Tuesday, December 04, 2007

Risky Business

Ever done one of those neat little calculations of expected value of an event based on the probabilities and the payoffs associated with them? Let's take an example. Suppose you have invested in a project that has a 50 per cent chance of success and will pay you $200 if you succeed and nothing if you don't. Ignoring discounting of payoffs, we get an expected value of $100 for your investment. In real life though, you'd either make $200 if the investment succeeds, or nothing if it doesn't. Puts things into a whole different perspective, no?

Of course the explanation is that expectations are based on success and failure over very large number of trials. But in real life, there are only a small number of finite trials available to us, or scarier yet - only about 1-2 trials. In such a situation, your knowledge of probability has to be supplemented by a thorough understanding of the risks involved and your initiative to minimize risk, and an intuitive, perceptive understanding of decision-making.

Speaking of risk, it is interesting how people who would drastically overestimate risk in certain contexts would completely underestimate them in other areas of life. My mother for instance, thinks of all investing in stock as gambling with unacceptable risk and very uncertain payoffs. Given the institutional deficiencies of the Indian stock market, I don't blame her.

However, my mother thought it was the most natural course of things when a cousin of mine decided to agree to an arranged marriage with someone she had met just the day before.

TM: "Is that not a big risk to take? She doesn't have the slightest clue about him"

Ma: "What's there to know? He's from a well-established "good" family, went to the best universities, is now studying at a great university in the US. His academic record is brilliant. She'd be very happy"

TM: "So all it takes for a marriage to work is for the groom to have an impeccable academic record?"

Ma: "Uff!! Her parents know what they're doing."

The marriage imploded six months later because obviously neither the bride nor her parents knew what they were doing. You see, my mother's generation used to hedge their bets on a marriage's success on the fact that there are very steep penalties for the exit strategy, i.e., divorce. Turns out, they were working with historical information that has lost its relevance because the exit strategy costs have dramatically come down in the last decade or so.

My mother, smart cookie that she is, now no longer speaks of the chances of success of any marriage with such unqualified optimism.

Assumptions of risks associated with specific events should ideally evolve as new information is made available. However, usually there is a significant time lag between the appearance of new information and its incorporation into our world view model. Information is not cost-less, neither is adjustment to that information.

And herein lies the problem. Societies that evolved an extremely risk-averse model are often very slow to respond to the dramatic changes in risk estimates that new information and contemporary events have created.

Let's take Pakhtoon society as an example. The Pakhtoon tribal honour code and customs are examples of an extremely risk averse society(I didn't come up with this, I actually read this in an article whose reference I just cannot recall). You rigidly follow customs because they bring what you think is unfailing predictability in a climate of great uncertainty. However, what may have evolved as a response to political instability, change of rulers, frequent invasions, etc. has proved to be a not so successful strategy in dealing with 21st century realities.

I know I might get skewered for saying this, but I see an analogy to this in contemporary Bengali society as well. A combination of many factors (and those factors are another discussion altogether) have made us a very risk averse culture. We embrace the predictable, the anticipated, that which doesn't upset our world view that is at least a couple of decades out of sync with global realities.

This of course doesn't apply to a fairly substantial number of educated, cosmopolitan, globally mobile Bengalis who have excelled by being pioneers and risk-takers. However, make no mistake - these very visible Bengalis are essentially a visible minority. The vast majority of Bengali society is unable or unwilling to incorporate the updated information concerning India's changing economic and political paradigms into their world views.

I know that as individuals it is hard to seamlessly absorb information about an evolving world and update your perception of risk. Notice that I said hard, not impossible. In this case, I love to give the example of my great-grandfather. The man was quite a character - a very successful entrepreneur (unfortunately forgot to pass along his entrepreneurial genes), an Ayurved expert, an epicure (I think I can directly trace my love of food to him) and the most generous soul ever. However, like many men of his generation he believed that women had no business getting an education and should get married as soon as possible to ensure their financial security.

He stuck to these ideas in getting his daughter (my maternal grandmother) married off at a ridiculously young age, and marrying off my mother and my aunts very young as well. However, by the time my cousins and I came along, great-grandpa was taking notice of a very different world around him - a world he scarce recognized. I was 8 years old at the time, and we were visiting my great-grandparents on my summer vacation. My mother proudly announced to my great-grandpa that she had enrolled me in dance classes (don't ask).

Great-grandpa looked at her and suddenly his brow knitted into a look of irritation. In his booming voice he almost thundered:

"Well what's the point of teaching her how to dance. If you want to do something worthwhile make your daughter study to be a doctor"

(Err...a doctorate is good enough, no great-grandpa?)

I've seen the same sort of evolution of thought in the case of my grandparents as well. But it takes a long time in coming, and my fear is that the adjustment is not fast enough to thrive in this new global world.

Whatever happens at the individual level, societies as a whole absolutely cannot afford to ignore new realities or run on autopilot based on historical trends. If you try to do that on the trading floor you'd be wiped out in seconds. And face it the global economy and society is nothing less than a trading floor where if you don't seize the day, someone else definitely will.

9 Comments:

Blogger Chan said...

You are a fin major? Or a minor at least, somewhere? All the risk stuff you've put in!

10:20 PM  
Anonymous Anonymous said...

Did you know that there were psychological models describing the risk averse and risk taking behaviour of people? I could send you the papers if you are interested.

Good reading, as usual :)

Deepti

2:33 AM  
Blogger akhil said...

Hi!

Very nice post. I’ve been reading your blog for a while now and quite enjoy reading it. I like your writing style, your thought process, your liberal ideas. You come across as a rational, practical,thinking and fun person.

I liked the way how put the risk element in your post. Damn I think you’d be a good economics prof or writer:)

Anyways I think the inability of most Indians to make rational decisions, incorporating new information and knowledge in their thought process and assessing the risks involved in any situation is due to the fact that most of us are not trained or encouraged to think on our own and thus we readily accept whatever bullshit is thrown at us by our elders without questioning any of it and maybe only get rid of these misconceptions, ideas and beliefs not consistent with present realities, when some unfortunate event occurs to us or around us.

To give you an example, one friend of mine, who is a post graduate in Business Management, when asked why he believed in Socialism replied that he believed in it because the government was practicing it. Note that there is no individual thought process or logical reasoning as to why he should believe in it. There is no attempt to understand and analyse the basic premises underlying the concept of Socialism. He doesn’t realize that socialism is nothing but a system of rules, where the government assumes absolute power appealing to the altruistic nature of humans by advocating the greatest good for the greatest number. Whose good exactly, it never defines. Now society is nothing but a number of individual people. So those who are most vocal and powerful usurp the right to represent the masses. All it leads is different interest groups pressuring the government to get themselves benefits in the name of the masses. The results: inflation, lack of entrepreneurship, government controlling the private and economic spheres of our lives, no technology and innovation, no reward for merit, brain drain, the economy’s growth stagnates and you have the kind of economic crisis that India had in 1991.

Akhil (Bombay)

3:52 AM  
Anonymous Anonymous said...

Two of my very favorite Eliot quotes:

Only those who will risk going too far can possibly find out how far one can go.
T. S. Eliot

There is no absolute point of view from which real and ideal can be finally separated and labelled.
T. S. Eliot

3:02 PM  
Blogger Shantanu said...

LOL, you have covered so many things in one post...probably that long break you took before this post. :-)

I think Bengalis live too much in the past too, and I am hoping that will change.

However, while I am not a big supporter of arranged marriages, I don't think the chances of a successful marriage improve by much if you were dating the person earlier. :-)

I agree with your 'cost of exit' point though.

1:22 AM  
Blogger Tabula Rasa said...

a wily side-swipe at conservatism, perhaps? :-D

good to have you back.

6:42 AM  
Blogger thalassa_mikra said...

Chan - Nope, though I have been drawn to the world of finance lately - as a place where financial independence and intellectual arrogance may happily coexist.

Deepti - very interesting. Is this at all related to the research of Tversky and Kahnemann? I'd love to see the papers.

Akhil - thank you so much for your very nice words - I do hope I'm even part of what you think I am. And I do like your analysis of why things are the way they are - as well as how socialism landed us in the mess that we're in.

Amusing how your friend studied Business Management and advocates socialism!

Anonymous - marvelous quotes. And I do like Eliot - though the man had such pessimism for the future of mankind.

Shantanu - Please do not think that I was critical of the fact that this was an arranged marriage.

You see there are arranged marriages for the right reasons (where you consider the compatibility of the partners, their values, aspirations, financial situation, etc.) and then arranged marriages for all the wrong reasons.

And to me, to marry someone for his resume is marrying for the wrong reasons.

TR - a very deliberate frontal attack on conservatism, but then I tend to be a bit too oblique at times (I'm too much of a contrarian to take an absolute position on anything :) )

11:47 AM  
Anonymous tony said...

ooooooooppppppppssss.... I was in Santa Clara most of last week, and I remembered you after I got back :( .....

Wasssup otherwsie.. been long time ..

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