Archive for the ‘everyday math’ Category

Synthetic Collateralized Alchemy

Thursday, April 29th, 2010

What Was Wrought

CDO’s (collateralized debt obligations), see this for my introduction to these, depend on underpriced low grade debt. If I can get a 20% discount on debt that has a 10% chance of defaulting, then I should just buy this all day. All I need is enough risky debt (and some confidence in these percentages, but that’s a story for another day). But as CDOs became more and more popular low grade debt was getting used up. Even worse, as demand for it grew its price rose. CDOs were changing the entire ecosystem of low grade debt. There wasn’t enough of it and it was too pricey. There was no profit left. What to do?

One compelling answer was to simply issue more of it. Brokers could persuade people to take on deceptively structured mortgages, that could only get paid back if house prices rose forever. Lousy business plans were funded by people whose sole investment in the debt was they commission they got for issuing it. Dogs were being offered credit cards. These guys made the Glengarry Glenross salesmen seem like saints.

But there’s only so much new low grade debt that this can create and only so low you can go. Enough of it was issued to ruin the economic lives of people who thought they were just buying a house, but not enough to feed the maw.

Alchemy

What there was plenty of was collateralized debt. Some was graded AAA, some graded B. Why not buy these crappy debts and create CDOs? So, we start with $100 of debt that someone was misled into borrowing. We structure that to create $60 worth of grade B debt. Get enough of that and you can create another CDO, with $50 worth of single B tranches, and so on. $100 of crappy debt turns into $300 worth of crappy debt. (I’m making up all these numbers, but the principle is correct.) These were the synthetic CDOs. George Soros (that vicious communist) says pretty much that in April 23rd’s Financial Times.

So why was so much money lost? Why were trillions of dollars needed to prevent an economic meltdown?  It wasn’t because people took out trillions of dollars of mortgages they couldn’t afford. It happened because people got paid, and very well paid, for turning $100 worth of debt into $300 of debt. So they did it again, and again. What did they have to lose?

The Unexpected Cost of Lotteries

Sunday, April 25th, 2010

By definition, the expected value of a one in five chance of winning $10 dollars is worth $2 ($10/5). But to human beings, with our finite life spans and our asymmetric financial needs, a one in a million chance of $1,000,000 is not necessarily worth $1, it might be worth more.

Lottery tickets cost far, far more than their expected value. The amount you would win times the probability of you winning is pretty close to zero. They are, as far as expected value goes, practically worthless.

But despite what Adam Smith says, buying lottery tickets is not necessarily a bad idea. They’re vastly overpriced, but unless I’m already rich the difference winning $1,000,000 would make to my life is worth far more than the extra $1 I’m getting charged for my ticket.

Given the choice between $2 and a one in a million chance of a million dollars, I know which choice is more exciting. The poorer I am the more enticing that is. (If I’m well off I have many more, and better, opportunities to make money.)

The injustice of lotteries is that they exploit the perfectly natural assumption that if buying one ticket is a good idea buying 20 is 20 times better. But Adam Smith is right again: buying all the tickets would guarantee that you won the lottery and lost a fortune.

Lotteries are not a tax on stupidity, they are a tax on poverty and lack of opportunity that exploits an almost universal miscalculation of the effects of scale on risk and value.

They are a lousy form of taxation. If you want more money for schools, roads or, cultural institutions, then raise taxes, or issue bonds. Don’t fund opera from lotteries, that way poor people pay for things they can’t afford to enjoy.

Insurance and Mortality Curves

Sunday, April 25th, 2010

The life insurance business is very good at calculating the probability of you dying within the next year. It’s one of these things that we’ve being doing so long that we’re pretty good at it.

Given your circumstances, they can produce a curve showing the probability of you dying at any given year from then on.

Here is an hypothetical curve of life expectancy at birth. Babies have a higher risk of dying than older children, then it pretty much rises (though far more complexly than the curve below suggests).

morality curve

Given your circumstances

Your circumstances, the things that shape your probable mortality curve, are complex. Your sex, your ethnic mixture, your behavior, your age, (not always a negative, in Mediaeval Venice insurance for a 20 year old cost the same as that for a 40 year old, the 40 year old having proved himself immune to the prevailing diseases). These, and  many other dimensions, contribute to the shape of your mortality curve. Think of it as eHarmony calculating your annualized compatibility with death.

If the insurance companies can calculate these curves accurately enough, can sell enough insurance to even out the risks, and have enough capital behind them that they can survive a temporary run of bad luck, then they can charge a little bit above the real risk, and make a tidy, reliable profit. Paying over the odds can be well worth it for the individual, given the effect of catastrophe, and this can be a perfectly reasonable business. That’s what most of AIG did, and did well.

Insurance companies also have a get out of jail free card: the Act of God. Mortality curves can only take so much into account. If the earth’s crust splits, if a meteor strikes and makes half the planet uninhabitable, if the zombie epidemic finally erupts, or if the river floods (different insurance contracts are more or less inclusive in what they count as Acts of God), then all bets are off.

What Insurance Is

Insurance is a way of sharing risk. If we each have a one in a thousand chance of our house burning down, and we all pay two thousandths of the value of our house, then all things being equal, the people whose houses burn down will be paid back, and there’ll be some money left over as recompense to the people who set up the deal.

But insurance can’t reduce risk, it can only share it. And probabilities can only be calculated based on an enormous number of assumptions. The reliability of these assumptions is up for grabs. In the financial world the invisibility of these assumptions can have dire consequences. I shall take this up again in an overdue discussion of Credit Default Swaps.

"Show Your Working"

Saturday, April 4th, 2009

One of the many things that makes math difficult to learn is the seemingly universal reluctance to be comfortable with incomplete thoughts. In math terms this translates to “write down you’re intermediate results”. Kids hate to do this.

If you ask them to do a multi-step problem it is an enormous struggle to get them to write down intermediate results. This, of course, makes it much, much harder to get to the final result. Trying to add two numbers together while remembering a third is so much harder than just adding two numbers. Why is this hard to learn?

I suspect it is evolutionary. Externalized memory is evolutionarily recent. As a survival skill it has been of no value until relatively recently (even Socrates despised writing as something that weakened the reason, rather like the current argument that Google rots the brain). Human beings like to take in the whole picture at once.

Given that this is a more or less universal problem in teaching math I think it’s reasonable to assume that this is a reluctance that is genuinely difficult to overcome. There have been plenty of great math teachers (not enough to distribute adequately, of course, but a large number nonetheless). If there was some teachable trick – teachable to teachers, that is – that could convince students, at an early stage, of the value of externalizing intermediate results, then someone would have figured it out. (This is an obvious area for empirical research.)

Instead we have generation after generation of math teachers, themselves all too often under-trained, and unaware of the existence or implications of short term memory limitations trying to browbeat children into following a rule none of them really understand.

Those who go on to advanced mathematics are generally either docile enough to have done what they were told, or had capacious enough short term memories to get by until they finally figured out the value of externalizing intermediate results. An article in the New York Times covered some interesting research on innate number sense and its correlation to achievement in mathematics – about as surprising as a correlation between hand eye coordination and achievement in sports.

Dijkstra, the programming genius, once wrote: “The competent programmer is fully aware of the strictly limited size of his own skull” This awareness generally involves painful experience, and more time than can be fit in a school math curriculum. It certainly involves far more comfort with error than most school boards have.

 

The Punchline

If I don’t know the answer to the teaching problem I do know an implication of this for the reporting of mathematics in the public sphere: make minimal demands on the reader’s short term memory.

People can compare two charts. They can’t remember one chart while looking at another. In fact most people can compare dozens of charts – as long as they can see them all together.

No one I know of does this better, on a regular basis, than Martin Wolf in the Financial Times. Most of his articles are illustrated by a number of charts, all beside each other, most with multiple lines or bars, often in different scales. (Here is a recent, depressing, but illustrative, example.) These are fairly extreme examples, written for a specialized audience, willing to devote considerable attention, and knowledgeable about the subject matter. But the principle holds for any audience. Teachers should keep trying to get the damn kids to record their intermediate results. Those trying to communicate to the public should know that their audience wont do that. The audience won’t do this work for you. Show them the working yourself.

Simulation and Modeling

Wednesday, July 30th, 2008

Simulation is a wonderful thing. It’s one of the foundations of mathematics.

Scale models are a good example. If you want to see what the new building will look like make a model. It isn’t going to tell you everything, the architectural models of housing projects usually look wonderful, but it’s a great example of using the external world to think for you, of externalizing your brain. Yes, you can read a description and imagine what something will look like, but making a model, reduces how much of your brain that uses, leaving more brain for other things, like deciding whether any child is really going to want to play under the gaze of a thousand anonymous windows.

The power of modeling is real. From the scale drawings my father used to make before decorating the kitchen, to the simulation that demonstrated that the proposed system for baggage handling at Denver Airport was guaranteed to fail horribly. (Unfortunately the simulation, costing a few thousand dollars, was done after the actual system was built at the cost of hundreds of millions, and then millions more in delays.) Dangerous, lengthy and expensive processes can be evaluated for a fraction of the cost of the actual experiment. Some people’s love this new power, others can’t forget what’s being lost.

What’s lost in any abstraction is the specific, the individual, everything that matters. Some people can’t get over that.

Simulations and models only work because they ignore details, knowing whether they are important details can be difficult. A scale model works fine for the forces on a house or a skyscraper, but is hopeless for a ship. Econometric models are notorious for their spurious certainty.

So the practical fitness of a model to it’s purpose is one question, but there are others. For some people it is impossible to imagine the classic absurdist math problem characters “a man”, or “a woman” without some humanity to hang on to. People differ on this.

I remember some fine junior high level course material on date arithmetic. A drawing of a set of gravestones: name, born, died. The question was: how old was each person when they died. One child faced with “James Brown: March 1823 to June 1839″ confounded his teacher by insisting on knowing why Jim died. I don’t share that need, but I rather like it. I’m glad it’s around. If we want to make more people more mathematically adept, this is the kind of fact we need to acknowledge and deal with.

What’s the Biggest Number in the World?

Sunday, May 18th, 2008

They go on forever, of course, but one of the entertaining things about mathematics is its habit of defining and naming fabulously large numbers. This can also be useful. The Romans could barely write down the number of citizens in their empire. These days Roman numerals couldn’t write down the number of people on the planet. Not all number systems are created equal.

Millions

The Roman’s could count up to a few million, which turned out to be enough for them. (It is not a coincidence that people never “need” math that hasn’t been invented yet. That’s for essentially the same reason that programmers never need features the programming languages they know don’t have. It’s hard to think things you don’t have language for.)

Googols

Indian place notation made “orders of magnitude” meaningful – every new column increases the size of the largest number by a factor of 10, and that turns out to be plenty for the physical world. There are about 10^80 elementary particles in the universe. And even if we turn out to be missing 99.999999% of the universe, that still doesn’t takes us to 10^90.

Stupid Big

But while the number of “things” is relatively small, the number of relationships between things grows shockingly fast. If there are 20 people at your party there are 171 introductions to make. If you have four tables of five there is a truly ridiculous 11 billion ways of assigning guests to tables.

Does that matter? Sometimes it does. There are  53,644,737,765,488,792,839,237,440,000 different ways to deal a deck of cards to four players. This is a giant number – at one deal per millisecond that’s still about a hundred million times the age of the universe. And yet, if you play cards you care about this number. This is the basis of card odds in Bridge. Sometimes money is at stake.

Stupid Big, But Still Useful

If you think about it, it is extremely odd that such a practically uncountable number could ever have a practical use. This, I think, is one of the distinctive features of mathematics, and one that can either make it seem pointless – why should I care about numbers so big we can never count them? – or almost supernatural.

Here we have tools that let us calculate numbers so large we can’t possibly count to them, and yet we can reason about them, and come to practically important conclusions. We start in reality – 52 cards – we fly off into a fairy land of numbers so big we sometimes need new notations to write them down, and we come back with a discovery that lets us beat the other guy at poker.

Let’s hear it for fairy land.