Those cold and timid souls

It may be that stupid people take too much risk in their lives -- perhaps without knowing it. But my guess is that intelligent people tend to be too risk averse. Were it not the case, we'd have more startups, innovation, scientific breakthroughs, and even great art.

Theodore Roosevelt, speech at the Sorbonne 1910:

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly; who errs and comes short again and again; because there is not effort without error and shortcomings; but who does actually strive to do the deed; who knows the great enthusiasm, the great devotion, who spends himself in a worthy cause, who at the best knows in the end the triumph of high achievement and who at the worst, if he fails, at least he fails while daring greatly. So that his place shall never be with those cold and timid souls who know neither victory nor defeat.

I have great respect for Teddy Roosevelt's insights. He understood MMA a hundred years ago; historians of the sport will note that early UFCs didn't even have weight classes! From an earlier post, Mama said knock you out:

From a letter to son Kermit, dated 02/24/1905:

Yesterday afternoon we had Professor Yamashita up here to wrestle with Grant. It was very interesting, but of course jiu jitsu and our wrestling are so far apart that it is difficult to make any comparison between them. Wrestling is simply a sport with rules almost as conventional as those of tennis, while jiu jitsu is really meant for practice in killing or disabling our adversary. In consequence, Grant did not know what to do except to put Yamashita on his back, and Yamashita was perfectly content to be on his back. Inside of a minute Yamashita had choked Grant, and inside of two minutes more he got an elbow hold on him that would have enabled him to break his arm; so that there is no question but that he could have put Grant out. So far this made it evident that the jiu jitsu man could handle the ordinary wrestler. But Grant, in the actual wrestling and throwing was about as good as the Japanese, and he was so much stronger that he evidently hurt and wore out the Japanese. With a little practice in the art I am sure that one of our big wrestlers or boxers, simply because of his greatly superior strength, would be able to kill any of those Japanese, who though very good men for their inches and pounds are altogether too small to hold their own against big, powerful, quick men who are well trained.

"Theodore Roosevelt's Letters to His Children" edited by Joseph Bishop.

Catastrophe bonds and the investor's choice problem

Consider the following proposition. You put up an amount of capital X for one year. There is a small probability p (e.g., p = .01) that you will lose the entire amount. With probability (1-p) you get the entire amount back. What interest rate (fee) should you charge to participate?

What I've just described is a catastrophe bond. A catastrophe bond allows an insurer to transfer the tail risk from a natural disaster (hurricane, earthquake, fire, etc.) to an investor who is paid appropriately. How can we decide the appropriate fee for taking on this risk? It's an example of the fundamental investor's choice problem. That is, what is the value of a gamble specified by a given probability distribution over a set of payoffs? (Which of two distributions do you prefer?) One would think that the answer depends on individual risk preferences or utility functions.

Our colloquium speaker last week was John Seo of Fermat Capital, a hedge fund that trades catastrophe bonds. Actually, John pioneered the business at Lehman Brothers before starting Fermat. He's yet another deep thinking physicist who ended up in finance. Indeed, he claims to have made some fundamental progress on the investor's choice problem. His approach involves a kind of discounting in probability space, as opposed to the now familiar discounting of cash flows in time. I won't discuss the details further, since they are slightly proprietary.

I can discuss aspects of the cat bond market. Apparently the global insurance industry cannot self-insure against 1 in 100 year risks. That is, disasters which have occurred historically with that frequency are capable of taking down the whole industry (e.g., huge earthquakes in Japan or California). Therefore, it is sensible for insurers to sell some of that risk. Who wants to buy a cat bond? Well, pension funds, which manage the largest pools of capital on the planet, are always on the lookout for sources of return whose risks are uncorrelated with those of stocks, bonds and other existing financial instruments. Portfolio theory suggests that a pension fund should put a few percent of its capital into cat bonds, and that's how John has raised the $2 billion he currently has under management. The market answer to the question I posed in the first paragraph is roughly LIBOR plus (4-6) times the expected loss. For a once in a century disaster, this return is LIBOR plus (4-6) percent or so. Sounds like a good trade for the pension fund as long as the event risk is realistically evaluated.

Note there is no leverage or counterparty risk in these transactions. An independent vehicle is created which holds the capital X, invested in AAA securities (no CDOs, please :-). If the conditions of the contract are triggered, this entity turns the capital over to the insurance company. Otherwise, the assets are returned at the end of the term.

In the colloquium, John reviewed the origins of present value analysis, going back to Fibonacci, Fermat and Pascal. See Mark Thoma, who also attended, for more discussion.

National character?

Social scientist Geert Hofstede of the University of Maastricht has done cross cultural surveys concerning attitudes about egalitarianism, individualism, risk aversion, etc. The results are quite interesting and can be found here.

The characteristics are as follows:

Power Distance Index (PDI): the extent to which the less powerful members of organizations and institutions accept and expect that power is distributed unequally. Higher means less egalitarian.

Individualism (IDV) (versus collectivism): Higher means more individualistic.

Masculinity (MAS): the distribution of roles between the genders. Higher means more chauvinistic.

Uncertainty Avoidance Index (UAI): tolerance for uncertainty and ambiguity. Higher score means more risk averse.

Long-Term Orientation (LTO) versus short-term orientation.


Here are two sample comparisons:





So, Americans are more egalitarian, more individualistic, more chauvinistic and less risk averse than their French cousins. They are also more egalitarian, more individualistic, similarly chauvinistic, more risk averse, and more short-term oriented than their Chinese counterparts. (Did I get all that right?)

It's just a small step to define a "metric on the space of national characters" :-)