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On Black Swan Probability and Tail Obesity

For a long while now, having watched bubbles form and pop, I have found it frustrating how people pile into assets with straight line trajectories. I first noticed it in the time of the dot-com bubble of the late 1990s. During that time, as I recall, returns in the market were frighteningly close to straight line, not only highly positive, but with a low volatility of returns from month to month.

A more frightening version of this, in terms of risk to our way of life, was in residential real estate. Prior to the popping of the real estate bubble, residential real estate in the United States had also had fairly straight line appreciation over a considerable number of years. Again, not only was the appreciation significantly positive, it had little variance.

It reminds me of a favorite “simple wisdom that is obvious but that we tend to forget” type quote:

 

“If something cannot go on forever, it will stop.”
~ Herbert Stein

 

I’ll not be at all surprised if what I’m about to propose has been done before, as it seems so simple. If so, forgive me.

It would seem that one can represent the degree to which a return has been straight line fairly easily as R/V, where R is some measure of return and V is some measure of volatility, likely for the same period of time, but not necessarily so. As this ratio increases, I propose that tail probability, the probability of a significant move, call it a black swan or gray swan event to use Nassim Taleb’s term, increases (tail obesity). My theory is that significant moves become more probable as tension increases, similar to how a major earthquake becomes more likely as tension grows between tectonic plates, and that in some situations this tension increases following periods of straight line appreciation.

It might also be that a formula like (R / R2) / (V / V2), where R is some return, R2 is some return prior, V is some measure of volatility, and V2 is this measure for some period prior (again, likely for the same periods, but not necessarily so), would identify this tail probability more accurately, as it would serve to measure the change in return versus the change in volatility over a period of time.

This, to some degree, goes against conventional wisdom that higher volatility implies higher risk. Note that I’m not proposing that lower volatility implies higher risk, but that high returns over a period of time, when combined with low volatility of those returns, serves to change the shape of the parabola of possible returns. In other words, I’m merely proposing that there may be a way to identify a time when a black swan or gray swan type price movement, to use Nassim Taleb’s term, is more probable than usual.

Also note that I’ve concentrated on straight line positive returns, ignoring similar moves downward, likely to the chagrin of statistical purists. Intuitively, I feel that the tail probability increase is more likely with straight line appreciation, and that the increase in probability at the tail is isolated or at least heavily weighted to the down side. Capitulation happens both ways, of course, but given that there is no limit to upside, while the downside always has to contend with zero, there is simply more opportunity for straight line returns to the upside.

If this is some sort of common knowledge, which I fear as it seems to simple, then egads, and sorry. If not, call it the Hawkins Ratio; my kids will think it is cool.
Originally published 7/7/11 in Science 2.0.
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The Socialism Paradox

I find myself fascinated how similar people, with similar values, can feel so differently about social engineering. This comes out in political discourse, and certainly is a hot topic today, with those more in favor of socialism, which I’ll refer to in this article as socialism inclined, having dramatically increased momentum for putting their more socialistic policies in place.

I’ve paid attention to this for a while, inquiring of people who feel differently that I (I believe in little or no socialism) why they felt the way that they did. Over time, I’ve come up with a theory, which is that they generally perceive the effects of some socialism differently.Fairly well all people, whether more capitalistic and or more socialism inclined, would agree that an entirely socialist system would result in a drastically smaller, less productive economy, so much so that everyone suffers. Spectacular and catastrophic failures of socialism dot history. The reason for this is human nature; take incentive away from those capable (for whatever reason) of producing and they stop producing, leading toward a subsistence like economy. The reality is that people don’t produce to give; they produce to get.Where those more vs. less socialism inclined begin to disagree is in the effect of a little bit of socialism, frequently referred to as social engineering. The socialism inclined, in the United States generally considered to be most represented by The Democratic Party, believe that there is little if any effect of some socialism. The anti socialism crowd, generally fiscal Republicans (some Republicans, as well as Democrats, vote based on other reasons such as their opinion on abortion, religion, gay rights, etc., and don’t care about or concern themselves with economic policy), instead believe that the effect of a little bit of socialism is immediate and significant. The difference in this perception could be represented graphically as follows:

Socialism Effect Perception
I personally believe more like the red line, that a little bit of socialism has an immediate and significantly negative impact, and that we would be better off over all with negligible socialism. This is what I refer to as The Socialism Paradox. In the process of trying to help those on the bottom, those in favor of socialism actually instead negatively affect them, as well as everybody else. At least this is what I believe is likely the case.

This is based in part on the way I find things tend to work. In general, it seems that if a lot of something has a given effect, a little will have some, and the incremental effect actually tends to be greater early on than later.

The good news is that we are on the same team, and have the same goal. We all want to go the same direction, and as far as possible. It is simply, to use a football analogy, that one person thinks we should throw a pass, while another thinks we should rush it up the middle; but we all want to get to the goal line. Frankly, given some of the animosity over the past few years, believing this grants me some comfort.

A Plug For My Convictions

Nevertheless, I get the feeling that we are, as a society, losing track of the fact that stuff does not appear out of thin air. You can’t just give someone something without an effect somewhere else. Stimulus, for example, is borrowing. To use an analogy, if you max out your credit cards, you’ll have more stuff in the short term, but you’ll pay for it big time later. Isn’t this essentially the same thing? Worse yet, aren’t we really simply borrowing money that we will not begin to start paying back, if ever, until those in grade school today are in the workforce? Thus, instead of owning up to our failures and enduring some pain, are we not instead saddling these children with debt so that we can avoid pain ourselves (as if they will have no problems of their own to deal with)? Is it not possible that the pendulum could swing too far?

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Could The Story of Cain & Abel Be The Story of The Genocide of Neanderthals?

A couple of years back I read a theory in Charles Pellegrino’s book “Ghosts of Vesuvius” that has fascinated me since, that the Biblical story of Cain and Abel is an echo of the genocide of Neanderthals by Homo sapiens.

It is known that Neanderthals and Homo Sapiens lived around the same time. Doesn’t it only seem reasonable that this story may be the story, passed down from fireside to fireside, of the end of neanderthals?

Note the similarity. Homo sapiens were farmers, like Cain, while Neanderthals were herdsman, like Abel. The story, instead of being about how murder first entered the world, might instead be the story of how Homo sapiens dominated by being the variant willing to kill to win.

Other stories in The Bible are widely speculated to be related to historic events. Noah, it is speculated, is the story of flooding of lower populated areas caused by the breaking of ice dams around 10,000 BC, a theory discussed extensively and somewhat persuasively in Graham Hancock’s book “Underworld.” Remember, these were the areas that were populated at the time. People did not have luxury mountain cabins in Aspen back then; they had a dwelling near water. As another example, some of the stories in the passages about Moses are likewise speculated to be related to surrounding and caused by the eruption of Thera.

Thus two of the most prominent stories of the bible, that of Noah’s Ark and of The Exodus, may be stories of some of the biggest events of history, which have simply echoed through time due to the raw impact of the events.

Would not the first genocide also qualify as significant? Isn’t it then reasonable that this story of Cain and Abel could also be the story of one of history’s most significant events?

Originally published 3/27/09 in Science 2.0.

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Socially Stunted by Facebook?

I was listening to a presentation being given by futurist David Houle a few days ago. He began to talk about how technology is changing the way that people communicate and work, particularly with the exponential global growth in cell phone subscribers. As he relayed stats, he discussed implications for how society works. This made me begin to think of something that had been pestering the back of my mind for a while, the implications of the rapid adoption of Facebook.

Recently I read in The Economist, in an article titled Primates on Facebook, about a study that was done of the number of friends people tend to have on Facebook. What is interesting is that the findings are fairly consistent with limitations theorized by Robin Dunbar, who believes that the brain limits the size of a social network an individual can develop. An implication of this that came to my mind is that of the potential of reduced (not eliminated) social mobility. By social mobility I don’t necessarily mean upward, but at all.

What do I mean?

Most people go through life making batches of new friends, friends whose interests match theirs at some given point in life. If, however, there is a cap on the size of a social network, and the legacy social network is preserved longer than it would be otherwise by way of Facebook or similar technology, then it would seem that the tendency to develop new friendships would have to be somehow inhibited.

Think about it. How many relationships have you developed in the last couple of years that have changed your life significantly? If your ability to begin these relationships were somehow inhibited by an otherwise full network on your side or the others, such that you did not develop the same friendship, what would your life be like?

This could have important implications. In another article recently in The Economist titled The Road Not Taken a theory was discussed that says that higher home ownership percentages are negative for an economy due to the decreased mobility of the workforce. I had not heard this before, but it immediately made some sense to me, especially in these times of economic stress. It also matched a long held personal belief that government intervention to increase home ownership is messing with nature, at least beyond some point, and thus may have adverse consequences, something that seems to be more evident now.

The reason I mention this is that the idea that increased home ownership percentages might be negative for an economy is, at least initially, a bit counter intuitive. The same goes for the idea of reduced social mobility due to the increased use of online social networks like Facebook – it is a bit counter intuitive. Seemingly the increased communication would be good, for all kinds of reasons. The problem may lay in the fact that we are all, well, primates.

Originally published 3/23/09 in Science 2.0.

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Implications of The Sexual Attraction Exception

There was a study done over a decade ago by Claud Wedekind in which 44 men wore the same T-shirt for three days, refraining refrained from deodorants and scented soaps so they wouldn’t interfere with their smell. Thereafter women sniffed the shirts and indicated which ones they felt smelled the best. In this test, the researchers found that women preferred the smell of a man whose MHC (major histocompatibility complex), which is a series of genes involved in our immune system, was most different from their own.

But there was an exception… The MHC attraction for women taking the pill was almost the exact opposite, with women on the pill finding the scent of men with MHC’s similar to their own to be attractive.. The assumption is that because the pill tricks your body into thinking it is pregnant, it chemically alters the sense of attraction. This article is about potential implications of this exception.

First, one has to consider why it is believed that the natural attraction is for dissimilar MHC. It is thought that this is a byproduct of evolution, in that those attracted to dissimilar MHC would have offspring with better immune systems, and thus would have a better chance of surviving, a genetic advantage. This leads to the first potential implication, birth control pills may be leading to weaker immune systems for the human species. I’m not saying they should not exist, or be used, as they certainly make life more convenient. I’m simply making an observation that this could be an implication.

Let’s consider another possible implication. Many single women in the industrialized world take birth control pills. They flirt, date, get engaged, get married, and plan families while on birth control pills. Considering the results of this study, however, it would seem that women might be sexually attracted to a person while on birth control pills, only to find this attraction muted when not on birth control. This leads to the second potential implication, birth control pills could increase divorce rates.

I’m not saying birth control pills will increase divorce rates, but it would certainly seem to make sense that they could. As idealistic as someone might strive to be when it comes to their commitment to marriage, sexual attraction still matters. Going even further, many do not strive for any particular ideal, but instead, finding themselves less attracted to their mates, simply head for the exit (or more accurately to another bedroom door). Thinking about it, without looking at actual data, it seems that an increase in divorce rates has some correlation with the inception of use of and growth of use of birth control pills.

This article may cause some controversy. Keep in mind, I’m only making observations about possible implications, I’m not stating these things for a fact, and I’m certainly NOT making any type of moral statement or other statement about society. More than anything, I do not wish to limit anyone’s freedom, of any kind.

Originally published 2/25/09 in Science 2.0