Applying Methodological Individualism to the Financial Markets

I recently received a suggestion for me ‘quantify’ the probabilities of my risk scenarios.

While this may represent the conventional practise by the mainstream, I see this as a foolish undertaking.

Putting numbers assumes that I KNOW the nitty gritty or the minutest details of the risk events that I have been investigating. It also means that I KNOW how people think and their corresponding responses to the changes in the economy, the environment or the financial marketplace. Otherwise, I would be making irresponsible assumptions that may be out of touch with reality.

Besides, I don’t see the need to ‘signal’ or project my expertise just to get plaudits from any institutions. All I aim to do is to excel at my current undertakings in order to survive.

Anyway the prediction markets such as Intrade.com exhibits the probabilities of specific events based on actual risk money or bets and not merely from mathematical models.

For instance, the odds of a US recession in 2012[1] has been quite volatile.

The odds of a recession began to recede since the last quarter of 2010 and began to bottom out in the first quarter of 2011. But this trend reversed to the upside and currently stands at the highest level since the last quarter of 2009.

As of this writing, the odds of a recession by the betting public is at 43.6% and constantly changes depending on the risk perception of the betting public.

The above simply shows that there is NO constancy in people’s actions or that the only thing constant in the real world is change.

Therefore to apply probabilities based on math or econometric constructed ‘models’ from faulty and flawed assumptions would not be only ridiculous but dangerous, especially to our management of portfolio.

Class and Case Probabilities

A better option would be to apply what the Austrian School of economics calls as Class and Case Probabilities.

Class probability, as the great professor Ludwig von Mises defined is[2]

We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.

We know, for instance, that there are ninety tickets in a lottery and that five of them will be drawn. Thus we know all about the behavior of the whole class of tickets. But with regard to the singular tickets we do not know anything but that they are elements of this class of tickets.

On the other hand, Case probability according again to Professor Mises means:

We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.

Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.

Let me apply these probabilities to the recent typhoon that hit Metro Manila. [As a caveat I don’t know exactly the details of the typhoon but am comparing the major hits from a typhoon in the metropolis.]

Class probability means that we know some generalized information of the risk event.

-Typhoons can result to loss of lives, injuries or damage to properties as a result of flooding, strong winds and other related or ancilliary consequences (landslide, health hazards as leptospirosis, snake bites, E. coli and etc..).

-We can predict the path of typhoons using satellites.

-We know for instance that around 19 cyclones or tropical storms enter the Philippine area of responsibility every year[3].

From the above, we can even parallel class probabilities or “the behavior of a whole class of events or phenomena” to former US secretary of defense Donald Rumsfeld theory of uncertainty called ‘known knowns’[4]

Yet if there are ‘known knowns’ then the antipode would be the ‘unknown unknowns’.

This would represent as the Case probabilities or fragmented, dispersed and localized information on specific risk events.

Back to typhoons, we don’t know the exactitude and the variability of the typhoon’s strength (only estimates) and or its impact to particular affected localities.

While the Typhoon Nesat[5] [code name: Pedring] recently hit Northern Luzon’s Aurora and Isabela provinces the hardest, in Metro Manila, the famous Manila district of Roxas Boulevard got slammed by a barrage of extremely high storm surges that caused flooding at a public hospital, a five-star hotel and the US embassy.

This is in contrast to Typhoon Ketsana[6] [code name: Ondoy] in 2009 where strong continuous rains basically submerged Metro Manila’s Marikina City that led to many fatalities.

Think of it, about 19 typhoons hit the Philippines every year, yet we hardly know much about the prospective destruction or the scale of calamity these typhoons would bring about and where they will hit for us to apply precautionary measures.

But if you listen to the self-righteous blarneys of prominent media broadcasters, who base their comments on ex post analysis of ‘case’ events, you’d bear the impression that if the government only does as they propose the next typhoon won’t have an impact to the nation at all. Duh!

Yet fallacies from such presumptive omniscient gibberish can be applied to the most recent triple whammy calamity of Japan: the 2011 Tohoku earthquake, tsunami and the nuclear reactor meltdown[7].

Japan’s geographical location[8] makes her exceedingly vulnerable or prone to earthquakes. Thus Japan has lavished in putting up scientific prediction models, which only has proven to be a massive failure in predicting the latest catastrophe[9].

The moral: While it would seem as intellectually comforting to be guided by math based models in predicting the probabilities of the markets or the economy or of any people based risk events, unfortunately, they almost always fail to achieve their goals. The problem is that the social science isn’t physics or natural sciences that are quantifiable and work on some constants.

As Professor Mises wrote[10],

People would like to find in an economics book knowledge that perfectly fits into their preconceived image of what economics ought to be, viz., a discipline shaped according to the logical structure of physics or of biology. They are bewildered and desist from seriously grappling with problems the analysis of which requires an unwonted mental exertion.

Another notable example would be how the 2008 crisis exposed the travesty of quant[11] models[12]. UK’s Queen Elizabeth even questioned the economic profession[13] on why they haven’t seen the crisis coming.

To insist on applying something that doesn’t work is an exercise of self-deception or delusion.

Using Methodological Individualism on Uncertainty

The best methodology will always be to apply the understanding of human action or methodological individualism on social problems

Again from Professor Ludwig von Mises, (bold highlights mine)

Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.

We can predict, as will be shown later, that — other things being equal — a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.

The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions.

Understanding of how individuals interact with one another and with the environment should give us a better insight than sloppy thinking based on hypothetical numerical aggregates which attempts to substitute for people’s choices.

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[1] Intrade.com The US Economy will go into Recession during 2012

[2] Mises Ludwig von Uncertainty Mises.org

[3] Wikipedia.org Typhoons in the Philippines

[4] Wikipedia.org There are known knowns

[5] Wikipedia.org Typhoon Nesat (2011), Philippines

[6] Wikipedia.org Typhoon Ketsana

[7] Wikipedia.org 2011 Tōhoku earthquake and tsunami

[8] Wikipedia.org Seismicity in Japan

[9] See Science Models Fail To Predict Japan’s Earthquake, March 12, 2011

[10] Mises Ludwig von Blue-Collar Anticapitalism, Mises.org

[11] See How Math Models Can Lead To Disaster, February 25, 2009

[12] See Beware Of Economists Bearing Predictions From Models, May 27 2009

[13] The Telegraph The Queen asks why no one saw the credit crunch coming, November 5, 2008

Peter Buffett: Freedom over Money

Not everything is about money. Peter Buffett, son of one of the world's richest and investing savant Warren Buffett, gave up his inheritance of Berkshire Hathaway shares (worth about $72 million in 2010) for the freedom to live a life as musician.

Peter Buffett writes, (hat tip Professor Russ Roberts) [bold emphasis mine]

My inheritance was relatively modest, but it was more than most young people receive to get a start in life. Having that money was a privilege, a gift I had not earned. If I'd faced the necessity of making a living from day one, I would not have been able to follow the path I chose.

Would my father have helped me get started if I'd chosen a career on Wall Street? I'm sure he would have. Would he have given me a job at Berkshire Hathaway if I'd asked for one? I suppose so. But in either of those cases, the onus would have been on me to demonstrate that I felt a true vocation for those fields, rather than simply taking the course of least resistance. My father would not have served as an enabler of my taking the easy way out. That would not have been an exercise of privilege, but of diminishment.

This demonstrates the differences of value preferences. Peter's priorities are different from his father's. One cannot measure individual choices from aggregates or statistics.

Yet like Professor Roberts, who counselled his students “not to take the job that pays the most money” but instead go for trade which delivers “satisfaction, meaning, leisure, beauty, pride, and honor,” I recently advised my newly graduate eldest son not to seek the pursuit of money as the primary objective for career development, but to go for specialization in the field which he feels comfortable with.

After all, achieving career excellence is about the ability to serve consumers; where consumers ultimately determine one’s market value or career success (outside the political spectrum).

Should Economics Be Left To The Economists? Is Economics Value Neutral?

At a recent assembly, I counselled a promising and youthful colleague, who had been rebuffed in trying to introduce classical liberalism to the economics departments of one of the elite schools in the Philippines, that since we eat, drink and sleep economics—where everyone engage in making and acting upon choices around the world of scarcity—that economics must not be left to the economists.

My point is since these elite schools have benefited from the current arrangement, there would be no incentive to assimilate changes that would only risk undermining their stature.

And I further added that politics is essentially economics, where politics signify no less than economics in morality’s clothing. Morality here, I am speaking of depends on whose sense of morality gets to be argued and or implemented; is it the minority, the majority, the despot, the King?

Thus, since economics is ubiquitous, it must be learned by everyone.

And for those in the know, it would be our civic duty to teach economics even in the non-traditional sense in our non-conventional way. In warfare, this is known guerrilla tactics.

As Ludwig von Mises once said,

Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man's human existence.

Nevertheless the main aspect that differentiates the mainstream and classical liberalism would be the former’s emphasis on mathematical or empirical formalism vis-à-vis the latter whose analysis are based on logical deductions via praxelogical axioms or methodological individualism.

For instance, the mainstream would argue that their brand of math and statistical models based economics can be value neutral or value free when applied scientifically.

But this is would only be partly true because:

1. We are dealing with human action where every action involves subjective value preferences and ethical judgments.

As Murray N. Rothbard wrote, (bold emphasis mine)

I am not taking the position, now fashionable in many quarters, that there is no such thing as a value-free economics, that all economic analysis is inextricably shot through with value assumptions. On the contrary, I believe that the main body of economic analysis is scientific and value-free; what I am saying is that any time that economists impinge on political or policy conclusions, value-judgments have entered into their discussion. My conclusion, then, is that economists must either make their value judgments explicit and defend them with a coherent ethical system, or strictly refrain from entering, directly, or indirectly into the public policy realm.

In short, it would be inescapable for economists to fall for the value trap once they incorporate analysis based on the socio-political spectrum.

For instance, opportunity costs may not all be quantified in monetary terms as there would psychic and disutility costs. Thus, value free or value neutral can hardly be realizable except under classroom environment.

2. Economics is not the same as natural science.

Economics, as Jörg Guido Hülsmann wrote in MISES: The Last Knight of Liberalism, is a science with clear political implications, not a mere intellectual exercise.

Bottom line: Economics is human action.