|
Risk Management Lessons From A Cockroach - 02/15/09 Simplifying complex, intricately linked events, people, and decisions into a few take away messages is at once the primary task and the biggest challenge an author faces. In A Demon of Our Own Design, Richard Bookstaber adroitly conquers the complex question of "why do our markets keep crashing?" by using decades of first hand experience and observation to show that our so called efficient markets are actually "built to crash". Having been the managing director of firm-wide risk management at Salomon Brothers and a hedge fund manager, Bookstaber knows his stuff. While most pundits and market professionals consider the most recent developments to be an event beyond predictability, Bookstaber saw it coming all along. Despite the growth in the world GDP, life expectancy, and overall improvement in just about every global indicator, the financial markets seem to be missing this memo. Or, perhaps more accurately, doing too much with it. It isn't for lack of enough information that the markets seem so fragile Bookstaber claims, but because we drape layers of complexity over our markets in the form of options, portfolio insurance, leverage, statistical arbitrage, regulations, etc. As a result, the financial system becomes "tightly coupled" whereby stability depends on many components all working in harmony. While the failure of any one component in isolation is unlikely and inconsequential, the same failure within the context of a larger system can trigger a catastrophic unwinding of the system. Correcting the death spiral becomes more difficult, as actions taken to stem the crisis actually end up accelerating the meltdown. For instance, in a flight to liquidity mass selling of an asset begets even more selling. Challenging academic economic theory seems to be a running theme these days, but in the spirit of progress, the evidence is growing that theories concerning the rational agent and the profit maximizing firm may need revision. Bookstaber gives the reader insight into an intuitive sense he had in graduate school "that the culprit leading to our apparent nonresponsiveness to optimality was a lack of knowledge, a realization that the world could change in ways we could not anticipate or model." Merely having a "sense" got him nowhere in a field dominated by theoretical mathematics, so he took his idea into the world of biology. He was most interested in identifying behavioral patterns that would increase a species' probability of survival and applying these lessons to the world of finance. Bookstaber notes, "Because the cockroach has survived through many unforeseeable changes--jungles turning to deserts, flatland giving way to urban habitat, predators of all types coming and going over the course of the countless millennia--it can provide us with a clue for how to approach unanticipated risks in our world of financial markets." So, what makes the cockroach so survivable? Simple, really. It moves away from slight puffs of wind, wind that might indicate an approaching predator. By keeping the algorithm simple, the cockroach can respond to whatever environoment he's thrown into. On the other hand, species that develop behaviors optimized for their current environment flourish while the ecosystem remains constant, but perish when confronted with a new predator or ecosystem. Bookstaber concludes, "The coarse response although suboptimal for any one environment, is more than satisfactory for a wide range of unforseeable ones." In the long run, the best approach is to hedge against the unknown. But the time horizon of the inidividual is much shorter than the firm's. Where's the incentive to hedge against something that doesn't exist when it's possible to own your own island in a few years? Why not squeeze every possible dollar out of the system now, and let someone else worry about the consequences? This is precisely the rigorous wealth maximizing attitude that Bookstaber cautions against. "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... Each innovation adds layers of increasing complexity and tight coupling." What is his prescription for fixing the system? In a single word, simplify. "Complexity is not intelligence" -Michael Lewis "The Achilles' heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan that will appear to be the most fit for survival" -Nassim Taleb |