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Quote:In the experiment, however, those involved by no means followed blindly the behaviour of previous investors. quite the contrary. As a rule the participants mainly allowed themselves to be influenced in their choice of share by their adviser's tip. In fact, many investors made a conscious decision to buck the trend, thereby contributing to a stabilisation of the share prices. This can of course be perfectly sensible if you think that the share is currently overpriced and that this is partly due to the irrational behaviour of earlier investors, says Dr. Roider. The psychologists, particularly, seemed to ascribe share prices to these sorts of 'psychological' effects. Their intuition about the possibly irrational behaviour of other investors meant that they made bigger profits. By contrast, players who had studied Physics seemed to rely on the cool rationality of other participants -- and thus fared worse.
Mar 17 08 2:59 PM
We will never have a perfect model of risk
- Alan Greenspan (Financial Post, 03-17-08)*
The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end
eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source
of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will
be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes - those
belonging to builders and investors - have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will
stabilise remains problematic.
The American housing bubble peaked in early 2006, followed by an abrupt and rapid retreat over the past two years. Since summer 2006, hundreds of
thousands of homeowners, many forced by foreclosure, have moved out of single-family homes into rental housing, creating an excess of approximately 600,000
vacant, largely investor-owned single-family units for sale. Homebuilders caught by the market's rapid contraction have involuntarily added an
additional 200,000 newly built homes to the "empty-house-for-sale" market.
Home prices have been receding rapidly under the weight of this inventory overhang. Single-family housing starts have declined by 60 per cent since
early 2006, but have only recently fallen below single-family home demand. Indeed, this sharply lower level of pending housing additions, together with the
expected 1m increase in the number of US households this year as well as underlying demand for second homes and replacement homes, together imply a decline
in the stock of vacant single-family homes for sale of approximately 400,000 over the course of 2008.
The pace of liquidation is likely to pick up even more as new-home construction falls further. The level of home prices will probably stabilise as soon
as the rate of inventory liquidation reaches its maximum, well before the ultimate elimination of inventory excess. That point, however, is still an
indeterminate number of months in the future.
The crisis will leave many casualties. Particularly hard hit will be much of today's financial risk-valuation system, significant parts of which
failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked
disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the
fundamental balance mechanism for global finance.
The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years. To
be sure, the systems of setting bank capital requirements, both economic and regulatory, which have developed over the past two decades will be overhauled
substantially in light of recent experience. Indeed, private investors are already demanding larger capital buffers and collateral, and the mavens convened
under the auspices of the Bank for International Settlements will surely amend the newly minted Basel II international regulatory accord. Also being
questioned, tangentially, are the mathematically elegant economic forecasting models that once again have been unable to anticipate a financial crisis or
the onset of recession.
Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on
August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems - and the models at their core - were
supposed to guard against outsized losses. How did we go so wrong?
The essential problem is that our models - both risk models and econometric models - as complex as they have become, are still too simple to capture the
full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In
line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations
between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset
prices, rather than offsetting each other's movements, fell in unison on and following August 9 last year, huge losses across virtually all riskasset
The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used
to estimate a model's structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different
The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase,
which is driven by a slow but cumulative build-up of euphoria. Over the past half-century, the American economy was in contraction only one-seventh of the
time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during
an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.
If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk
management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges
during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current
euphoria, they will irretrievably lose market share.
Risk management seeks to maximise risk-adjusted rates of return on equity; often, in the process, underused capital is considered "waste".
Gone are the days when banks prided themselves on triple-A ratings and sometimes hinted at hidden balance-sheet reserves (often true) that conveyed an aura
of invulnerability. Today, or at least prior to August 9 2007, the assets and capital that define triple-A status, or seemed to, entailed too high a
I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world. The
exploration of the benefits of diversification in risk-management models is unquestionably sound and the use of an elaborate macroeconometric model does
enforce forecasting discipline. It requires, for example, that saving equal investment, that the marginal propensity to consume be positive, and that
inventories be non-negative. These restraints, among others, eliminated most of the distressing inconsistencies of the unsophisticated forecasting world of
a half century ago.
But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling -
the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a
learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure,
we tend to label such behavioural responses as non-rational. But forecasters' concerns should be not whether human response is rational or irrational,
only that it is observable and systematic.
This, to me, is the large missing "explanatory variable" in both risk-management and macroeconometric models. Current practice is to introduce
notions of "animal spirits", as John Maynard Keynes put it, through "add factors". That is, we arbitrarily change the outcome of our
model's equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not
sufficiently address the problem of the missing variable.
We will never be able to anticipate all discontinuities in financial markets. Discontinuities are, of necessity, a surprise. Anticipated events are
arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the
speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the
period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an
unexpected and sharp discontinuous response.
In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to
anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the
structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open
* In-text bolding mine - T
Mar 17 08 3:42 PM
Oct 30 08 5:02 AM
Here is the Mirror of Galadriel. I have brought you here so that you may look in it, if you will.
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