The biology of risk

That was the title of a fascinating opinion piece by John Coates from back in early June in the NYTimes.

Most of us tend to believe that stress is largely a psychological phenomenon, a state of being upset because something nasty has happened. But if you want to understand stress you must disabuse yourself of that view. The stress response is largely physical: It is your body priming itself for impending movement.

As such, most stress is not, well, stressful. For example, when you walk to the coffee room at work, your muscles need fuel, so the stress hormones adrenaline and cortisol recruit glucose from your liver and muscles; you need oxygen to burn this fuel, so your breathing increases ever so slightly; and you need to deliver this fuel and oxygen to cells throughout your body, so your heart gently speeds up and blood pressure increases. This suite of physical reactions forms the core of the stress response, and, as you can see, there is nothing nasty about it at all.

Far from it. Many forms of stress, like playing sports, trading the markets, even watching an action movie, are highly enjoyable. In moderate amounts, we get a rush from stress, we thrive on risk taking. In fact, the stress response is such a healthy part of our lives that we should stop calling it stress at all and call it, say, the challenge response.

Coates notes that the challenge response in humans is particularly sensitive to uncertainty and novelty, causing an elevation in cortisol which reduces our appetite for risk.

Based on that thesis, Coates argues that in reducing uncertainty about upcoming interest rate movies, Greenspan and Bernanke have actually “one of the most powerful brakes on excessive risk taking in stocks was released,” leading to much greater stock market volatility and more dramatic stock market booms and busts.

It may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles. More generally, if we view humans as embodied brains instead of disembodied minds, we can see that the risk-taking pathologies found in traders also lead chief executives, trial lawyers, oil executives and others to swing from excessive and ill-conceived risks to petrified risk aversion. It will also teach us to manage these risk takers, much as sport physiologists manage athletes, to stabilize their risk taking and to lower stress.

I watched more soccer (I'd use football but most posts tagged football in my blog will be about the American rendition, so for disambiguation I'm going to use what soccer fans would consider the profane nomenclature) than I have in my entire life up until now this summer because of the World Cup. People put on the game in the office, and everywhere I went it seemed some American TV was dialed to a game.

[This is a topic for another post, but I am curious about what drove this noticeable uptick in interest in soccer in the U.S. this summer. Was it the greater build out of social media? The success of the U.S. team? Increased coverage on ESPN? The fact that games were in the U.S. timezone this time, unlike the next World Cup or this past Winter Olympics? The rise of MLS? All or none of the above?]

While I'm far from a soccer expert, I did detect a noticeable tightening of game play in overtime. This could purely be because of fatigue, but it led to a less interesting form of play in those periods.

Coates' theory of the relationship between risk-taking and uncertainty reminded me of one of my pet peeves about many sports: the many mental traps that reduce risk-taking in athletes and coaches. From a sports design perspective, I'd argue that fans would prefer greater daring from players and teams more often. Volatility, with dramatic boom and busts, may be not be desirable when it comes to your finances, but in sports and entertainment it's the building block for more compelling drama.

It's not just soccer. The reluctance of football coaches to go for it on fourth down more often is another example where reduced risk lowers entertainment value. The irony is that mathematically, what feels like riskier behavior may be the more rational play. The math supports going for it on fourth down most if not all the time. In soccer, ending overtime deadlocked leads to the randomness of penalty kicks. I'm not conversant on the statistics around soccer, but leaving your fate to penalty kicks feels less certain than just trying to win in overtime.

If the players and coaches won't behave rationally, however, they can have their hands forced by rule changes. What if the NFL just banned punting? Everyone would go for it on fourth down, and I'm confident that would be a more exciting game. What if soccer's overtime were sudden death?

My ideal sports design guiding philosophy: maximize entropy but still reward skilled play. That is, you can let the rough at the U.S. Open grow wild so golfers have to try to stay in the fairways or risk having to hack their way out of the weeds. You can shorten the first round 7 game series in the NBA to 5 games to give the underdog a greater chance.

Don't design a game so skill-based that the outcome is never in doubt. There's a reason why people don't watch televised checkers. But also don't design a game so random that every contestant has an equal chance of winning regardless of skill. You might as well watch two teams flip a coin.

The Uncertainty of Risk

The startup economy is an example of an antifragile system rooted in optionality. Venture capitalists power the tech scene by making investments in nascent firms. These upfront costs are relatively small and capped. VC firms cannot lose more than they put in. But since there is no upper limit to success, the investment’s upside is potentially unbounded. Of course, venture capitalists need to make smart bets, but the business model doesn’t require them to be so good at predicting winners as to pick one every time. The payoffs from their few wildly successful investments more than make up for the capital lost to failures. While each startup is individually fragile, the startup economy as a whole is highly antifragile, and predictive accuracy is less important. Since the losses are finite and the gains are practically limitless, the antifragile startup economy benefits overall from greater variability in the success of new firms.

From a book review of Nate Silver's The Signal and the Noise, Nassim Nicholas Taleb's Antifragile, and James Owen Weatherall's The Physics of Wall Street at n+1.

As the financial crises of the past three decades have painfully demonstrated, the global banking system is dangerously fragile. Financial institutions are so highly leveraged and so opaquely intertwined that the contagion from a wrong prediction (e.g. that housing prices will continue to rise) can quickly foment systemic crisis as debt payments balloon and asset values shrivel. When the credit markets lock up and vaunted banks are suddenly insolvent, the authorities’ solution has been to shore up underwater balance sheets with cheap government loans. While allowing a few Too Big To Fail banks to use their “toxic assets” as collateral for taxpayer-guaranteed loans makes their individual fiscal positions more robust, all this new debt leaves the market as a whole more fragile, since the financial system is more heavily leveraged and fire-sale mergers consolidate capital and risk into even fewer institutions. These “solutions” to past crises transferred fragility from the individual banks to the overall financial system, creating the conditions for future collapse.

Too Big To Fail is an implicit taxpayer guarantee for banks that privatizes profits and socializes losses. Markets have internalized this guarantee. The judgment that Too Big To Fail banks are, perversely, less risky is reflected in the lower interest rates that creditors demand on loans and deposits. Recent studies estimate that this government protection translates into an $83 billion annual subsidy to the ten largest American banks. This moral hazard rewards irresponsible risk taking, which management will rationalize ex post facto by claiming that no model could have predicted whatever crash just happened. Being Too Big To Fail means that predictors have no “skin in the game.” In making large bets, they get to keep the upside when their models work, but taxpayer bailouts protect them from market discipline when losses balloon and their possible failure put the overall economy at risk. To promote an antifragile economic system, bankers must be liable for the complex products they produce, each financial institution must be small enough to safely fail, and the amount of debt-financed leverage in the system overall must be reduced. These are the most urgent stakes obscured by the difficult mathematics of financial risk. Markets will never spontaneously adopt these reforms; only political pressure can force them.