Monday, May 04, 2015

That's All I've Got

Chancellor Angela Merkel (image from businessinsider.sg)
The 2007-2009 Global Financial Crisis has been one of the most analyzed events in recent history.(For different perspectives see here, here, and here). There are numerous, similar lists of causes---for example, risky loans, complex financial instruments, government guarantees, inter-relationships of too-big-to-fail financial institutions---but the financial crisis at its heart, IMHO, demonstrated that fear and greed overwhelm safety mechanisms based on the assumption that human beings behave rationally in a crisis.

Per David Viniar, CFO of Goldman Sachs, August 2007 [bold added]:
“We were seeing things that were 25-standard deviation moves, several days in a row.” To put this in perspective, even an eight-standard deviation event should not have occurred in the entire history of the universe. Any model that produces such a result must be wrong.

Mr Viniar was relying on “value at risk” models which supposedly allowed investment banks to predict the maximum loss they might suffer on any given day. But these models assumed that markets would behave in reasonably predictable ways....
The new fields of behavioral economics and behavioral finance may eventually help to design better controls, but first economists, central bankers, and financiers have to acknowledge uncomfortable truths:
Neuroscientists have shown that monetary gain stimulates the same reward circuitry as cocaine – in both cases, dopamine is released into the nucleus accumbens....

Similarly the threat of financial loss apparently activates the same fight-or-flight response as a physical attack, releasing adrenalin and cortisol into the bloodstream. Risk-averse decisions are associated with the anterior insula, the part of the brain associated with disgust. In other words, we react to investment losses rather as we react to a bad smell.
Until a 21st century Keynes designs a 21st-century financial system, we protect ourselves the old-fashioned way: by keeping at least six months income in an insured bank account and not putting all our eggs in one basket (Is that all you've got? Yes).

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