What is the purpose of society?

Ants are fascinating little creatures. You drop one little piece of food on the floor and in no time, a swarm of ants will be all over it. Follow their path and somewhere along the line, you will be treated to one of nature’s most interesting formations – an ant colony. This huge pile of earth is like the mirror image of the world that we humans inhabit.

The human society is an organization, much like an ant colony. It is a system that allows us to achieve certain things we otherwise couldn’t have achieved individually. Humans have lived in some sort of society for a long time now. A society serves many purposes. It has helped in hunting-gathering, protection from predators and as human culture evolved societies became more complex.

The main aim of any society is to create a better life for it’s inhabitants. Now better is a qualitative term, every individual’s definition differs. How then can society work towards making lives of its citizens better?

Nature’s great truth – Inequality

Civilization has evolved and throughout history, the structure of the society has existed on a spectrum from closed societies which are authoritative and stress on the “collective” on one extreme to open societies which believe in providing “individual freedom” to citizens or maximizing the utility of an individual on the other. We believe that open societies lead to more productive economies thus benefiting the whole world.

One of the major concerns in a society is the notion of inequality. Inequality is inherent in nature. We can be strong, we can be weak, we can be born rich or poor, we can ace the IQ tests or fail them. Inequality in abilities naturally leads to inequality in returns. But that is not the problem. For a society to exist, it is essential that performance and ability are rewarded. But what a society should aim for is not equality in returns, but equality in opportunities.

Be the creator, be the created

The acclaimed investor, Warren Buffet has a very interesting viewpoint on this issue. Lets see what he thinks:

Let’s say you are given the freedom to design a society structure for the whole world – yeah something like how Morgan Freeman gave the reins of the world into Jim Carrey’s hands in Bruce Almighty (note: you should watch the movie if you haven’t. It’s quite funny).

But there is a catch. You yourself lose your identity and have to pick a slip randomly from a bowl which has 7 billion slips each having the characteristic of a human from the current population. There it is. You could get any slip – A male or a female, A rich guy in America or maybe a poverty stricken person in Congo.

Now this changes things, doesn’t it ? How would you frame the rules of society knowing that you could end up being anyone ? You wanna excessively reward the highly skilled ? What if you turn out to be one of those who isn’t so good ?

So you want to design a society that gives everyone the opportunity to be able to succeed, not knowing what slip an individual gets. As you can guess, it is gonna be a very delicate balancing act. The boundaries of incentives for performance and security for the less-abled are blurred.

Open society

A society striving to move towards the open end of the spectrum, therefore must provide a safety net for the people at bottom, let the top take risk in such a manner that the result of their failure does not affect the general public. Look at the hedge fund industry for example. No player is too big to fail. The industry gains from failure as only the top performers stay in business and are allowed to take risk. The failure of several others does not affect the whole industry like the failure of big investment banks on wall street affected the whole global financial system leading to anger in general public about inequality between the rich and the poor. The middle should be left as it is because they more or less have the same opportunities as anyone in America.

Now the American system may have its faults but it has worked fairly well for many people for centuries.The current political scenario may not be the most efficient in years, but that is where team-work and reconsidering incentives becomes essential.

To create a system that works for everyone, policymakers must put aside their divisive party issues although such games increase their popularity with certain factions of society. Everybody wants different things. Therefore you can lump people in groups, in terms of demographics, race, religion, geography, etc. and appeal to their common issue. But one group’s issue of interest may be radically opposed to another group’s opinions. How does a politician then resolve this conflict of interest so that the policies he puts in place that benefit one group do not harm other conflicting groups? A political campaign can be based and won by focusing on a certain issue that appeals to people’s emotions. But when the politician takes office his policies cannot be divisive, in the sense that they benefit one group at the expense of others. That is being short sighted because in the long run things will normalize and other issues he didn’t tackle carefully will also present themselves decreasing the politician’s popularity.

Only when a politician is capable of thinking of all of these qualities that the“true” population of citizens may be distributed across will he understand the disadvantages of being so short sighted by putting in place policies that put a certain group at an unfair advantage.

Now the unfortunate part is that the politician might get away with being short-sighted, depending on the level of transparency and bureaucracy in the system, the appeal of his political campaign may mask his shortcomings. Therefore incentives are important. So that everyone is accountable. For example, if unchecked deregulation in the markets is believed to be the cause of excesses leading to a bubble and then panic eventually popping the bubble and causing enormous damage to the economic system like the most recent recession did, then policies must be put in place that regulate these excesses no matter how much a particular interest group lobbies to have policies set up their way. This is because judging from history, its the taxpayers that eventually end up paying for the repercussions of greed in society.

The system is too complicated and there are lots of variables to get it right the first time, but we must strive to work on incentives that influence people’s behavior. Because only governments can set the rules which lead to excesses and only government can set the rules that minimize the ill effects of excesses.

References
  1. http://blogs.rhsmith.umd.edu/davidkass
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Statistics and Human Psychology

The human mind has made tremendous achievements in logically understanding the world around us in the past two centuries. Since the industrial revolution science has given us breakthrough technology, medicine as well as a “rational” way of looking at the world around us. Causality that had been explained using “gods of rain/wind” for example has slowly been discarded across cultures as more experimentally verified  explanations developed. Does that mean the human mind has achieved complete rationality and all human behavior can be explained using fundamental laws or the concept of equilibrium? The short answer is no.

There have been number of experiments and studies in the second half of the 20th century that show just how poor human mind (including ours) is at coping with randomness. It turns out that not only are people not rational in their decision-making, but they are completely fooled by the properties of randomness.

Its human tendency to take shortcuts (Kahneman). Rather than carefully evaluating risks, humans usually just look at the past and assume it reflects the future. Even when we extrapolate past statistics often times we only count events we remember, events that were significant. So frequencies of events measured in the past often times is used as the probability of an event in the future. Just like a fair coin toss. The probability of getting heads is calculated by repeating the coin tossing experiment a large number of times and dividing the # of heads by the total # of outcomes. So the probability of heads on each coin flip is 0.5. In most real world situations (like financial markets) you cannot necessarily rely on historical frequency  based probability. Just because an event has never happened in the past does not mean it wont happen in the future. This is because unlike a coin toss, the initial conditions keep on changing everyday and most of the times are unobservable or get too complicated. So any probability assigned to such an event in the future is based on belief and is referred to as belief-based or subjective probability.

Do you understand the weather ?

Just consider the weather predictions. A weatherman brings out a 30% chance of rain and you keep your umbrella tucked at your home. You go out and see the clouds thundering and water drops battering the ground and you curse the weatherman. But the poor guy has done no wrong actually. A forecast of less than 50% chance doesn’t mean no rain. It simply means that if weather conditions like today played over 100 times, 30 of those times it will rain.

Value of Money

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This figure above shows two curves – blue and red. The blue curve has a constant slope (rise over run) whereas the red one rises less sharply in gains territory and falls more sharply in losses territory. The red curve indicates that losses hurt more than equal amount of gains. Kahneman and Tversky (see Prospect theory) found that generally people behave according to the red curve. Consider a situation where a person gains $100 and then loses all of them. The blue curve would suggest that the person got the same amount of happiness from winning that money as the sorrow she got from losing it and so she should be indifferent. But if that person has a value function similar to the red curve then the sorrow of losing will be greater than the happiness of winning.  Now this may seem strange because it seems like people do not care about the absolute wealth. This asymmetry can also be used to explain why investors still hold on to losing stocks despite it probably being a riskier proposition. It is because losses hurt them more psychologically. Loss aversion does not necessarily mean risk aversion. It is important to remember that this behavior is not absolute but depends upon the reference point and the change in wealth and varies for every individual.

Black Swan 

Most of us probably remember where we were, what we were doing when two planes flew  into the World Trade Center in New york City on the morning of September 11, 2001. The shocking images of the tall skyscrapers crumbling to the ground are probably vivid in most people’s mind. 9/11 is what we call a “black swan” in probability terms. It was unexpected and caused great destruction – low probability and high impact event. Any normal distribution would have failed to recognize the true impact of 9/11 not just in terms of loss in human lives but economic impact as well. yet we continue using normal probability distributions to quantify risk in many cases only because its simple.

Power law

In our daily lives, we often face situations where the errors are only minor. Consider a machine which we encounter at work. It looks like it breaks down only infrequently and with small defects. So you might come to the conclusion that you are never going to face a big headache due to the machine. Enter the power law!

This strange but simple looking distribution is probably one statistical tool we can use in this case. The mundane small failures are all on the left. You can see that these events have a high probability of happening. But have a look at the right tail – the dreaded uncommon events. it shows that the probability is low, but they can occur. This may not apply in all situations. But we have to be ready for the right tail. The nice looking yellow part is the one that’s going to matter. Be prepared for that!

Don’t discard common sense! 

In many situations however its better to follow a heuristic approach to decision making because its simply impractical to do a complex analysis. This approach is quite common with traders of financial assets. The problems at hand are very complex and so the mind takes short cuts without being fully aware of the process. But a smart trader is aware of this fact and learns from trial and error. We believe that trial and small error accompanied by a sound understanding of statistics is probably a better approach in such situations than relying on complex mathematical models because the real world situations really make the decision-making process too complicated due to incomplete information. Its very similar (but more difficult) to learning how to drive in traffic – switching lanes to reduce the time of travel gets better with trial and error.

Uncertainty is everywhere; Deal with it !

For most of us, death will be unexpected and for almost all of us (don’t wanna piss off those who claim to have risen from the dead) its a once in a lifetime event. But many of us do not go about worrying if the fateful day is going to be today. But it is our duty to ensure that after we are gone, the impact of our death is minimal on those who survive us. Failure to do so cannot be attributed to a sudden catastrophe; only to the flaw in our understanding of this great game of chance.