Peter Thiel on the Role of Technology and Globalization in Our Economy

Peter Thiel tends to be best known as an investor and entrepreneur. He is a co-founder of PayPal and the first investor in Facebook, both of which have made him wealthy and well-known.

I tend to be more interested in Peter Thiel for his regular and careful analysis of economic and technology trends. Though Thiel is a self-described conservative libertarian and Ron Paul supporter, his analysis tends to be more nuanced and thoughtful than a lot of people give it credit for.

Two weeks ago he gave a fascinating talk at the DLD 2013 Conference entitled “Developing the Developed World”. Thiel’s analysis mostly centers on the prospects for economic growth in the foreseeable future. His analysis takes into account both the instability related to our recent economic crisis, as well as the prospect that much of the growth that previously drove our economy may have been an historical anomaly.

Growth from Globalization or Technology Innovation?

Thiel’s primary thesis categorizes the two driving factors of the future of our economy as globalization and technological innovation. In Thiel’s view, globalization is the economic growth from copying existing technologies and models from the developed world to the developing world. Technological innovation, on the other hand, is growth derived from the creation of new things. Thiel’s conclusion is that sustainable growth requires strategies to pursue both.

As TechCrunch reported:

In Thiel’s view, four things are likely to happen to the current group of developed countries. Growth and innovation can continue at a decelerating rate, they can enter a cyclical pattern of growth and collapse, completely collapse, or continue to accelerate. In the end, of course, the only acceptable option in his view is accelerated growth.

Exponential Technology Growth: The Singularity

Since Thiel’s prescription emphasizes the need for innovation growth to accelerate, rather than stagnate, Thiel focuses on the potential for continued exponential growth in computing power and software. Thiel is a well-known supporter of singularity studies, the prediction that exponential technological progress will lead to a point in the near future where artificial intelligence outpaces collective human intelligence and leads to a new era of rapid progress. In the DLD speech, Thiel notes the continued importance of Moore’s Law and accelerating innovation growth as a potential driver of economic recovery. He cites examples such as the future of self-driving cars, and bioinformatics as possible technologies to lead this growth.

This is fun stuff to think about.

I’m excited see if some of these themes are given more depth in Peter Thiel’s up-coming book “The Blueprint: Reviving Innovation, Rediscovering Risk, and Rescuing the Free Market”

You can watch Peter Thiel’s entire 50-minute talk at the DLD Conference is here:

10 Steps to Risk-Proofing our Economy


Nassim Taleb’s Financial Times op-ed recommends 10 fixes to our economy

Last week in the Financial Times, Nassim Taleb published an op-ed entitled, “Ten principles for a Black Swan-proof world.” In it, Taleb lays out a number of major economic reforms we could make to limit the likelihood of catastrophic risk in the future (expanded upon in the full FT article):

  • 1. What is fragile should break early while it is still small.
  • 2. No socialisation of losses and privatisation of gains.
  • 3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
  • 4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
  • 5. Counter-balance complexity with simplicity.
  • 6. Do not give children sticks of dynamite, even if they come with a warning.
  • 7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence.”
  • 8. Do not give an addict more drugs if he has withdrawal pains.
  • 9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
  • 10. Make an omelette with the broken eggs.

I have mentioned Taleb’s recommendations on rethinking on the economy before. He’s not always right, but he’s certainly worth understanding. In this case, his 10 principles are unlikely to be implemented, but maybe policy makers should give them some consideration.

Taleb is the author of the tremendously interesting (though somewhat disjointed) books “Fooled by Randomness” and “The Black Swan” and is also the subject of a great essay by Malcolm Gladwell. Check him out.

How Close Are We to an Economic Depression?

economic depression

Are we on the verge of a Second Great Depression?

There has been a lot of whispering lately that our current economic crisis may be leading to another Great Depression.

On Tuesday, the ultra-liberal Nation magazine proposed that we might already be in the midst of the Second Great Depression.

Though there is no universally-agreed-upon definition of the term “depression”, an op-ed in Wednesday’s Wall Street Journal proposed one common definition: a 10% decline in per capita GDP.

If we take the definition of “10% decline in per capita GDP” as our working definition, how close are we to this kind of economic depression?

For the sake of this analysis, we’ll equate real GDP with per capita GDP, since month-to-month national population changes are trivial. For the curious, the US Census does publish that data.

On Monday, the Associated Press reported:

“A Depression doesn’t have to be Great — bread lines, rampant unemployment, a wipeout in the stock market. The economy can sink into a milder depression, the kind spelled with a lowercase ‘d.’

“And it may be happening now.

“The trouble is, unlike recessions, which are easy to define, there are no firm rules for what makes a depression. Everyone at least seems to agree there hasn’t been one since the epic hardship of the 1930s.

“But with each new hard-times headline, most recently an alarming economic contraction of 6.2 percent in the fourth quarter, it seems more likely that the next depression is on its way.”

Government (and press) are inflating data to hype the economic crisis

Here’s the problem: the 6.2% decline that the AP cites doesn’t really exist. That piece of data comes from a Bureau of Economic Analysis report from last Friday that announced a 1.6% quarterly GDP decline estimate — with an annualized rate of 6.2%.

For those with quick brains: 1.6 x 4 = 6.4, not 6.2, the discrepancy is likely due to the rounding of both numbers for simplicity.

As the New York Times graph (above) demonstrates, the only actual decline in GDP, so far, has been the 1.6% of last quarter. Any annualized extrapolation beyond the current quarter’s data, is pure conjecture. This curve could turn up or down, we don’t yet know.

This is all to say that the government announcement, and the AP report on it, are hyping the data to indicate GDP declines four times worse than they actually are.

I’m perfectly willing to concede that the data for 2009 could be as bad as (or worse than) a 6.2% decline in the American economy, but let’s wait for the data. Hype and fear aren’t going to help anything.

Will Banks Be Nationalized This Weekend?

bank nationalization

Calls for Bank Nationalization Are Increasing

This week both Senate Banking Chairman Christopher Dodd and former Federal Reserve Chairman Alan Greenspan indicated that some form of federal bank takeover may be necessary in the near future.

I wrote a few weeks ago that nationalization may be one important way to create accountability and stability in our financial system.

Others have suggested that nationalization has been the Obama Administration’s plan all along — which might indicate why their announced bank bailout plans have sounded confused.

I have no special knowledge as to whether or not this is the correct solution to our massive bank insolvencies, but lots of people seem to think it might be.

If Banks Are Nationalized, Will It Happen Soon?

If nationalization might be in the cards, when can we expect it to happen?

The trick is that if banks are nationalized, their stocks will become worthless.  That means any announcements of a nationalization plan would send those stocks plummeting.  This is one reason why many observers think the Administration might keep a nationalization plan under wraps until it is ready to be implemented.

Adam Davidson of NPR further indicates that a nationalization plan would likely be announced on a Sunday:

“This is why so much of the big government moves happen on a Sunday afternoon. They wait until the markets in NY close on Friday, then they pounce. They spend a sleepless weekend–when global markets are closed–putting everything together and then announce it on Sunday afternoon, NY time, before Tokyo’s stock market opens.

“If the economists who tell us that nationalization is inevitable are right, then we’ll probably see things happen just like that. We’ll get breathless, hurried rumors on a Friday evening followed by a Saturday of confusing, contradictory leaks and a Sunday news conference announcing that the U.S. government now owns and operates several of the world’s largest banks.”

Part of this prediction could already be happening as traders today apparently worried about an impending nationalization and sold many financial stocks.

Economist Nouriel Roubini, on the other hand, thinks Obama plans  to wait a few months before  nationalization:

“The savvy Geithner, this theory goes, has determined that seizing Citigroup (C) and Bank of America (BAC) now would trigger a run on the bank at JP Morgan (JPM) and Wells Fargo (WFC)–thus forcing the immediate seizure of those giants, too. JPM and WFC are also insolvent, so this wouldn’t be irrational, but Geithner and his bosses might get blamed for destroying them.

“In 6-12 months, meanwhile, the market will gradually have realized that JPM and WFC are insolvent, so nationalization will no longer be a startling alternative (and Obama and Geithner won’t get blamed).”

My guess is that the odds of nationalization are probably very slim and that it would probably happen in weeks, not days, from now. But if it does happen this Sunday, I guess I can say I told you so.

Why Don’t We Hold “Experts” Accountable?


When Media “Experts” Assist in Ruining Our Economy, Why Aren’t They Fired?

Yesterday I wrote about a depressing appearance by Nouriel Roubini and Nassim Taleb on CNBC, where the show’s hosts were demonstrably incapable of engaging in a serious discussion about the structural problems in our economy. A few days ago, I also wrote about how one of the problems with our current economic crisis is that we aren’t making a point of holding financial leaders accountable for harming our economy.

I can understand that it’s politically and logistically difficult to fire all of the regulatory and financial industry leaders who played a part in getting us into this situation. What I have a harder time understanding is the 24-news stations (CNN, Fox News and, most notably, CNBC) who for years have held out financial “experts” to predict for us which stocks were “buys” and which were “sells”. Of course, none of these “experts” have any particular prescience (because nobody does) and all of them have had their specific predictions fail more often than not. Most importantly, these so-called “experts” didn’t see our crisis coming, didn’t prepare anyone for it, and yet are still on TV, pretending to predict hot and cold stocks for us. Why do these worthless “experts” still have jobs?

Can We At Least Agree to Boycott the “Experts”?

A number of financial bloggers recently participated in International Boycott CNBC Day, heeding the call:

“We are boycotting CNBC because of what we perceive as a gross lack of accountability and editorial judgment.

“We are boycotting CNBC because they produce shows with personalities who take zero responsibility for stock picks and markets calls which misinform viewers and distort the severity of the economic crisis.

“We are boycotting CNBC because they trot out so called expert guests who have cost investors millions without warning viewers and allow these guests to pump themselves up without demanding the disclosure of performance.

“We are boycotting CNBC because we want to send a message that such asshat behavior is unacceptable to us, their viewers.”

Now, I’m sad to admit that I didn’t learn about International Boycott CNBC Day until it was too late (the boycott was on February 3). Then again, it would be hard for me to “boycott” something I’ve never voluntarily watched [I do regularly watch it, involuntarily, as it is the station of choice in my gym lockerroom].

The saddest part is that not only are most people not dismissing these clowns, CNBC’s ratings are actually UP since the financial crisis started.

Don’t Believe (All) the Hype About the Stimulus Plan

US Capitol

Nancy Pelosi Wants You to Think This Is the Current State of American Unemployment

Last Friday, Speaker Nancy Pelosi released a graph showing the number of unemployed Americans from each of the last three recessions:

“This chart compares the job loss so far in this recession to job losses in the 1990-1991 recession and the 2001 recession – showing how dramatic and unprecedented the job loss over the last 13 months has been. Over the last 13 months, our economy has lost a total of 3.6 million jobs – and continuing job losses in the next few months are predicted.

“By comparison, we lost a total of 1.6 million jobs in the 1990-1991 recession, before the economy began turning around and jobs began increasing; and we lost a total of 2.7 million jobs in the 2001 recession, before the economy began turning around and jobs began increasing. [Emphasis mine].”

The explicit purpose of this graph is to support the Speaker’s view that a stimulus package of some kind — any kind — needs to be passed immediately to do something about this “unprecedented” precipitous fall in employment numbers. From the data presented, this seems quite persuasive. But it’s not the whole story.

A Better Way to Think About American Unemployment — In Context

Jim Manzi at “The American Scene” created this graph in response to the Speaker’s graph, adding two pieces of context:

“Of course there are a couple of odd things about this. First, it shows absolute job numbers, rather than unemployment rate (that is, job losses per capita). This matters, because the U.S. labor force is a lot bigger now than in prior recessions. Second, it ignores the recession of 1981 – 1982, which was by far the most serious of recent recessions.”

He also apologizes in the blog post for using such an ugly Excel spreadsheet to present his new data.

Some Observations on the Stimulus Plan — From the Addition of Context

The American Scene” draws two observations from its additional data:

1. What seems to matter in getting to really bad job losses is the duration of the recession. So, speed in passing a stimulus bill is probably a lot less important than getting our countermeasures right. This is, of course, diametrically opposed to the natural conclusion one would reach in looking at the first chart.

2. The structural work on the economy is at least as important as how we deal with the recession. The stagflation of the 1970s meant that we started the ’81-82 recession at about the unemployment level that we have taken more than a year of recession to reach today. Doing something, anything, to stop the pain of the current recession, no matter what its structural effects on the economy, might seem practical, but it is not.

I think the two graphs also beg a question (which I don’t have the data to answer):

What does this picture look like when given lots of extra data — say all worldwide recessions of the past 100 years? Or even easier: If this job loss is really “unprecedented”, then how does it stack up against even just the 7 U.S. recessions from 1900-1980? If the picture continued to be consistent, or showed some other trending with LOTS of data, then I might feel comfortable drawing conclusions from it about policy solutions.

As it stands, the Speaker does her position a major disservice by withholding the context needed to interpret her data.

5 Ways to Rethink America’s Current Economic Crisis

economic insurance

Nassim Taleb and Daniel Kahneman Explain the Real Roots of the Economic Crisis

Check out this hour-long video of a panel discussion between Nassim Taleb and Daniel Kahneman reflecting on the current economic crisis:

Unfortunately the beginning of the discussion is a little disorganized, but it gets better at around 12 minutes.

Nassim Taleb is a financial trader and scholar and the author of the books “Fooled by Randomness” and “The Black Swan.”

Daniel Kahneman is a psychology professor at Princeton, Nobel Prize winner in economics, and the author of the seminal book on cognitive biases “Judgment Under Uncertainty.”

Five Ways to Think Differently About America’s Financial Crisis

Listening to this discussion, I draw five major points regarding the causes of Wall Street’s economic crisis and the problems with Washington’s response:

1. Banks and Politicians Misunderstand the Risks of Rare Events

Nassim Taleb and Daniel Kahneman argue that the true cause of our current economic crisis was not just the nation’s “housing bubble” or the derivative investments based on it, but Wall Street bankers’ and Washington politicians’ fundamental long-term misunderstanding of the concept of risk.

In Taleb’s book “The Black Swan” he develops the metaphor of the life of a turkey to describe the problem of trying to make future predictions based on the data of past events when faced with rare, but catastrophic, risk:

Taleb’s Turkey Metaphor: “A Turkey is fed for a 1000 days—every day confirms to its statistical department that the human race cares about its welfare ‘with increased statistical significance.’ On the 1001st day, the turkey has a surprise.”

The Fate of Today’s Banks: “The graph above shows the fate of close to 1000 financial institutions…The banking system (betting AGAINST rare events) just lost…trillion[s of] dollars…on a single error, more than was ever earned in the history of banking. Yet bankers kept their previous bonuses and it looks like citizens have to foot the bills. And one Professor Ben Bernanke pronounced right before the blowup that we live in an era of stability and ‘great moderation’ (he is now piloting a plane and we all are passengers on it).”

The problem with this misunderstanding of risk is that the fundamental economic principles underlying America’s banking industry were to make steady profits day after day by placing large, highly-leveraged bets against the possibility that rare, catastrophic events would ever occur.  Our banking and investing infrastructure (including public policies and regulations) supported the idea of consistently making money in the short term, because the risk of long-term collapse was unlikely.

The primary problems with this line of thinking are (1) no one can know when the collapse will come; (2) given enough time, rare events do eventually occur; and (3) big bets against rare events DO WORK day after day after day, until one day they blow up.

Experimental psychology has shown that humans prefer small gains over time to one big payday and conversely prefer one big loss to a series of losses over time.  This psychological inconsistency reinforces people’s beliefs in the theories underlying our current financial system.  Taleb calls this the phenomenon of “bleeds versus blowups.”  Society prefers people who are successful most of the time, even if they occasionally lose big, to people who are consistently losers, but occasionally win big — even if the net gains and losses for each are the same.

The cause of our economic crisis was not the housing bubble or even the complicated derivative instruments, but the fact that their risks were misunderstood by the banks and regulators that created them.

2. Wall Street and Washington Created a Dangerous Financial Monoculture

A second problem is that Wall Street and Washington have created a financial “monoculture” — an entire economic infrastructure built almost entirely on the same sources of risk: more and more money held by fewer, larger banks, all highly-leveraged on the exact same set of derivative investments.  When an entire system is built around a single idea (or single source of risk) — and that idea turns out to be exactly wrong — the system collapses.

The concept of monoculture comes from the idea that a farm planted with all the same variety of crop is at risk of complete collapse if a disease catches that crop.  This same problem of monoculture effects things like software viruses (when a single Windows virus can put almost all computers at risk) and manufacturing (as seen in the current peanut butter recall where products all over the country are sourced from a single facility).

Here the problem was that every major investment bank had taken the exact same risk against a specific rare event.

They did this primarily for two reasons: (1) almost all economic “experts” and investment bankers were schooled in the same theories and models; and (2) the incentive structures consistently in place throughout the market encouraged investment managers to seek high short-term gains, with little incentive toward long-term stability. (For an example of these two issues at play, see Taleb’s favorite case study: Long-Term Capital Management).

Washington regulators — especially Federal Reserve Chairmen Alan Greenspan and Ben Bernanke — helped to make this system more fragile by encouraging major bank consolidations — thus creating this monoculture.

We saw a major turning-point in the last few months when Alan Greenspan confessed that his theory of the world was wrong: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”  The problem is that financial institutions are simply collections of individual agents all operating with short-term incentives.

3. Financial Systems Need Redundancies

This financial monoculture has created another industry-wide problem.  Because large, publicly-trade banks had to compete with each other for analyst recommendations, every bank had short-term profitability as its primary motivation.  This narrowly-focused incentive structure discouraged investment managers from hedging their long-term risks through the use of insurance or redundancy.

Banks could have used a small percentage of their short-term profits to purchase options or other hedges on the rare possibility of extreme loss, but such a move would have made them comparatively less profitable than competitors.

In this case, the extreme competition among a small number of nearly-identical entities created a “race to the bottom” whereby any insurance or redundancy would have driven away investors – all of whom wanted short-term profit maximization.  This race to the bottom, did create extremely efficient short-term investment vehicles, but at the cost of extreme fragility and risk.

4. Bankers Keep Their Profits, We Pay Their Losses

The existing financial system has created a  “moral hazard” problem.  Moral hazard is the idea that a person tends to behave less carefully if they are insulated from the risks of their decisions than they do if they know they will have to bear the consequences of their actions.

In the current system, bankers were (and are) rewarded with huge bonuses for meeting or exceeding their short-term annual profit goals, but when it turned out that those short-term profits were derived from placing big, risky bets, and the system collapsed, the banks (and bankers) were bailed out by the Federal Government (on behalf of regular taxpayers).

These financial institutions didn’t have to bear the marginal cost of insuring against extreme risk because of this moral hazard — they could act recklessly, knowing full-well that catastrophe would be insured by the general public.

As Taleb describes it, this created a system of “capitalism for gains, socialism for losses” — when bankers MAKE money, they get paid (big), but when they LOSE money, we pay (big).  This incentive system creates perverse incentives related to short-term reward derived from long-term risk.

It is worth noting that — Obama’s temporary limits on executive pay aside — this short-term incentives payment structure continues to exist in America’s financial services industry.  For instance, we have not yet learned the ramifications of the broken hedge fund 2+20  incentives structure.

The main problem with the moral hazard of bank bailouts is that since bankers and investment managers don’t bear personal consequences from placing money at extreme risk, they are actually acting RATIONALLY as individuals when they do so.

For example, check out Taleb’s Facebook Group: “Make Bankers Accountable” accusing Citibank executive (and former Clinton Treasury Secretary) Robert Rubin of making over $100 million by putting the world’s largest bank in extreme risk — and then being bailed out by taxpayers.  It’s hard to say that a guy making $100 million should feel like he did anything wrong — he did what the system encouraged him to do.

5. When a System Breaks, Change It

Taleb concludes his discussion with two pleas: (1) financial services executives and regulators should all be fired — to actually face consequences for their actions, and (2) business schools should reassess their curricula, most of which teach a set of economic theories that created our financial monoculture.

When the people running our financial system have failed and their theories have been proven wrong, the people and their theories must be replaced.

Taleb argues that the American banking system should be nationalized, so that regular people’s savings and retirement accounts aren’t leveraged against risky investments.  He argues that simple savings-and-loan banking should be run by the Federal government, with no profit or competition incentives. He suggests that risky, leveraged investing should be done through private hedge funds — but then NEVER bailed out.  The idea is to separate most people’s desires for long-term stability from the minority of investors seeking riskier short-term gains.

Regardless of a bank nationalization plan, all the regulators and executives (Geithner, Bernanke, Summers, etc.) involved in the recent crisis need to be fired.  We have had a system run by people with a certain set of economic theories.  Their theories have been proven wrong.  Yet they continue to run our economic system.  Worst of all: because their economic theories do indeed result in day after day of short term profits, we are easily lulled into letting them remain in charge.  Their theories WILL look stable for a long time, until one day it again BLOWS UP.

Similarly, Taleb argues that business schools should pause their teaching and reassess their theories before graduating another class of students steeped in the economic theories that created this mess.  Taleb has called for a boycott of any business school that teaches modern portfolio theory. His argument is that no business school is better than a destructive business school – theories only have value if they outperform no theory.

Where Does Our Economy Go From Here?

I am glad to see that some of these ideas are beginning to gain acceptance in mainstream thinking about the American financial crisis.  If ever there was a time to reassess our ways of doing things, now is that time.  When Kahneman and Taleb find themselves at the elite Davos World Economic Forum, arguing their viewpoint before world leaders, it makes me optimistic that maybe we can find our way.

Here’s my recommendation.  As you hear about upcoming bailouts and stimulus packages, assess whether these issues are addressed:

1. Does the plan acknowledge the existence of FUTURE catastrophic risk? Or does it create a system where this same problem could arise again?

2. Does the plan provide for DIVERSITY in (1) recovery methods, (2) financial institution types, and (3) economic theories? Or does it perpetuate a few small institutions driving our economy with a single philosophy and a narrow set of investments?

3. Does the plan call for INSURANCE and redundancy – requiring that future investments are hedged against extreme risk? Or does it put all of our proverbial eggs in a single basket?

4. Does the plan create an appropriate system of rewards and consequences, making decision-makers ACCOUNTABLE for the risks that they take? Or does it create a situation where firms could be bailed-out again if (when) they fail?

5. Does the plan CHANGE the people and theories that have been running the economy? Or does it allow those who crashed our economy to keep driving our economy?

Bernard Madoff Even Scammed Other Scammers

Bernie Madoff Auction

One More Reason Bernard Madoff Succeeded: Investigators Didn’t Investigate

Now that Bernard Madoff is being investigated for allegedly running the biggest ponzi scheme fraud in history, lots of people are trying to figure out how he was able to get away with it for so long.

One clue as to how he got away with it and what little oversight or critical analysis goes in to vetting major investment advisors can be found in the example of hedge fund Access International Advisors (AIA).

AIA’s founder lost $1.4 billion in client money through his investments with Bernard Madoff before commiting suicide in December.

How does a major hedge fund get tricked into losing $1.4 billion? By having an already-useless investigation and due diligence process – and then not even using it.

The AIA hedge fund had a due diligence process for vetting potential investments. This due diligence process included handwriting analysis, also known as “graphology,” to investigate whether investment advisors were skilled and trustworthy enough to handle large investments. However, because of Madoff’s strong reputation on Wall Street, AIA decided it didn’t need to perform its standard investigation before investing with him.

As Risk Magazine reports: “[I]t’s not even that they used graphology… in order to assess investment prospects… It’s that they didn’t even bother to use graphology when they thought someone was an nice guy. Their due diligence process was, essentially, ‘are you a decent chap? If not, do you at least write with the letters all sort of wiggly?’”

But what if they had followed their standard practice of performing handwriting analysis on Bernard Madoff?

Handwriting Analysis Is Not an Investigative Technique or a Science – It’s Pseudoscience and Fraud

Let’s be clear here: in common language there are two types of “handwriting analysis.”

The first, otherwise known as “forensic handwriting analysis,” or “questioned document examination” is a scientific discipline, used regularly in courts of law, whereby experts examine documents to detect forgeries or to try to match handwriting examples to identify people. This is a valid – though still occasionally inaccurate – profession.

Expert forgery analysis should not be confused with its insidious step-child, otherwise known as “graphology,” which is a form of pseudoscience (a practice that claims to have scientific merit, but fails to demonstrate scientific verifiability).

Graphologists claim to be able to draw conclusions about a person’s personality based on characteristics of that person’s handwriting. Based on the size, shape, slant, loops, and compactness of one’s handwriting, “handwriting analysts” claim to know whether someone is confident, introverted, risk-taking, injured, mean, or hard-working. Peer-reviewed studies of graphology have concluded that it lacks validity.

Yet major corporations continue to use “handwriting analysis” as part of their HR hiring practices and, as in the Bernard Madoff example, to determine whether someone can be trusted to invest billions of dollars for them. Think of what’s happening here: a job applicant (or hedge fund manager) could be selected or rejected because her sloppy handwriting convinced a “handwriting expert” that she was an “extreme extrovert”, or a very “risk-averse” person.

Don’t believe me yet?

“Michael Shermer Explores Graphology” Videos

Watch this series of two short videos as Michael Shermer, the editor of Skeptic Magazine and author of “Why People Believe Weird Things“, tests the abilities of a professional graphologist:

The Michael Shermer handwriting analysis investigation continues in this second short video:

Graphologists Exist Because Graphology Triggers Our Confirmation Bias

After watching these videos, I think it’s reasonable to say that you could be left unconvinced that Shermer had done a thorough job of debunking graphology. Every test subject seemed somewhat pleased with their readings, and at least one thought the reading was quite accurate.

So doesn’t that mean that graphology might actually work?

Remember the example at the beginning of the first video of the employee who was going to “blow up” because of a medical condition, and it turned out to be true? That’s seems pretty convincing that graphology can work.

Here’s the problem with that line of thinking: The graphologists makes broad, generalized statements (”likes to do things sequentially”, “embarrassed if other people see her get emotional”, “man of action”, “learns best by reading and studying”, “not sure of his place in the world”) that could apply to just about anybody – which is why people saw accuracy even in readings about other people. An “analysis” that tends to draw broad conclusions that are accurate for most people, isn’t really a useful analysis.

But there’s a bigger problem: The graphologist also always makes a large number of predictions, some of which were accurate, some of which were not. The first woman in the video is told that her handwriting indicated that she grew up with an absent parent and that her mother had died. It turned out that her father had been “absent” while she was growing up – in that he worked a lot – but that it was her father – not her mother – who was dead. The woman interpreted the “absent parent” comment to fit the facts, and decided the other prediction was close, even though the identity of the parent wrong. [Note: A prediction of an “absent parent” is one that is vague enough to fit almost any person’s childhood and a large percentage of middle-aged people will have at least one parent who has died].

Graphology “works” because of what’s called a “confirmation bias” – the tendency of people to focus on facts that confirm their predictions, and discount facts that contradict their beliefs.

This is the same method psychics use in their readings.

First, we are told to believe that the “expert” has a special skill. Then the “expert” provides a large number of “cold” statements, which could be generally applicable to most people. The “expert” follows with “warm” statements – specific predictions – which are altered to fit the facts (”Your mother died?” “No, it was my father.” “I knew I was seeing that a parent had died.”) The “expert” always makes sure we direct our focus on the statements that we accurate, but doesn’t mention – or changes – the predictions that were false.

My conclusions:

1. No wonder people can commit fraud for billions of dollars when prospective investors choose to skip their due diligence if someone just seems trustworthy.

2. No wonder our economy is in crisis when major American corporate hiring and investment decisions are based on the “predictive” whims of charlatans.

Your Finger Length Determines Your Ability to Make Money?

finger length

When (Not Very) Good Reporting Goes (Extra) Bad

So there’s this news story zooming around the world right now.

Maybe you’ve seen it or heard about it.

First, some high-profile researchers from Cambridge University in the UK last week published an article, “Second-to-fourth digit ratio predicts success among high-frequency financial traders” in the journal Proceedings of the National Academy of Sciences (”PNAS”).

Two days later, the story was reprinted in The Economist as, “Digitally Enhanced – Successful financial traders are born as well as made.”

Then, this morning, the Economist story was reprinted in the Star Tribune as, “Looking for a winner? Check the ring finger – Cambridge study shows: successful financial traders are born as well as made.”

The study found that men working as “high-frequency” stock traders often had longer ring fingers than middle fingers – a trait that is known to be a sign of high levels of testosterone. The articles then drew the conclusion that a useful way to find out if someone is good at making money is to measure their fingers.

Here’s my beef with all of this.

I’ve read the Economist and Star Tribune articles and the abstract from PNAS, but full text PNAS articles require a password, so I haven’t read the full version of the original study

The Problem of Sample Size and Source

The study that claims to have drawn scientific conclusions regarding all “high-frequency” traders sampled a recruited group of 44 people from a single trading floor with 200 people total. That is, there is no indication that this group was at all randomized, or representative of the makeup of any other trading floor in the world. Also, even if it were 44 random people, that doesn’t seem to me like enough people to draw useful medical or statistical correlations.

The study makes it very clear that trader “experience, counted for a lot.”  I can’t figure out how a study can use such a tiny sample size, which finds one strong correlative factor (experience),  and still draw any conclusive findings related to the correlation of another far-weirder factor.

The Problem of Specialty Generalization

Next, though the original study makes clear that they were only analyzing the limited sub-group of “high-frequency” traders, the news reports made the much broader claims that “successful financial traders are born as well as made” and that “making money comes naturally to some people — specifically to men exposed to high levels of testosterone before they were born.” It should be totally obvious to anyone that even a valid study of “high-frequency” traders doesn’t by logical extension make any claims about “successful traders” generally or even worse, people good at “making money.”

The Problem of Survivorship Bias

Survivorship Bias is the logical error of drawing conclusions about an activity based only on data related to those successful at the activity, while ignoring data related to anyone who attempted the same activity, but failed.  Here, the researchers only studied current traders’ fingers, not the fingers of anyone who had failed in the same role.  If they were to do the additional research and find that failing “high-frequency” traders also have long ring fingers, then maybe finger length/testosterone predicts for an interest in that kind of work more than predicting for success in that work, as both the study and articles claim.

The Problem of Hindsight Bias

Hindsight Bias is the logical error of drawing conclusions about future success based on past success. This concept has tremendous application in the field of finance.  In this case, the study and the article drew the conclusion that because these traders had been successful in the past, that they were, therefore, going to be successful at the work in the future.  That is, they explicitly made the claim that 44 people who have been successful at this kind of trading were therefore talented at it.  Is it possible that “high-frequency” trading takes a tremendous amount of skill?  Certainly.  Is it also possible that “high-frequency” trading just takes a lot of luck and the “survivors” that were sampled happened to be the lucky few? Seems possible.  The big problem is, this question is not addressed.  We are just told, as fact, that “success” at this kind of work is a game of skill, not chance.

The Problem of Drawing Practical Recommendations from Scientific Research

Journalists know that most people who read their articles (especially in science reporting) will assume that the whole article is based on valid scientific study. These journalists know that very few readers will ever bother trying to find and read the original study. Yet, here these articles try to convince people that maybe they need to start worrying about the finger length of their family’s financial advisor or banker. This crazy-generalized claim is never made in the original study, but it certainly helps a newspaper editor get excited about publishing the article. Shame on them.

This is all to say that (1) I’m highly skeptical of the original Cambridge study; (2) I’m disappointed in the mainstream media who report on these findings and draw their own conclusions from it, without showing any skepticism themselves; and (3) it’s made worse when media outlets republish other’s flawed reporting without any original analysis on their part.

Am I being too harsh? Probably.

But if you’re interested in learning more about cognitive biases, logical errors, and financial trading, I highly recommend Nassim Nicholas Taleb’s book “Fooled by Randomness.”

For an overview of Taleb’s theories, check out Malcolm Gladwell’s New Yorker article, “Blowing Up.”