Fora.tv have a video titled Nassim Taleb and Daniel Kahneman: Reflection on a Crisis from the Digital, Life, Design (DLD) conference from January of this year. This discussion has interesting insights on what led to the current crisis, and Taleb’s recommendations to avoid this going forward, foremost of which involves nationalizing banks (to shield them from forecast errors). The discussion hits on some interesting points, noted below:
- Certain events, that Taleb calls rare events or black swans cannot be predicted with any level of precision, because there is not enough historic evidence for such events. Why is it then, he asks, that people (that act on behalf of financial firms) take large risks without any insurance against such events. He offers the following three reasons (1) because they are ignorant about the odds (2) because they would rather make small profits than one big profit, but rather take a big loss than a series of small losses, what he refers to as the convexity of losses in a negative domain, a topic that falls within the area of Prospect Theory. (3) non-neutrality of representation: loosely, the tendency of people to use irrelevant quantitative information as an anchor when making predictions.
- Kahneman talks about the mismatch of time scales: there is a mismatch between the expectations of firms and the agents that act on their behalf. Firms have a long horizon, the agents have a different, shorter time-scale, when it comes to making profits.
- Kahneman brings up the two systems for human decision making as put forth by psychologists – system 1 which is the intuitive system, and system 2 which is the reasoning system. Often in making decisions, people tend to give precedence to system 1 (intuition) over system 2 (reason).
- In a discussion involving the inadequacy of financial models, Kahneman asserts that the models used in finance are useless and dangerous , dangerous because they give people confidence even if they are wrong.
- In the last few minutes, Taleb talks about how financial firms used the bailout money – 1) to pay themselves fat bonuses and 2) to take on higher levels of risk. He had, earlier in the talk, mentioned backward capitalism where profits are theirs (financial institutions) to keep, and losses are ours (the tax-payers) to bear. It is in this context that he calls for the nationalization of banks.
Interesting perspectives from two renowned personalities. I don’t know why Taleb is researching the history of medicine that has little to do with all the financial stuff that he has been talking about (portending may be a more apt word that, fortunately for him and unfortunately for many of us, he’s done with a good level of success). Perhaps we’ll find out in a book to come.