The culture of finance

Shelia Kolhatkar’s Black Edge is a cracking good read about how the growth of hedge funds was rocket-fuelled by their extensive reliance on insider trading. The focus of the story is Steve Cohen’s SAC capital. The abuse was enabled by the fact that the regulators were slow to cotton on to the scale and interconnections of the sector, and by the presence at the head of the SEC at the time a Bush-appointed free marketeer who thought the government should keep out of the way of the markets. The book reads like a thriller (leaving just the usual slight uneasiness about how the author knows what people were feeling, and wondering who spilled the beans out of two people in a reported conversation).

It left me reflecting about the culture of financial markets and how quickly and extensively unethical and illegal behaviour spread, like a rampant infection, after the deregulatory turn in the US and UK. Perhaps the obvious conclusion is that a culture of eternal vigilance is necessary in finance, and there was something sensible about the extremely strong cultural prohibitions applying to finance in times past. It is interesting, and sobering, to note how much the main characters in this sorry saga act just like homo economicus.

The authorities did eventually charge Cohen with failing to prevent insider trading; SAC was fined Capital and the fund was closed. Cohen is active again in the markets and a super-wealthy man.


Wise and foolish finance

I’ve thoroughly enjoyed reading The Wisdom of Finance by Mihir Desai. It aims to humanise finance in two ways. One is by pointing out to non-finance folk that finance is dealing with inescapable aspects of the human condition: risk and uncertainty, asymmetric information, values, stewardship for the future. The other is by pointing out to finance folk how finance can and should serve society.

The approach is to draw examples from literature and history – and films and TV shows – demonstrating the way financial techniques absolutely permeate life. The cultural references range from The Simpsons to Jane Austen, Euripides to Bob Dylan, linked to recent events in business and the financial markets. The book starts with the fundamentals: insurance against risk, opening with The Maltese Falcon. It goes on to discuss options, valuation, leverage, and M&A.These chapters have lots of examples that could prove useful in the classroom, as well as being an enjoyable read.

The latter part of the book takes a more philosophical turn, and rather than explaining finance to the uninitiated reflects more on the character of the financial sector and the motivations of those who work in it. What drives people to lead highly leveraged personal existences rather than opting for simplicity (taking leverage broadly to mean building interdependence with other people in order to benefit from their skills or resources – and correspondingly owe them commitments in return)? Is it always possible to identify the ‘right’ course of action in a context such as financial failure or takeovers? Here the book quotes Martha Nussbaum:

“To be a good human being is to have a kind of openness to the world, an ability to trust uncertain things beyond your own control that can lead you to be shattered in extreme circumstances, in circumstances for which you are not yourself to blame. And I think that says something very important about the condition of the ethical life. That it is based on a trust in the uncertain, a willingness to be exposed.”

Needless to say, this almost existential openness is not what comes to mind when we think of finance, of Enron, Madoff, the sub-prime frauds. So Desai ends by pondering – without reaching a firm conclusion  –  what makes so many people in the financial markets so unethical, or at least driven by selfishness and greed. He also gives us a wonderful model of an ethical financier. It is Alexandra Bergson in Willa Cather’s O Pioneers!, the homesteader who borrows to invest and brings the land to life. What a great example. I devoured Willa Cather’s books some 30 years ago and had forgotten about them. It sin’t finance that’s good or bad, it’s people.

The Wisdom of Finance ends with a nice afterword pleading for inter-disciplinary alertness, citing C.P.Snow’s famous The Two Cultures and E.O.Wilson’s Conscilience, both excellent books.

All in all, highly recommended, for those who already know a lot about finance, and those who don’t.


Agents and theorists

There are three books in one in Richard Bookstaber’s The End of Theory, it seemed to me. This compôte is even flagged up in the subtitle: ‘Financial Crises, the Failure of Economics, and the Sweep of Human Interaction’.

One sub-book is a tedious critique of economics, tedious because like all (the many) similar critiques it (a) says ‘economics’ but means ‘macro/financial economics’; (b) assumes economics is a monolithic subject stuck some time around 1980-85, which was indeed the height of the rational expectations, real business cycle approach. Some of the points Bookstaber makes are perfectly valid. Macroeconomists have responded to the implications of the financial crisis for their approach, but not yet enough – this is why the ESRC has funded the new ‘Rebuilding Macroeconomics‘ network. I also agree in particular with his point about economics needing to get to grips better with self-fulfilling phenomena and performativity. But, really, a lot of economists – at least in academia but I think out in the non-ivory tower world too – are now doing exactly the kind of work Bookstaber enthuses about. I’d argue that even when economists are using rational choice equilibrium modelling, or ignoring the radical uncertainty of the real world, it is often done in a knowing way – that is, understanding the assumptions fail, but using the conclusions they lead to as a way of evaluating what is happening and why. Anyway, his complaints about economics are both wearily familiar territory and decreasingly true; economics is and has been changing a lot. In finance specifically, think of Andrew Lo’s new book, Adaptive Markets.

The second element of The End of Theory is a useful mini-survey of some alternative approaches (alternative to rational choice, maximising, equilibrium) models for financial markets in particular: this includes complexity and emergent phenomena, non-ergodic processes, heuristics in decision making, and so on. None of these is novel either – for example, Paul Ormerod’s Butterfly Economics and Why Most Things Fail tackle many of the same areas, Kahneman’s Thinking Fast and Slow was a best seller and Gigerenzer’s heuristics approach is widely discussed among behavioral economists, while Taleb’s books have brought the ideas about radical uncertainty to millions. Still, having these ideas set out again in a concise and accessible way is useful.

The third book-in-a-book is a very interesting approach to an agent-based modeling approach to the financial system, looking back at the 2008 crisis. Here, the author’s expertise shines through. But this section is very condensed – I wished the whole book had been about this and had used the extra room to say more about the complexities of the financial structure and how the agent based approach can illuminate them. For example, the section on the 2007-8 liquidity crisis in US markets is fascinating but condensed. Again, agent based modeling is hardly new, and is even growing more popular in economics, but I found the detail from someone who is an experienced market participant very interesting, although the idea that agent based modelling really spells the end of theory is not really addressed explicitly.

In the end, I wondered what audience Bookstaber had in mind. The final chapter ends, “I’m a frustrated novelist.” He is a indeed a good writer but needs to work on the narrative arc. I’d have thought the three components of this book appeal to at least two different sets of readers; and it distracted at least this economist reader to have the argument keep heading off on a tangent to criticise economics: ‘And another thing,….’. I hope he goes on to write the book starting to emerge from this one diagnosing the past about an agent based future for finance. If this is the right way to model financial markets, what do we do with it?

PS I see The End of Theory is doing well on Amazon, with some 5* reviews, so my perspective may be jaundiced!


Fear, greed, fairness, imagination and finance

I’ve thoroughly enjoyed reading Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew Lo. I should say that, apart from being a distinguished MIT finance professor and the co-author of the classic A Non-Random Walk Down Wall Street, Andrew is an old friend. But this should not put off any readers. This new book will become another essential read for anybody interested in financial markets.

The book aims to do what ultimately all of economics must do, and situate economic decisions and behaviour in the context of our biology and evolutionary history. Behavioural economics and finance have gone some way toward this in introducing the now-familiar heuristics such as loss aversion and framing effects, and herding is a familiar phenomenon in finance models. The issue with these has been how if at all they relate to rational choice models and the Efficient Markets Hypothesis. The Adaptive Markets Hypothesis is a synthesis, proposing that context makes the difference, and when conditions are sufficiently stable for long enough, financial markets are efficient. Otherwise, fear, greed, fairness, imagination – the characteristics evolution has given the human brain – kick in.

The opening chapter starts with a powerful demonstration of the potential efficiency of markets: after the Space Shuttle Challenger tragically exploded on 28 January 1986, a five month inquiry pinned the blame on a part, the O-ring, manufactured by one of four contractors, Morton Thiokol. Yet on the day of the accident, the share price of Morton Thiokol plummeted – the markets knew the company was to blame almost immediately, without the expert verdict: “Somehow the stock market in 1986 was able to aggregate all the information about the Challenger accident within minutes, come up with the correct conclusion and apply it to the assets of the company.”  The decline in its market capitalization – about $200m – was  almost exactly equal to the damages, settlement and reduced future cash flow, a later study found.

But often, of course, financial markets are all too obviously sometimes not efficient. The intellectual challenge is to figure out when they are in which mode. The book voyages through neuroscience, psychology, evolutionary biology and AI to try to answer this. The Adaptive Markets Hypothesis reverses the conventional framing: rather than thinking about a rational benchmark with a set of psychological quirks sometimes kicking in, we are a collection of quirks, but sometimes we can get beyond the heuristics to rational choice.

Frustratingly, although perhaps inevitably, there is no neat list of conditions for being in efficient rather than non-efficient mode: it depends, in particular on having had enough time in stable conditions to learn from experience. But Andrew does hold out hope for the prospects of being able to make better investment decisions – with socially useful outcomes – and being able to manage financial markets better so events like the 2008 crisis are far less likely to recur. In line with the Adaptive Markets perspective, he argues for treating financial markets as an ecosystem (so the interconnections are front of mind), using AI techniques to monitor markets and adjust regulatory instruments such as cyclical buffers. There is an interesting section on the role of technology in finance, including HFT, a technological arms race being one of the predictions of the Adaptive Markets Hypothesis. Currently, he is exploring ideas from biology such as immune responses and ecosystem management techniques. He also recommends introducing a body similar to the National Transportation Safety Board that would analyse market crashes and make recommendations for regulatory change. (One thing not spelled out here is whether this would have to be a global body.)

The book is a thoroughly interesting and enjoyable read. It is not technical, the explanations are super-clear, and there is some excellent story telling. Andrew recounts how in 1986 he and his co-author Craig MacKinlay, presenting at the NBER the work that turned into A Non-Random Walk Down Wall Street, were savaged by discussants from the world of academic finance. Since then, the academic community’s faith in the Efficient Markets Hypothesis has wavered significantly, but it is still the benchmark – as the book says, it takes a theory to beat a theory. I find the Adaptive Markets Hypothesis a persuasive theory, but then I firmly believe economics must be consistent with what we learn about ourselves from the other human sciences. I guess the test will come in the shape of how widely market participants themselves embrace it.41CpHzPtybL



Humans and financial markets

Well this is exciting: the proof copy of the new book by my brilliant former classmate Andrew Lo (now director of the MIT Laboratory for Financial Engineering) has arrived. It’s Adaptive Markets: Financial Evolution at the Speed of Thought. Paging through, & from conversation with him, the book is a synthesis of modern financial economics and psychology/evolutionary biology, with some AI and neuroscience in the mix. It aims to get away from the stale ‘the efficient markets hypothesis is right/wrong’ dichotomy and looks instead at the interaction between rational calculation and what we know of the structure and non-rational habits of human decision making.

The book starts with a historical perspective; it ends with the financial crisis and recent developments, and discusses what regulatory framework is appropriate. A proposal that seems utterly sensible is to establish a financial market analogue to the National Transportation Safety Board, a standing expert (sorry!) body that investigates transport accidents to determine causes and recommend regulatory adjustments if necessary.

I can’t wait to read it. The book is equation-free and I know from graduate school experience that its author (also co-author of the classic A Non-Random Walk DOwn Wall Street) is so clever he can explain really difficult things ultra-clearly. Looks like one for all interested in financial markets. It will be out in April so I’ll review it properly closer to the date.)