Emanuel Derman

I had dinner with Kahneman once a few months ago, and have now been dipping into his deep and thoughtful book Thinking, Fast and Slow.

Though I haven’t read all of it, I begin to realize that though he and I both sometimes use the word intuition, we are talking about different qualities.

For Kahneman, I think, intuition is fast thinking, snap judgements,  attractive because they avoid hard rational thinking of the second kind. As a result, it’s riddled with biases and mistakes which are interesting to psychologists.

But I once was a physicist and I’m still interested in the mysteries of nature, and so I use the word intuition in another sense. I like to think I’ve had a few occasional intuitions that were correct in small ways about small things while doing research, so I’m talking from experience. When they were right, they were the result of long hard exhausting preliminary rational struggles, banging one’s mind against the object of one’s attention. Then, finally, once in a few years, came an insight or idea or intuition, after all the struggle, that still had to elaborated by further rational effort. That’s what I call intuition.

Kahneman’s and mine are both legitimate uses of the word, but different ones.

A few remarks

Kahneman’s “intuition” = a quick guess; I mean by intuition the insight that can come only after long mental struggles.

Kahneman is concerned with the biases of intuition. I am impressed with its occasional glimpses of absolute essence. Think Newton, Ampere, Maxwell, Einstein, Feynman, Spinoza or Freud or Schopenhauer maybe … That kind of intuition plays a major role in the discovery of nature’s truths.

Intuition is comprehensive. It unifies the subject with the object, the understander with the understood, the archer with the bow. Intuition isn’t easy to come by, but is the result of arduous struggle.

In both physics and finance the first major struggle is to gain some intuition about how to proceed; the second struggle is to transform that intuition into something more formulaic, a set of rules anyone can follow, rules that no longer require the original insight itself.

Intuition: From Models.Behaving.Badly

It takes intuition to discover theories. Intuition may sound casual, but it emerges only from intimate knowledge acquired after careful observation and painstaking effort. Before you can move one level higher in the pyramid of understanding, before you can attain intuition in some domain, you have to struggle with the particulars of that domain until knowledge of its details is second nature to you.

A cyclist develops physical intuition about the correct angle to tilt body and bicycle to a curved track so as to maximize stability; the builder of a velodrome can calculate the correct banking angle to ensure the cyclist remains in equilibrium; together biker and builder combine visceral and theoretical knowledge. Intuition is learning to ride a bicycle without thinking. You have to incorporate the laws of the world into your body.

Feynman’s insight into the parallel evolution of quantum mechanical paths, Dirac’s grasp of the essence of electrons, Newton’s understanding of mass and its motion—all are instances of the external world joining with the internal. Intuition is a merging of the understander with the understood. In the words of the Upanishads, Tat Tvam Asi, Thou art that.

The Insightful Keynes on The Great Newton Sees Intuition the Way I Do:

I believe that the clue to his mind is to be found in his unusual powers of continuous concentrated introspection. . . . His peculiar gift was the power of holding continuously in his mind a purely mental problem until he had seen straight through it. I fancy his pre-eminence is due to his muscles of intuition being the strongest and most enduring with which a man has ever been gifted. Anyone who has ever attempted pure scientific or philosophical thought knows how one can hold a problem momentarily in one’s mind and apply all one’s powers of concentration to piercing through it, and how it will dissolve and escape and you find that what you are surveying is a blank. I believe that Newton could hold a problem in his mind for hours and days and weeks until it surrendered to him its secret. Then being a supreme mathematical technician he could dress it up, how you will, for purposes of exposition, but it was his intuition which was pre-eminently extraordinary—“so happy in his conjectures,” said De Morgan, “as to seem to know more than he could possibly have any means of proving.”

Someone directed me to this remark by Larry Page: “DNA is about 600 megabytes compressed making it smaller than any modern operating system like Linux or Windows.”

I’m a firm believer in logic. Therefore

1. Either my programmer is much better than the 1000s of people who created Windows; or
2. My hardware is much better than Intel’s; or
3. Both of the above.

Linux, I’m not so sure about.

What follows are some remarks I intend to make on Friday Oct 21 2011 at a panel on global risk organized by GARP and the Federal Reserve Bank of New York.

Introduction

I have the luxury of not being a regulator, which I think is a very difficult job. I used to be a physicist, and Nature doesn’t care about regulations; she cares about principles. (If you tried to regulate the motions of the planets you would have a very hard time: turn here, Earth, not too fast, spin more slowly, watch out for the moon, etc. Instead, a few principles of Newton’s take care of everything.) Therefore I’m more partial to principles than regulations, and so I’m going to take the luxury of talking about principles of modeling and the principles of capitalism that, if respected, might mitigate the need for so many regulations.

What I say is based on direct experience of building models in physics and also building and using models at Goldman and Salomon on various derivatives desks, and then at Goldman in Firmwide Risk.

The main question I’m going to address this morning is the one I was given: What is and what should be the roles of models in identifying and managing risk? Should this role differ between the private and public sector.

To answer this I need to clarify the taxonomy of  “models”, a word which can cover a multitude of follies and smartnesses.

The Principles of Modeling

There are two types of models: absolute-value models and relative-value models, and these two types have different purposes and different efficacy.

Absolute-value models are models that aim to predict, without reference to anything else, absolutely, what’s going to happen or what something is worth. In physics, Newton’s principles for the motion of matter or Maxwell’s equations for the propagation of light are absolute models; they work without reference to anything else, and they work astonishingly well – that’s how your iPhones work, and that’s how your Blackberry’s don’t. In a book of mine coming out next week, called Models.Behaving.Badly, I say that absolute models are better called theories, because they stand on their own two legs.

In finance and economics, there are very few absolute models or theories. The efficient market model is an absolute model. It’s nice and beautiful and general, but unlike Maxwell’s equations, it just isn’t true. The truth is, absolute value models in finance and economics suck. They can’t tell you reliably whether something is going up or down tomorrow. Don’t trust them.

Relative-value models stand on someone else’s legs. Relative-value models tell you how something you don’t understand behaves provided you first calibrate the model by telling it how something else you do understand behaves.  So for example, in physics you can model the nucleus of an atom as a small drop of liquid provide you calibrate the liquid’s properties to what you observe about the nucleus. But the nucleus isn’t a drop of liquid, though, if you pretend it is, temporarily, you can approximately predict things like nuclear fission. It’s useful but not gospel.

In finance, all useful models are relative-value models. The Black-Scholes-Merton model is an immensely useful relative value model: it says that if you make some naïve but plausible assumptions, then you can create an option out of stock and cash, because the risk of an option is related to the risk of the underlying stock. Traders use the model not to predict the future, but to interpolate from a liquid stock and a liquid bond to an illiquid option price. It works pretty well but not perfectly, because its naïve assumptions aren’t quite true.

Now the question: What are the roles of models in identifying and managing risk?

Let’s look at the principles of taking risk. Loosely, there are two kinds of risk taking:

(i)             making naked bets on directions, of stock prices or volatilities or default rates, and

(ii)           making hedged bets, as is done, for example, by derivatives traders or market makers.

You Need Relative Value Models for Hedged Bets, and That’s OK for the Private Sector.

Relative value models are relatively good for identifying and managing the risk of hedged bets, because hedges are relative positions. These models are very useful for an individual desk in estimating exposures. I’m all in favor of it for use by a particular desk or a particular product area of a bank that is making markets or carried out hedged trades. These are reasonably good models for the private sector. Reasonable is good enough. You have to expect to lose money sometimes.

In the Public Sector You Need Absolute Value Risk Models for Naked Bets, And They Don’t Work Well At All.

But the really big risks that can take down a firm or a financial system come from naked bets or poorly hedged relative bets. The public sector requires protection from naked bets, and modeling their risks requires forecasting and absolute models, and those, as I said, suck. (In my experience most traders who make naked bets don’t use complicated economic models or even listen very much to the economists in their banks.) So I don’t think any of these models are really good at managing risk.

Furthermore, the shattering risks to firms and systems come from illiquidity and contagion. No one quite knows what liquidity really is, and so there’s no good model of it. (Liquidity is a metaphor based on fluids. People define it by its proxies – bid-ask, average daily volume, market impact etc, which are features of but aren’t actually liquidity itself.)

So What Does The Public Sector Need?

Academics and perhaps regulators sometimes think that just around the corner is the “right” model that is going to work correctly. That’s not the case.  So what can one do?

When I attended risk committee meetings at Goldman ten years ago, I was impressed but how well people understood the limitations of models and what to do about it. They didn’t live by mechanical bounds on risk according to some model. They understood that danger comes in many forms, that there is no generic tail risk, and that you need to protect a firm as a whole by putting many heuristic bounds on your exposure: to creditors, to leverage, to countries, to liquidity, etc. They understood that stale positions are probably dangerous, and therefore should probably be unwound. I think that’s the right way to proceed, to use models but no be aware that they aren’t gospel, to keep thinking about what can happen inside of and outside of your model, because the world isn’t a model.

I think that’s the right way to go about risk from the public sector point of view. The public sector needs to attract skilled experienced capital markets people who aren’t beholden to where they were trained and don’t intend to go back there, because their incentives as public protectors will have to differ from the private sector.

A Principle: If You Use a Model, You Are Short Volatility

All models are analogies, and being analogies, they are limited in their scope. In physics you can describe ice, water and steam, and the phase transitions between them, with one unified theory, amazingly, and hence you can handle the extremes of freezing and boiling.

In finance or economics we have nothing like that. Even beautiful Black-Scholes-Merton ignores volatility variations, illiquidity, panic, government regulations on shorting, to name just a few things that lie outside it.

Therefore, when the world changes dramatically, every single model you can think of is likely to fail.  I would like the following principle to be engraved on the foreheads of all financial and economic model users: All models are short volatility. When volatility changes a lot, the model is going to fail.

_____

A second question I was asked to consider is: Does Public Disclosure of Models Make Them Less Useful? Does disclosure result in a competitive disadvantage, and if so, does the public benefit outweigh the costs?

I think many people on Wall Street justify many things on the grounds of secrecy and efficiency, and most of this is just a knee-jerk defence of making a profit at all costs. Models are important, but more important is computerized risk systems that can aggregate over the entire firm. Building these are labor-intensive projects.  Therefore I think that public disclosure of risk models is valuable and important; it doesn’t reduce competitiveness that much; its public benefit to the taxpayers who are on the hook clearly outweigh any disadvantages. Similarly I believe regulators should have as much access to linkages between firms, to exposures, to protect both the taxpayers and the firms and even the banks who will suffer if the worst happens.

Capitalism: Some Principles

As I’ve argued, there is no model that will tell you when catastrophe is coming.

(I am nevertheless hopeful for some of the agent-based models that take account of collective effects and regime changes. They are only models but they may suggest metrics related to the number of links between participating agents in the economy that give warnings of risk and danger.)

Nevertheless, what we really need is a few strong defensible principles that, if rigorously applied, will produce incentives that mean less regulation is needed. Unfortunately, these principles have been violated very badly during and after the great financial crisis. Let me list a few that I think are good. I’m sure there are more, but still less than the number of regulations.

• If you want the benefits of risk taking, you must suffer the disadvantages too.
• Don’t treat (only some people’s) insolvency as illiquidity.
• Efficiency isn’t everything. Efficiency alone isn’t a good reason for anything.
• You can’t solve political or spiritual problems by tackling the money supply. You can only postpone them.
• If you stimulate at some times, then you must dampen at others.
• “If you believe that capitalism is a system in which money matters more than freedom, you are doomed when people who don’t believe in freedom attack using money.” (Edward Lucas)
• Above all, do no harm.

The Tides

The sun’s gravity pulls at all parts of the planet, and the bits of earth closer to the sun get pulled harder than the bits farther away.

This gradient in the force on the earth tries to tear it apart, atom from atom, but as long as the earth is far from the sun the gradient is not too steep, and the stronger mutual attraction between bits of the earth keeps it intact.

The moon causes a similar gradient that produces the tides. Water on earth nearer the moon bulges towards it as the earth rotates; the center of the earth is pulled towards the moon too, and the water on the opposite side remains a little behind. So you get two tides a day. Spring tides occur when the moon and sun line up and act in unison on the earth.

Forces of unequal gradient are called tidal forces. Were the earth to get really really close to the sun, it would be torn apart, the variation in the sun’s gravity across the diameter of the earth overcoming the earth’s own internal attraction.

The Ides

At Times Square on the evening of Oct 15th it felt as though tidal forces were beginning to pull people apart. The gradient of unequal opportunity is beginning to dominate the attraction of common destiny.

It’s not hard to see that one needs a diminished gradient and a stronger mutual attraction. It would be nice if someone stepped up to the plate soon, before things get too unmoored.

This is an extended version of a review I wrote on Amazon for Lucky Bruce: A Memoir (Hardcover)

Terrifically Charming, Funny, Insightful, Interesting Mix of Braggadocio and Self-Deprecation

Many years ago I read “A Mother’s Kisses” and laughed out loud. The only other books I ever did that with were Kingsley Amis’s “Lucky Jim” and Donleavy’s “The Unexpurgated Code: A Complete Manual of Survival and Manners.”

The latter is devilishly funny. “Lucky Jim” is funny and rebellious but also perceptive. “A Mother’s Kisses” is funny too, but much more insightful about adolescence, about trying to grow up and break away from parental ties and from a fascinating womanly but ultimately suffocating mother whom he’s loyal to.

I write now from ancient memory. Everything in “A Mother’s Kisses” is psychologically plausible and yet unexpected and surprising and elliptical. The character is totally convincing, some sort of cross between Holden Caulfield and Woody Allen and Alexander Portnoy, Jewish, with a strong urge for survival at all costs. (I hesitate to describe him as a cross between these people because it doesn’t do him justice.) But mostly it’s astonishingly funny and psychologically deep.

I read some of Friedman’s other books — Stern and the play Scuba Duba — and saw the PBS production of Steambath in 1973, which I intend to regretfully download off some illegal website tonight if I can’t find it any other place.

I remembered all this when I saw a review of Bruce Jay Friedman’s new memoir “Lucky Bruce,” whose title makes reference to my favorite “Lucky Jim” itself, and so I bought “Lucky Bruce.” I’m half way thru and it has the the throwaway comic style of “A Mother’s Kisses”, but admittedly more contrived and self-indulgent. It’s the disingenuously frank memoir of an old guy who still feels young, trying to make a point and remind you who he was in the literary heyday of NYC in the 50s 60s 70s, when he was the discoverer of Mario Puzo, friend of James Salter, boxer against Norman Mailer, etc etc etc. Lots of self-acknowledged name-dropping. Nothing obviously deep.

Here’s a short excerpt:

Seated beside me at dinner was one of the most beautiful women I’ve ever encountered. Never mind The English Rose. She was an entire country garden. She said to me:
“Hours and hours of lovely lovely love. Don’t you find it the most wonderful of activities?”

I agreed, of course, though I’d had little experience at it. As Joseph Heller would have put it, “Maybe a quick bang or two …”

I took her words as an invitation. Decades later, the words still haunt me. There was a gentle and chubby man beside her. I believe he was part of the package. I could have slipped away with her, and even worked in the chubby man. I probably wouldn’t have been missed … But it would have been rude. Throw a little cowardice into the mix. (“We could do it. But it would be wrong.” Richard Nixon.) And yet, there it is, branded in my memory forever … Hours that got away.

I began “Lucky Bruce” during a long period of downtime in a doctor’s waiting room yesterday and it made my day. I’m not recommending it for anyone except me. But it’s a charming self-centered reminiscence of a NYC when you could make a living as a writer by writing articles for Esquire and Playboy. I’m very fond of it so far.

It could have been better edited. He often refers to a book or person in several chapters, and each time reminds you about what you already know.

This article about Raymond Tallis, whom I’ve never heard of, strikes a chord with me because it’s related to a post I wrote recently on this blog, as follows:

A very short video account of amazing but true things that can actually go wrong when you publish a book:

1. In this country politicians use polls to try to figure out what people want, and then offer it to them in order to get elected.

2. In the social sciences and even in some of the hard sciences, you can often only get tenure if you publish in the sanctioned journals in the sanctioned style.

I went to the NY Film Festival for the first time in years last night and saw David Cronenberg’s A Dangerous Method, a movie about the interactions between Jung, Freud, and Sabina Spielrein who was Jung’s mistress, Jung and Freud’s joint patient sequentially, and an eventual analyst herself.

It was consistently absorbing, but I wouldn’t say more than that.

What I did find thought-provoking was its recreation of the impact of psychoanalysis as a technique. I got a glimpse of how revolutionary it must have seemed, not just because of its focus on infantile sexuality, but even more so because of its use of what they refer to as the dangerous method, by which they mean the talking cure, the idea that you can treat what appears to be an organic or seized-by-spirits illness by words, by access to the mind through its natural outputs. (I suppose in a way it isn’t that different from putting spells on people, and therefore not that new really. Yuri Manin in one of his books refers to the fact that hypnosis is impossible without the invention of language.)

According to Spinoza, to whom I devote a chapter in my book Models.Behaving.Badly, everything in the universe has a Thought attribute and an Extension attribute, i.e. a mental and physical side. Our temptation these days is to give major weight to the physical and regard the mental as a byproduct. But Spinoza thought (and I like the idea) that the two were but complementary sides (and there are more than two, he insisted) of the same underlying thing, and that one aspect can’t explain the other.

I may be putting words into his mouth, but he liked the idea of explaining physical events by physical causes, and mental events by mental causes. So, according to him you can legitimately say: I blushed because blood ran to my face, or: I’m embarrassed because I said something revealing, but you can’t say: I blushed because I’m embarrassed. Blushing and embarrassment are equivalent, the physical and mental sides of the same coin, neither one causing the other.

Recently there was an article in the Times about using the talking cure on schizophrenics.  I don’t know how well psychotherapy really works, but I like the idea of using talking to try to cure mental disturbances and using antacids to cure indigestion. I realize of course that you can have indigestion as a result of what feels like psychic disturbances, but I think Spinoza would argue that the psychic disturbance and the indigestion are parallel, not sequential.

The other thing I liked about the movie is Freud’s notion that everything has an explanation. A dream isn’t just a random thing but is related to your life in a meaningful way. I don’t know whether that’s true but it’s a deeply causal way of looking at the world, a way of treating the mental on an equal footing with the physical.

Asking about the reason for everything is an interesting thing to do. My son once pointed me to a Theodor Adorno essay on why photos of people twenty or thirty years ago in the fashions of twenty or thirty years ago look so ridiculous. It’s true that they do, but asking why had never occurred to me.

Postscript: I just saw Melancholia tonight. Knew absolutely nothing about the movie before I went, not a clue. Nice to see a movie where you know zero about it going in, not even what it’s about. It was scary … not much redemption there except for the calming down of the child with fairy tales.

In this article on nightmares in the WSJ, there is the following paragraph:

Modern psychiatrists, led by Allan Hobson of Harvard Medical School, believe dreams are electrical pulses from the brain stem randomly bombarding the center of the brain where visual memories are stored, creating kaleidoscopes of images around which the brain concocts stories.

Here is the same paragraph, with one word changed:

Modern psychiatrists, led by Allan Hobson of Harvard Medical School, believe thoughts are electrical pulses from the brain stem randomly bombarding the center of the brain where visual memories are stored, creating kaleidoscopes of images around which the brain concocts stories.

Does that count as an explanation?