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This page contains all of the posts and discussion on MemeStreams referencing the following web page: On Markets and Complexity. You can find discussions on MemeStreams as you surf the web, even if you aren't a MemeStreams member, using the Threads Bookmarklet.

On Markets and Complexity
by noteworthy at 12:05 pm EDT, Apr 2, 2008

Robert C. Merton, founder of Long Term Capital Management:

Let me give you this analogy. If you're driving in inclement weather, you'd say that a four-wheel-drive car is safer than a two-wheel-drive car. Now suppose that we observed that over the last 15 years, the number of passenger accidents per passenger mile driven hadn't changed at all. And someone says, Now wait a minute: Has four-wheel drive made us safer? And the answer would be, Technically, no, because we're having just the same number of accidents we used to have. So, was this all a waste, or were we wrong? I think you know the answer, as I do. What really happened is that people get something that will unambiguously make you safer if you behave the same way you did before. That's the key element to understand first. The amount of risk we take personally, individually, or collectively is not a physical given constant. We choose it. What happens is, we look at some new, safer instrument and we say, Yes, we could be safer doing the same thing. Or, we could take the same amount of risk and do things that were too risky to do before. So with a four-wheel-drive car, you look out the window and see six inches of snow, and you say, That's okay: I'm going to go over and visit my family. So the question to ask is not, Are we safer? The question to ask is, Are we better off?


 
RE: On Markets and Complexity
by Stefanie at 3:23 pm EDT, Apr 2, 2008

TR: So why aren't we safer?

RM: You have to ask, What have we done with all of these improvements? We've gone to much greater complexity. We have many more instruments. Firms and individuals have been more willing to cut back on their equity cushions and leverage more. To go back to our car analogy, we're more willing to drive faster because of the better tools at our disposal and great transparency.

Not to compare myself to Dr. Merton in any way, but I agree that technology brings complexity, which can increase risk, from what I've seen in my office over the past couple of decades; and changes in technology have had a lot to do with recent trends. Investors have a tendency to flock to the latest financial instruments labeled as "cool" and "sophisticated" by those who know how to hype them, regardless of their skills at utilizing them or their comprehension of the risk.

For a while, day trading was the rage, as the Internet emerged and relatively small investors decided that they could do as well or better than the big firms. Some of them even established their own firms, so that they could charge other day traders to use their facilities and methods. Then, a few years ago (prior to the D.C. Circuit Court's overturning of the S.E.C.'s Hedge Fund Rule), we saw a trend emerge in which many small investment advisers wanted to become managers of their own hedge funds, which they might've considered too daunting a task a decade prior. I'm sure that's still the case, they just don't cross my line-of-sight anymore. Also around the same time, "Greeks" and "QQQ" became the new buzzwords, as more investors became fascinated with options trading (and judging it as more accessible, with new, sophisticated research tools), but what percentage of investors understand these investments or the amount of risk involved?

TR: So how do you think about technology generally, as it affects the functioning of markets?

RM: Technology is a huge thing. If you look at the costs of transferring risk around the world, it's just remarkable what technology has done. That's the good side. The bad side is that things are much more complex and much faster. Does that say it's riskier than before? No.

Again, I agree that the pros and cons of technology are a wash. For individual investors, the oldest advice is still the most applicable, regardless of technology:
1) If it sounds too good to be true, it probably is;
2) If you don't understand a particular investment vehicle, don't put your money into it;
3) Live within your means, avoiding debt whenever possible.

As for the large firms and the current subprime mortgage crisis, technology and complexity aren't to blame, although those factors helped to spread the wealth (or in this case, debt) faster and farther (as with MBSs and CDOs). Ultimately, the problems stem from poor decision making by humans (borrowers, lenders, and investors), not overly complex systems (in my very humble opinion).


 
RE: On Markets and Complexity
by Vile at 10:50 pm EDT, Apr 2, 2008

noteworthy wrote:
Robert C. Merton, founder of Long Term Capital Management:

Let me give you this analogy. If you're driving in inclement weather, you'd say that a four-wheel-drive car is safer than a two-wheel-drive car. Now suppose that we observed that over the last 15 years, the number of passenger accidents per passenger mile driven hadn't changed at all. And someone says, Now wait a minute: Has four-wheel drive made us safer? And the answer would be, Technically, no, because we're having just the same number of accidents we used to have. So, was this all a waste, or were we wrong? I think you know the answer, as I do. What really happened is that people get something that will unambiguously make you safer if you behave the same way you did before. That's the key element to understand first. The amount of risk we take personally, individually, or collectively is not a physical given constant. We choose it. What happens is, we look at some new, safer instrument and we say, Yes, we could be safer doing the same thing. Or, we could take the same amount of risk and do things that were too risky to do before. So with a four-wheel-drive car, you look out the window and see six inches of snow, and you say, That's okay: I'm going to go over and visit my family. So the question to ask is not, Are we safer? The question to ask is, Are we better off?

Thanks for that rambling bullshit! I didn't even read it. It was too long and it wasn't about beer or sex.


 
 
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