the tab based on income that illustrates the tax and spending dilemma.

So my opinion is that human behavior models are long overdue to be applied to economics.

Wow! Did Captain Obvious just fly in? (2, Funny)

Anonymous Coward | more than 5 years ago | (#29406237)

They're just *now* trying this?
.
Seriously?

Financial calculations (2, Funny)

Gorgeous Si (594753) | more than 5 years ago | (#29406257)

bringing behavioral modeling into their complex financial calculations.

Am I the only one who read that as 'fictional calculations'? It may be more appropriate ...

Flawed assumptions (1)

Gudeldar (705128) | more than 5 years ago | (#29406299)

Most economic theories have a hole you could drive a truck through. They assume people act rationally.

Re:Flawed assumptions (1)

hibiki_r (649814) | more than 5 years ago | (#29406419)

More than that, they expect people to have a very similar concept of what rational is. When people's different motivations are taken into account, what you get is a model that behaves like a real model, but that can't really be used to predict the future results of the market close enough as to let anyone make money from using it.

Re:Flawed assumptions (1)

ColdWetDog (752185) | more than 5 years ago | (#29406553)

Man is not a rational animal - he is a rationalizing animal. (Robert Heinlein)

Explains a lot.

Asimovian (1, Insightful)

Anonymous Coward | more than 5 years ago | (#29406309)

Psychohistory, anyone?

Get rid of Economic Man (5, Interesting)

GTarrant (726871) | more than 5 years ago | (#29406331)

While I dislike how suddenly the financial markets have gotten back into these windfall risky investments, there's little push to stop it, so I guess taking into account the kind of behavior that, you know, actual people would do, is better than nothing.

Most 'risk analyses' done by these things almost go as far as to assume everyone involved acts as Economic Man - the theory that everyone will always act in such a way as to best improve their position, in a 100% rational way. This is a pipe dream put up in economic theory and doesn't always work. If you assume everyone involved acts that way, then some possible outcomes - like the ones we saw in the past year - can't be the slightest bit possible, therefore the models that were being run at the time disregarded them. Of course, the models were wrong - because people don't act that way.

Consider what is sometimes called the Ultimatum Game - everyone's heard of it. Person A has a pile of money to divide between themselves and Person B. They split it, and Person B can either accept the division, in which case each gets their share, or reject it, in which case neither player gets one red cent and the money is lost.

Economic Man theory would say Person A should give the smallest possible amount (let's say 1%) to Person B, and keep 99%, or whatever the maximum share is, and that Person B should then readily accept, because they're better of taking something rather than nothing. In reality, when this "game" is tested, it doesn't work that way - if Person A doesn't offer enough to B (say, 20%), Person B tends to reject it, whether out of spite, or a sense of fairness. The responses change depending on how much money is involved, and culture (different countries and regions have different thresholds) and everyone seems to have their own threshold of course - but very few Person B's say "OK, I'll take one penny and Person A can have $99.99" even if that's what Economic Man would do.

Likewise, Economic Man doesn't see that much of a difference between, say, 10% chance of loss, or a 5% chance of losing double that amount and a 2 1/2% chance of losing quadruple - while real people tend to disregard a small chance of large losses, but be quite averse to a reasonable chance of smaller losses - they'd probably go for the last option, even if percentage wise the "odds" are the same.

Most of these financial models, in essence, assume people are Vulcans, when they're not - they're people, and no amount of economics saying "You should act like Economic Man!" is going to change that.

If they're going to continue using these models, a push to start getting them better is at least some progress.

Re:Get rid of Economic Man (4, Informative)

jcr (53032) | more than 5 years ago | (#29406519)

I dislike how suddenly the financial markets have gotten back into these windfall risky investments,

You can thank the geniuses in the legislature and the Federal Reserve who protect them from their losses for that.

-jcr

Just one more tweak! (1)

argent (18001) | more than 5 years ago | (#29406357)

It didn't work last time, but we know just the tweak to throw in to fix it! Honest! We're gonna get it right this time!

Feedback loop (0)

Anonymous Coward | more than 5 years ago | (#29406361)

Do the models include variables for investors believing only the mathematical models that tell them what they want to hear?

Wrong human behaviour (2, Interesting)

gmuslera (3436) | more than 5 years ago | (#29406369)

The human behaviour they should put into those models arent panic or riots, but what humans do when know what those models predict. Thats the biggest problem about predicting what people will do, what if that people know that prediction?

That was the problem, too much people "knowing" what will happen, acting in a big way, and of course, failing because those predictions didnt included that behaviour.

Step in the right direction (1)

4D6963 (933028) | more than 5 years ago | (#29406421)

We all know that modelling human behaviour in software is anything but a trivial task, and that the results have to be taken with quite a grain of salt, but that's a step in the right direction, because for the last few decades economists have considered the market players to be perfectly reasonable, rational and competent, assuming little to no chaos in what actually goes on. If this crisis did anything good, it's given a much needed reality check to economists, particularly west of the Atlantic. I read a great piece [nytimes.com] on the topic by the way.

There's also something I love about these economists who come up with Nobel prize-worthy equations but fail to see the elephant in the room that is making all these weird assumptions about how markets work. I think of them as smart fools, they're extremely intelligent, but never take a step back to see where they're going. They do very futile and dumb things, but in an extremely sophisticated and brilliant manner. And because they know they're extremely smart and experts in their field, they reject any notion that despite that intellect and expertise they might be fools. Anyone with any common sense and education could see the caveats of what they do, but everybody knows that these guys are smarter than us and experts, so they must be right, even if it's blatantly foolish. This applies to string theorists as well by the way, to a lesser extent.

Re:Step in the right direction (1)

jcr (53032) | more than 5 years ago | (#29406467)

They do very futile and dumb things, but in an extremely sophisticated and brilliant manner.

Sophisticated and brilliant? More like obfuscated and arrogant. Krugman is a moron.

-jcr

Good luck with that (2, Insightful)

PPH (736903) | more than 5 years ago | (#29406485)

Lets say the people who have the Federal Reserve Board of Governors on speed dial decide that the dollar needs to move in a different direction. So they call up Alan Greenspan and have him dump a few billion in foreign reserves. Exchange rates change, followed by interest rates. Pretty soon, people with marginal mortgages get caught short. Investment banks figure this out and pull the rug out from under mortgage backed securities. Commercial banks' capital ratios collapse. Wall Street sees this and responds. Panic ensues.

But its too late. Understanding the market by analyzing panic is like trying to diagnose diarrhea by looking in the public sewers. The people who initiated the problem have taken their profits and run long ago. Their lackeys have moved on and retired. If you want to know what the market is up to, you're going to have to collect data a lot earlier in the investment cycle.

Duh! (1)

Quixotic Raindrop (443129) | more than 5 years ago | (#29406541)

Of COURSE Wall Street's math models fail to take human behavior into account. We as a species don't even know what human behavior *is*, let alone what kind of mathematical equations might describe it. Attempting to model any behavior is doomed to failure as long as the model is incomplete. All humans have their own perceptions, interpretations of events, and people will make money decisions based on information that you can't possibly predict algorithmically.

At the moment anyway... (1)

plut4rch (1553209) | more than 5 years ago | (#29406573)

... mathematical and econophysical models are simply not powerful enough to model the financial markets in any accurate way. The markets are simply to vast and too complex.

My Second Theory of the Brontosaurus... (0)

Anonymous Coward | more than 5 years ago | (#29406585)

that which is mine, and my alone, which I came up with myself yada yada yada....

Here's where the host presents the consensus review: Oh, shut up.

Why bother? (1)

tthomas48 (180798) | more than 5 years ago | (#29406631)

We know they're frauds. We know that we're buying a ponzi scheme. They're the only ones who seem to believe their "models" have a basis in reality. Sort of like how facebook "models" my friends.

Yeah thats it (1, Insightful)

shaitand (626655) | more than 5 years ago | (#29406701)

This is the same bullshit they have been spouting among stock traders all along. Its all just because people are panicing and afraid. Sure the stock market works that way but the real world does not.

It couldn't possibly be that we trade debt and have changed our production system to solely attempting to maximize profit rather than total production. Never that.

A highly liquid economy is NOT a substitute for a solvent one backed by actual tangible assets of innate and functional value. Encouraging people to borrow and spend is NOT better than encouraging them to save and produce.

Yes that is old outdated thinking. From back when the economy was self sustaining, before the past few decades of turning liquid the foundation built by those before us and blowing it.

$0.02 (1)

mindbrane (1548037) | more than 5 years ago | (#29406709)

Oh hell just gimmie a penny for my thoughts.

Informed, rational investors can likely use game theory and an auction model to structure functional investment strategies in efficient markets. Irrational investors likely need to be viewed as lepers and those fleeing lepers. Irrational investors might even be more effectively treated as what they are. They're hunter-gathers with a built in reward system that fuels their investments as something akin to a huge rack of a recent kill nailed to the rec room wall, or, an equally huge rack on their trophy wife.

If irrational investors are seen as irrational and efficient markets must necessarily allow them to play then don't questions arise in terms of interference in efficient markets and the rights of irrational investors when attempts are made to circumscribe their irrational responses?

Lastly, it's been my experience that irrational investors driven by their primitive reward system tend to incorporate any rational response to their activity much as children in a playful frenzy will incorporate any attempt to control their behaviour into their play, or, more drastically, the way a mob fleeing an outbreak of leprosy will trample anyone attempting to instill order. (the last bit about children at play is borrowed from ideas suggested by Gregory Bateson)

Foundation pulling strings? (4, Funny)

macraig (621737) | more than 5 years ago | (#29406773)

Mark my words, there's some guy named Hari Seldon to blame for this....

At Last!! (0)

Anonymous Coward | more than 5 years ago | (#29406775)

Ludwig Von Mises wrote about that in the early 20th century and now the Keynesians are seeing that most of it its true!

financial experts (1)

1s44c (552956) | more than 5 years ago | (#29406815)

financial experts

You mean snake oil merchants.

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