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The Hitchhiker’s Guide to the Galaxy

Philosophies of risk management, briefly

November 18, 2009 in Finance, Risk

My last post made me think of a common question in risk management: “what is risk?”

A lot of time is spent deciding the various metrics, exposures, values, sensitivities, etc. that are considered “risks.” In the previous post, a simple change of perspective – is risk defined by dollars invested or shares controlled? – resulted in a dramatically different investment decision (granted, it was for a hypothetical insider trade… so it was definitely more illustrative than practical).

In the investment equation, the very definition of risk is a variable, not a constant.

This is probably much more interesting to talk about than write about, given the open-endedness of the question, but I would like to highlight how critical that question is. Before risks can be managed, they must be measured; and before they are measured, they must be identified. It’s very easy, particularly in a time when we are inundated by numbers and statistics, to look for a catch-all metric, or overlook risks that critical thinking would expose. Risk is rarely obvious.

Readers will know I am hardly espousing any sort of dive into complicated models or quantitative nonsense, merely an appeal to reason: every investment decision carries a unique set of risks which need to be identified and defined – from dollars invested, to sensitivities, to position in a larger portfolio, to leverage, and so on. More than merely identifying them, they should be understood – even VaR has its use, remember.

It wouldn’t be right to end this without a HHG2G quote which is almost, but not quite, entirely unrelated. Let’s just say it’s about things we take for granted:

Time is an illusion. Lunchtime doubly so.

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The most important news you will read this week

October 15, 2009 in News

It was buried deep, deep in the Arts section of Tuesday’s NYT, but nonetheless, sitting in an airport food court, I found it:

‘Hitchhiker’s Guide’ Sequel Lands in Britain

Apparently it is not standard practice for British men and women to gather dressed in bathrobes and toting towels. When hundreds of fans thus clad assembled in London on Sunday, it was to celebrate the 30th anniversary of “The Hitchhiker’s Guide to the Galaxy,” the comedic science-fiction franchise created by Douglas Adams, and the publication of a new book in the series, The Guardian reported. At Hitchcon 09, held at the Royal Festival Hall in London, fans assembled (many of them dressed in the shabby costume of the series’s hapless hero, Arthur Dent) to pay tribute to Mr. Adams, who died in 2001. He was the author of the original “Hitchhiker’s Guide” radio plays and the five-book sequence they spawned.

And most importantly:

The convention also served as a kickoff for “And Another Thing…,” a new novel by the “Artemis Fowl” author Eoin Colfer that is cheekily being billed as the sixth entry in the “Hitchhiker’s Guide” trilogy. The American edition of “And Another Thing…” was released by Hyperion on Monday.

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The rise of VaR

October 1, 2009 in Finance, Quotes, Risk

Simon Johnson and James Kwak take a look at how VaR got to be so popular in the first place. They make the insightful observation that a bad (or at least an incomplete) model can gain acceptance not only because of its simplicity but, oddly, because of its output as well.

Indeed, VaR succeeded not just because it seemed to capture risk accurately (“losses exceeded only 5% of the time” and so on), but because it provided the answer that financial agents were looking for. Most cynically, its greatest disadvantage – failing to look at what actually happens in crisis times, rather than just defining the crisis itself – turned into its biggest sell point when it came to market adoption. In a bizarre twist, the model was chosen because it gave the right answer; not because it answered the right question.

It reminds me of a passage from the ever-insightful Hitchhiker’s Guide to the Galaxy:

“I checked it very thoroughly,” said the computer, “and that quite definitely is the answer. I think the problem, to be quite honest with you, is that you’ve never actually known what the question is.”

“But it was the Great Question! The Ultimate Question of Life, the Universe and Everything!” howled Loonquawl.

“Yes,” said Deep Thought with the air of one who suffers fools gladly, “but what actually is it?”

But you don’t come here for HHG2G quotes (or do you?). Here’s the key excerpt from Johnson and Kwak’s analysis:

David Colander made this point about economic models: The sociology of the economics profession gave preference to elegant mathematical models that could describe the world using the smallest number of parameters. “Common sense does not advance one very far within the economics profession,” he says.

A similar point can be made about VAR models. Sure, maybe all the financial professionals who design and work with VAR know about its shortcomings, both mathematical and practical. But nevertheless, using VAR brought concrete benefits to specific actors in the banking world by helping them rationalize bad bets. If common sense would lead a risk manager to crack down on a trader taking large, risky bets, then the trader is better off if the risk manager uses VAR instead.

Not only that, but imagine the situation of the chief risk manager of a bank in, say, 2004. As Andrew Lo has argued, if he tried to reduce his bank’s exposure to structured securities such as collateralized debt obligations, he would be out of a job; VAR gave him a handy tool to rationalize a situation that defied common sense but that made his bosses only too happy. And at the top levels, chief executives and directors who probably did not understand the shortcomings of VAR were biased in its favor because it told them a story they wanted to hear.

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How did I miss this?

July 1, 2009 in Math

In a post called “So Long and Thanks for All the F-Tests“, Freakonomics writes about a new book called Mostly Harmless Econometrics: An Empiricist’s Companion, which they describe as:

…the rare book that captures the feeling of how to go about trying to attack an empirical question; and it does this by working through two or three dozen of the neatest empirical papers of the last decade…. It is also peppered with references to Douglas Adams’s writing — so what’s not to like?

Now, wait a second. TGR is peppered with Douglas Adams references. TGR has a post titled “F-tests begone!” How did I miss this?

(Freakonomics’ post title and the book’s title are themselves HHG2G references. I have refrained… for the moment.)

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Perspective

May 21, 2009 in Quotes

From my favorite 5-book trilogy, The Hitchhiker’s Guide to the Galaxy:

For instance, on the planet Earth, man had always assumed that he was more intelligent than dolphins because he had achieved so much – the wheel, New York, wars and so on – whilst all the dolphins had ever done was muck about in the water having a good time. But conversely, the dolphins had always believed that they were far more intelligent than man – for precisely the same reasons.

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The Answer to Life, the Universe and Everything

May 16, 2009 in Quotes

I would be remiss if I didn’t follow my last post by publishing the excellent passage that reveals that the answer to life, the universe and everything is, in fact, 42. This excerpt is from chapter 27 of Douglas Adam’s The Hitchhiker’s Guide to the Galaxy.

(Deep Thought is a computer that has been figuring out the answer for 7.5 million years; Loonquawl and Phouchg are the unfortunately-named descendents of those who first put Deep Thought to the task.)

There was a moment’s expectant pause whilst panels slowly came to life on the front of the console. Lights flashed on and off experimentally and settled down into a businesslike pattern. A soft low hum came from the communication channel.

“Good morning,” said Deep Thought at last.

“Er … Good morning, O Deep Thought,” said Loonquawl nervously, “do you have … er, that is …”

“An answer for you?” interrupted Deep Thought majestically. “Yes. I have.”

The two men shivered with expectancy. Their waiting had not been in vain.

“There really is one?” breathed Phouchg.

“There really is one,” confirmed Deep Thought.

“To Everything? To the great Question of Life, the Universe and Everything?”

“Yes.”

Both of the men had been trained for this moment, their lives had been a preparation for it, they had been selected at birth as those who would witness the answer, but even so they found themselves gasping and squirming like excited children.

“And you’re ready to give it to us?” urged Loonquawl.

“I am.”

“Now?”

“Now,” said Deep Thought.

They both licked their dry lips.

“Though I don’t think,” added Deep Thought, “that you’re going to like it.”

“Doesn’t matter!” said Phouchg. “We must know it! Now!”

“Now?” inquired Deep Thought.

“Yes! Now …”

“Alright,” said the computer and settled into silence again. The two men fidgeted. The tension was unbearable.

“You’re really not going to like it,” observed Deep Thought.

“Tell us!”

“Alright,” said Deep Thought. “The Answer to the Great Question …”

“Yes …!”

“Of Life, the Universe and Everything …” said Deep Thought.

“Yes …!”

“Is …” said Deep Thought, and paused.

“Yes …!”

“Is …”

“Yes …!!!…?”

“Forty-two,” said Deep Thought, with infinite majesty and calm.

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42

May 16, 2009 in Internet

I am absolutely ecstatic that Wolfram Alpha knows the answer to life, the universe, and everything. Indeed, it comes right back with “42″ and a parenthetical citation: “(according to Douglas Adams’ Hitchhiker’s Guide to the Galaxy).”

On reflection, it turns out Google knows the answer too, but doesn’t cite its source (which I think I actually prefer).

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The Nothingth

April 14, 2009 in Quotes

The reference in the last post was to an obscure HHG2G quote from The Restaurant at the End of the Universe, as Zaphod Beeblebrox, the fugitive President of the Galaxy, tries to summon his great-grandfather’s ghost:

“Concentrate,” hissed Zaphod, “on his name.”

“What is it?” asked Arthur.

“Zaphod Beeblebrox the Fourth.”

“What?”

“Zaphod Beeblebrox the Fourth. Concentrate!”

“The Fourth?”

“Yeah. Listen, I’m Zaphod Beeblebrox, my father was Zaphod Beeblebrox the Second, my grandfather Zaphod Beeblebrox the Third …”

“What?”

“There was an accident with a contraceptive and a time machine. Now concentrate!”

And when the ghost finally arrives:

“Ah,” he snapped. “Zaphod Beeblebrox. The last of our great line. Zaphod Beeblebrox the Nothingth.”

“The First.”

“The Nothingth,” spat the figure.

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Some people think we do that already

February 10, 2008 in Finance, Quotes

Money Tree On my way to play squash today, I got into a conversation with a girl on the subway. At one point she said, “Why can’t we just print a ton of money and give it to everyone? Then everyone would be happy.” So I laughed. Then she said, “Seriously, why not?”

And I realized she actually meant it. Because she had told me she was a ballerina (which, by the way, is really not something you expect to hear), I said, “Imagine everyone had a ton of money, and someone offered to pay you to dance. You wouldn’t do it because the money has no value to you. That’s inflation.” And she replied, “No, I would do it anyway because I like dancing, so everyone’s happy.” Seeing she had rather badly missed the point, I asked her to pretend she had a job she didn’t enjoy. Her straight-faced response was that someone in the world would like to do any job there is, so all you had to do was find that person and give them that job. Then, she concluded, you wouldn’t need money at all.

About this point, I got to Grand Central and our visit to this hyper-inflationary psuedo-teological daydream came to an end. This was quite fortunate because it gave me a chance to coax the laws of supply and demand back out from their hiding place. And as I walked off the subway, all I could think about was this passage from my tome of wisdom, The Hitchhiker’s Guide to the Galaxy:

“How can you have money,” demanded Ford, “if none of you actually produces anything? It doesn’t grow on trees you know.”

“If you would allow me to continue …”

Ford nodded dejectedly.

“Thank you. Since we decided a few weeks ago to adopt the leaf as legal tender, we have, of course, all become immensely rich.”

Ford stared in disbelief at the crowd who were murmuring appreciatively at this and greedily fingering the wads of leaves with which their track suits were stuffed.

“But we have also,” continued the Management Consultant, “run into a small inflation problem on account of the high level of leaf availability, which means that, I gather, the current going rate has something like three deciduous forests buying one ship’s peanut.”

Murmurs of alarm came from the crowd. The Management Consultant waved them down.

“So in order to obviate this problem,” he continued, “and effectively revaluate the leaf, we are about to embark on a massive defoliation campaign, and … er, burn down all the forests. I think you’ll all agree that’s a sensible move under the circumstances.”

The crowd seemed a little uncertain about this for a second or two until someone pointed out how much this would increase the value of the leaves in their pockets whereupon they let out whoops of delight and gave the Management Consultant a standing ovation. The accountants amongst them looked forward to a profitable Autumn.

- The Restaurant at the End of the Universe

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