Economics evolves into evolutionary economics

The July 2009 edition of Scientific American explores new ways of looking at economics in an article by Gary Stix entitled "The Science of Bubbles and Busts." The article explores the growing acceptance by professionals that people quite often are not rational when it comes to dealing with their finances. We are not homo economicus, as touted by many economists, including Milton Friedman. Our imperfections are many. For instance, we are supremely overconfident. We overrate our ability to make decisions in the market. We are also prone to "herding," following the crowd. We are also overwhelmed by our recall of recent events due to the availability bias. We are creatures who are strictly geared to the short-term. As a result of this mounting evidence establishing that we are not able to rationally deal with the market, new approaches are inexorably working there way into economics. These new approaches include evolutionary economics:

“Economists suffer from a deep psychological disorder that I call ‘physics envy,’ ” [MIT professor of finance Andrew] Lo says. “We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor and, as such, should be understood in the broader context of competition, mutation and natural selection—in other words, evolution.

Having an evolutionary model to consult may let investors adapt as the risk profiles of different investment strategies shift. But the most important benefit of Lo’s simulations may be an ability to detect when the economy is not in a stable equilibrium, a finding that would warn regulators and investors that a bubble is inflating or else about to explode.

An adaptive-market model can incorporate information about how prices in the market are changing—analogous to how people are adapting to a particular ecological niche. It can go on to deduce whether prices on one day are influencing prices on the next, an indication that investors are engaged in “herding,” as described by behavioral economists, a sign that a bubble may be imminent. As a result of this type of modeling, regulations could also “adapt” as markets shift and thus counter the type of “systemic” risks for which conventional risk models leave the markets unprotected.

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Michael Shermer talks patternicity and agenticity

In the June 2009 edition of Scientific American, well-known skeptic Michael Shermer discusses human tendencies to find things and agency where they don't actually exist:

Patternicity [is] the human tendency to find meaningful patterns in meaningless noise. Consider the face on Mars, the Virgin Mary on a grilled cheese sandwich, satanic messages in rock music. Of course, some patterns are real. Finding predictive patterns in changing weather, fruiting trees, migrating prey animals and hungry predators was central to the survival of Paleolithic hominids.

Thomas Gilovich conducted a now classic study regarding our tendencies toward patternicity. The subject was the "hot hand" that many people assume that basketball players get. You know . . . give him the ball. He's got the hot hand going . . . But we are also a bit too good at inferring agency:

We infer agency behind the patterns we observe in a practice I call “agent­icity”: the tendency to believe that the world is controlled by invisible intentional agents. We believe that these intentional agents control the world, sometimes invisibly from the top down (as opposed to bottom-up causal randomness). Together patternicity and agent­icity form the cognitive basis of shamanism, paganism, animism, polytheism, monotheism, and all modes of Old and New Age spiritualisms. Agenticity carries us far beyond the spirit world. The Intelligent Designer is said to be an invisible agent who created life from the top down.

Why do we claim to see things that don't exist? Shermer concludes that we are "natural born supernaturalists."

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Statistical illiteracy afflicts health care professionals and their patients

Over at Scientific American Mind Gerd Gigerenzer and his colleagues have published a terrific article documenting the statistical illiteracy that sometimes runs rampant in health care fields. The article, "Knowing Your Chances," appears in the April/May/June 2009 edition. The authors point out numerous medical care fallacies caused by statistical illiteracy , including Rudy Giuliani's 2007claim that because 82% of Americans survived prostate cancer, compared to only 44% in England, that he was lucky to be living in the United States and not in England. This sort of claim is based on Giuliani's failure to understand statistics. Yes, in the United States, men will be more quickly diagnosed as having prostate cancer (because many more of them are given PSA tests), and then many more of them will be treated. Despite the stark differences in survival rates (the percentage of patients who survive the cancer for a least five years, "mortality rates in the two countries are close to the same: about 26 prostate cancer deaths per 100,000 American men versus 27 per 100,000 in Britain. That fact suggests the PSA test

has needlessly flagged prostate cancer in many American men, resulting in a lot of unnecessary surgery and radiation treatment, which often leads to impotence or incontinence. Because of overdiagnosis and lead-time bias, changes in five-year survival rates have no reliable relation to changes in mortality when patterns of diagnoses differ. And yet many official agencies continue to talk about five-year survival rates.

Gigerenzer and his colleagues give a highly disturbing as example regarding mammogram results. Assume that a woman just received a positive test result (suggesting breast cancer) and asks her doctor "What are the chances that I have breast cancer?" In a dramatic study researchers asked 160 gynecologists taking a continuing education course to give their best estimate based upon the following facts:

A.) the probability that a woman has breast cancer (prevalence) is 1% B.) if a woman has breast cancer the probability that she tests positive (sensitivity) is 90% C) if a woman does not have breast cancer, the probability that she nonetheless tests positive (false-positive rate) is 9% The best answer can be quickly derived from the above three statements. Only about one out of 10 women who test positive actually has breast cancer. The other 9/10 have been falsely diagnosed. Only 21% of physicians picked the right answer. 60% of the gynecologists believed that there was either an 81% or 90% chance that a woman with a positive test result actually had cancer, suggesting that they routinely cause horrific and needless fear in their patients. What I found amazing is that you can quickly and easily determine that 10% is a correct answer based upon the above three statements--simply assume that there are 100 patients, that one of them (1%) actually has breast cancer and that nine of them (9%) test false positive. This is grade school mathematics: only about 10% of the women testing positive actually have breast cancer. As the article describes, false diagnosis and bad interpretations often combine (e.g., in the case of HIV tests) to result in suicides, needless treatment and immense disruption in the lives of the patients. The authors also discuss the (tiny) increased risk of blood clots caused by taking third-generation oral contraceptives. Because the news media and consumers so often exhibit innumeracy, this news about the risk was communicated in a way that caused great anxiety. People learned that the third-generation pill increased the risk of blood clots by "100%." The media should have pack is aged the risk in a more meaningful way: whereas one out of 7000 women who took the second-generation pill had a blood clot, this increased to two in 7000 women who took the new bill. The "absolute risk increase" should have been more clearly communicated. Check out the full article for additional reasons to be concerned about statistical illiteracy.

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