Complexity, Risk, and Financial Markets

Rating:
Summary: Peters has overlooked Keynes's contributions in this area
Review: Peters does an excellent job in clearly differenciating between the concepts of complexity, ignorance,risk,uncertainty,vagueness,and ambiguity.He shows how each concept has an important separate ,yet interrelated ,clearcut role to play in financial decision making.Unfortunately,Peters overlooks the fact that John Maynard Keynes had already provided an operational approach for such a decision making approach in his A Treatise on Probability(TP)in 1921.The role of conflicting and ambiguous evidence in decision making in general was discussed by Keynes in his rain-barometer-dark clouds example in chapter 3 of the TP.Keynes's point in discussing this particular problem was to show that it would be difficult to measure and quantify this particular dimension of a decision problem.The implicit danger is that no account will be taken of it if a strictly quantitative approach to decision making is taken.The importance of vagueness was discussed by Keynes in chapter 1,p.5,chapter 2,p.17 and in chapter 22,p.259.Complexity is discussed within the context of Keynes's discussion of induction and analogy.The ability to reason inductively starts to break down if the number of important independent factors(Keynes's principle of limited(finite)independent variety)grows too large and/or the interactive effects start to exhibit nonlinear relationships instead of proportionate,linear relationships.The clearcut differences between ignorance,uncertainty and risk in general decision making were discussed in chapters 6(the introduction)and chapter 26(the conclusion).Keynes defined an index to measure what he called the weight of the evidence,w, upon which probability estimates would be based.w is a measure of the completeness and the reliability of the relevant,potential,available evidence and information that a decision maker can obtain( or be aware of its existence).w is defined on the unit interval [0,1],where 0<=w<=1.Keynes's discussion of the Ellsberg Paradox takes place in chapter 6 of the TP forty years before Ellsberg published his 1961 paper.Keynes's w is practically the same as Ellsberg's rho measure of ambiguity.In the General Theory,Keynes defines uncertainty to be an inverse function of the weight of the evidence,where u(uncertainty)is a function of w.Thus,u=f(w).Ignorance(w=0),uncertainty(0<w<1)and risk(w=1)are all defined by Keynes relative to his w index.Risk can then be either linear(proportionate) or nonlinear(nonproportional).Keynes wraps all of this up into his conventional coefficient of weight and risk,c. c is a decision rule that incorporates nonlinearities in decision making.The goal of the decision maker is to maximize cA,where A is some outcome and c equals (p/1+q)(2w/1+w).This rule generalizes the expected value rule and the expected utility rule.Keynes doesn't make the common error of conflating risk with diminishing marginal utility.Finally,Keynes is the founder of the interval estimate approach to probability.Each probability has an upper and a lower bound .Keynesian expected values are thus also intervals.Keynes's development of an interval estimate approach to the estimation of probabilities in chapters 15 and 17 of the TP HAS BEEN OVERLOOKED DUE TO THE INFLUENCE OF TWO ERROR FILLED BOOK REVIEWS WRITTEN BY FRANK RAMSEY IN 1922 AND 1926,respectively.Ramsey completrly misinterpreted Keynes's definition of the words"nonnumerical" and"nonmeasurable".Keynes uses them to mean that two numerals ,not one, are needed to specify probabilities in general.Ramsey mistakenly assumed that Keynes was arguing that numbers could not be used in general to quantify the probability relation.This reviewer concludes that Peters should have based his overall approach upon Keynes's work and not upon an Austrian approach to economic theory which is impossible to operationalize due to their bias against any kind of quantification.Ramsey's criticisms are correct if applied to the Austrian position on the use of quantitative methods in decision theory.They are off target when applied to Keynes.A revised version of Peter's book would be even more convincing if he incorporated a chapter on Keynes's nearlty 80 year old approach.

Rating:
Summary: The dumbing down of market chaos (0 stars)
Review: Ever the standard bearer for the rational approach in the complacent and often hide-bound practices of most people to the world of financial-economics, Peters makes a compelling and ultimately convincing case for the paradigm of complexity to supplant that of equilibrium.

Lest the rank-and-file practitioner forget, the most humble methods one has for interpreting any information in the market have their conceptual grounding from the 1930's application of equilibrium in physics to economics. These humble methods include the Portfolio Theory of the 1970s and Graham & Dodd of the 1930s. What most practitioners fail to appreciate is that once that conceptual foundation is changed from equilibrium to complexity, every metric and every conclusion drawn from those metrics change also.

The changes Peters highlights, while based on solid science, challenge much of the convetional wisdom. It is the millenium and age of enlightenment. Investors should treat themselves to some of the same and read this book.

Christopher MAY - author Nonlinear Pricing

Rating:
Summary: Peters sheds light on complexity theory in finance!
Review: Ever the standard bearer for the rational approach in the complacent and often hide-bound practices of most people to the world of financial-economics, Peters makes a compelling and ultimately convincing case for the paradigm of complexity to supplant that of equilibrium.

Lest the rank-and-file practitioner forget, the most humble methods one has for interpreting any information in the market have their conceptual grounding from the 1930's application of equilibrium in physics to economics. These humble methods include the Portfolio Theory of the 1970s and Graham & Dodd of the 1930s. What most practitioners fail to appreciate is that once that conceptual foundation is changed from equilibrium to complexity, every metric and every conclusion drawn from those metrics change also.

The changes Peters highlights, while based on solid science, challenge much of the convetional wisdom. It is the millenium and age of enlightenment. Investors should treat themselves to some of the same and read this book.

Christopher MAY - author Nonlinear Pricing

Rating:
Summary: Disappointing and superficial content, questionable analysis
Review: I found the discussions of complexity and risk as applied to financial crisis to be superficial and somewhat platitudinous. There are no in depth discussions of the factors involved in any recent financial crisis. There are various discussions of risk, complexity, evolution and Keynesian vs. Austrian schools of economics but no real depth or new perspectives on any of these issues are presented. The discussion of the pros and cons of socialism(collectivism) vs. capitalism(free market) societies was not much more substantive than an article you might see in the Business Section of USA Today. A graph showing(arguing) that the US is higher in on the scale of economic "uncertainty" than China or Russia is highly suspect. One of the defining features and advantages of the US capitalistic system is the relative sanctity of private property and enforceable contracts which provide a foundation of "certainty" upon which vibrant commerce can be enabled. Such institutions are completely lacking in communist states which is one of the major reasons for their collapse. I have to question the scholarship behind the presentation of such a comparison. This book is not worth your time or money.

Rating:
Summary: The dumbing down of market chaos (0 stars)
Review: Peters' earlier work, "Fractal Market Analysis", is an excellent introduction to chaos theory applied to financial markets. It's truly one of the most useful finance books I've ever read.

I was therefore shocked and extremely disappointed to find "Patterns in the Dark" to be a collection of vague, banal observations about risk and uncertainty. On the few occasions when Peters attempts to make actual statements of fact, he's wrong as often as he's right (see below). It's almost inconceivable that this book was written by the same person. I can only conclude that Mr. Peters deliberately dumbed down this book in an attempt to reach a broader audience. Unfortunately, he went way too far. That a firm like Wiley would publish a book like this is disturbing.

If you don't mind 200 large-print pages of simplistic generalities, factual errors, anecdotes devoid of insight, and cartoons (no joke), this book is for you. But if you'd like to actually learn something about the nonlinear nature of markets, read Peters' excellent "Fractal Market Analysis".

Finally, for those interested in some details of the factual errors I mentioned above, I'll provide two glaring examples.

First, the author dredges up that old chestnut of probability, the "Monte Hall Dilemma". This is an often-quoted probability question that, while trivial once understood, is counter-intuitive and hence widely misunderstood. Peters gives the correct solution, but he states that the question "has caused a great deal of debate in statistical circles" and that there is "not universal agreement" on the answer, as if it were some great unsolved problem of mathematics. This is absolute hogwash. While it has caused much confusion among the general public and the press, to someone with a basic knowledge of probability, or to anyone willing to make the effort to really think about it, it's a very simple problem.

Second, and much more disturbing, is the author's assertion that "Darwin was essentially wrong", that "the basic premise of Darwinian evolution has deep flaws". This conclusion is based on his profound misunderstanding of Darwin's theory. Peters' argument is essentially as follows: the number of possible combinations of genes in even the most simple organism is astronomical, so to "search through these combinations to find the best one" would take "longer than the age of the known universe". Of course, as any high school biology student should know, Darwinian natural selection has absolutely nothing to do with the absurd notion of exhaustively "trying out" every possible organism that could conceivably exist. If the author is interested in understanding what Darwin actually theorized, and why nearly all biologists now think he was essentially right, I would refer him to Darwin's own "The Origin of Species", and to the excellent books by Richard Dawkins.