Undead Astronauts

With all the Occupy protests going around demanding that the 1% pay its “fair share,” it’s reasonable to go back and revisit the reasons for and against raising taxes Wall Street traders. The main reason cited by conservatives and free marketers for not taxing capital gains is that the market will function more efficiently when the rewards go to the individuals who were smart enough to pick winning stocks. Whatever the winners choose to do with the money they earned, so the argument goes, will likely be more efficient use of that money going forward than any other use it’s put to by people with less knowledge of how to make that sum earn more.

But not so fast my friend. Daniel Kahneman studied the investment choices (thanks to Steve Hsu for the link) of 25 wealth advisers for a period of 8 years and found that year to year correlations in how they ranked against each other came out to 0.01, or effectively zero. It means there is no skill differentiation in financial investment decisions made at the highest levels, or in other words, winners lucked out.

Well, how is it, you might ask, that the heralded Wall Street quants, the self-styled Gordon Gecko masters-of-the-universe types could do no better than luck in picking winners and losers? Didn’t these financial wizards concoct magical equations in their Wall Street towers that effectively predict future winners and losers? Maybe they did. But even if their equations and models were infallible, they still couldn’t predict anything with accuracy. A researcher named Jonathan Carter found that even perfect models failed to predict correctly because of the necessity of calibration.

Carter had initially used arbitrary parameters in his perfect model to generate perfect data, but now, in order to assess his model in a realistic way, he threw those parameters out and used standard calibration techniques to match his perfect model to his perfect data. It was supposed to be a formality–he assumed, reasonably, that the process would simply produce the same parameters that had been used to produce the data in the first place. But it didn’t. It turned out that there were many different sets of parameters that seemed to fit the historical data. And that made sense, he realized–given a mathematical expression with many terms and parameters in it, and thus many different ways to add up to the same single result, you’d expect there to be different ways to tweak the parameters so that they can produce similar sets of data over some limited time period.

The problem, of course, is that while these different versions of the model might all match the historical data, they would in general generate different predictions going forward–and sure enough, his calibrated model produced terrible predictions compared to the “reality” originally generated by the perfect model. Calibration–a standard procedure used by all modelers in all fields, including finance–had rendered a perfect model seriously flawed. Though taken aback, he continued his study, and found that having even tiny flaws in the model or the historical data made the situation far worse. “As far as I can tell, you’d have exactly the same situation with any model that has to be calibrated,” says Carter.

Sounds a bit like chaos theory. Okay, so we know that skill hasn’t nothing to do with picking winners and that it’s effectively impossible to do so in the first place on a consistent basis. We know that there’s no efficiency gain in allowing the winners to keep their new found wealth since their next picks aren’t any more prescient or more efficient than any one else’s. We tax lottery winners, who have done nothing more than buy a winning ticket, and so it seems pretty natural to tax the Wall Street quants who have done pretty much exactly the same. There’s nothing inherently wrong with gambling, but there’s absolutely nothing righteous about it either.

What we shouldn’t do is feed a gambling habit with the resources of others. Bank of America is doing just that. If I didn’t particularly feel any affinity for the protesters before, I do now. If the derivatives owned by BofA fail, their recent move saddles tax payers with paying off the debt. No gov’t regulators passed any bill to allow this move. There was no public discussion. Like Nike, they just did it.