applications of financial ideas to everyday life
The capital assets pricing model (CAPM) was developed by Bill Sharpe in 1964. The basic idea is, your expected rate of return on an investment is proportional to the risk you take:
The derivation of CAPM assumes a lot of things, for example that you are on the “efficient frontier.” The efficient frontier means you will maximize your returns if you make smart risky bets. For example, playing russian roulette is extremely risky, but it only pays off if you’re a character in the Deer Hunter -otherwise Russian roulette is very far from most people’s efficient frontier.
Like most “laws” of finance, CAPM is only approximately true, but it is still a broadly useful model. If you look at stocks with big rates of return, and run the machinery, you see that they have a high beta: a high risk versus the market average risk. It’s easier to think about with a concrete example: if you bought GE shares in 1998 and sold them in 2007, you’d make a little money. If you bought Ebay shares in 1998, you’d have made bank. Of course, you may have bought Pets.com in 1998, in which case you would have lost your entire investment. Both Pets.com and Ebay were inherently risky propositions, as nobody really knew if they were ideas which would take off, let alone of they were well run companies. If you gamble on risk, you might get a big payout, or you might get nothing.
People make a big deal about the philosophical implications of weird things in physics. For example, the seeming psychedelic unreality of quantum mechanics is often used by mush-headed people to justify whatever solipsistic spiritual nonsense they believe in. This was great discovery to me when I was a dorky grad student. When I discovered that women who believe in “new age” ideas will find you incredibly interesting if you mention Hilbert space, I’m pretty sure Alzo Sprach Zarathustra was playing in the background, like when the Ape-man in 2001 discovered that you can kick ass using bone clubs. At last I found a way to use Hilbert space for something in my everyday life! I’m pretty sure my discovery is the source of all the quantum mechanical mystical gobbledygook out there; surely other people noticed this as well. Certainly my theory makes more sense than the idea that quantum mechanics as weird mysticism has anything to do with actual reality.
“This is what it was like when I discovered an application of Hilbert space to everyday life!”
Regardless of the prurient uses of Hilbert spaces, the fact of the matter is, life is a lot more like finance than it is like misunderstandings of post 1920s physics. Finance is a purely human endeavor, so you’d expect the laws of finance to have some bearing on everyday life.
In ordinary life, CAPM is a useful law. People who take risks have more rewarding lives than people who don’t. People who don’t take risks end up living lives with the consistency of bland porridge, and are often struck down by the chances of fortune no matter how hard they try to live an orderly life. I am pretty sure that the only time your life will be risk-free is when you are dead, sort of like your financial life is only risk free when you have no money. The closer you get to a risk free life, the closer to waiting for death you are. It’s an odd phenomenon that people who live in modern societies are so often miserable. I used to think it was because life was too soft. Now I think it’s more related to the fact that modern life doesn’t contain enough perceived risk to make it seem worth living. Human beings are adapted to a world of random chance; we like taking chances. Deprived of chance, we become miserable.
Most people don’t think of themselves as gamblers; they prefer to think of themselves as people who make deliberate and rational choices in a deterministic world. Modern society is set up to give us all the illusion that we can be protected from all risk. Tort law in America is set up with the assumption that everything works in a Cartesian fashion, for example. There is very little allowance for randomness and fate: someone or something is always held responsible for bad things. The way modern people think about life, if you don’t eat enough broccoli, you’ll die of cancer, or if you eat too much bacon, your heart will explode. The reality of things is you will probably die of cancer, stroke or a heart attack no matter what you do. If not, you got into a car wreck: driving cars is a risk most people willingly take which is much more serious and deadly than eating bacon.
Similarly, people misunderstand the role of risk and randomness in their professional lives. Most people, for example, get jobs. A job seems like a relatively risk-free lifestyle. Jobs certainly remove virtually all upside potential, so you’d expect to be compensated with lower volatility. I think a lot of people are now finding out they mis-calibrated their job volatility risk. Is a job on the efficient frontier? Probably not as often as you might think. For example: if you attempt a career in physics in the 21st century, your chances of having a nice life are fairly low. The probability of actually getting a job in physics is fairly low. Even if you manage a job in physics by being lucky, marshaling all of your military and naval power, and having no life for a couple of decades, you’ve basically gotten yourself a job which pays about the same as being a cop or an auto mechanic (I know: I’ve done all three). Job security … well, tenure appears safe for now, but I’m of the opinion that higher education is another speculative bubble: so, best of luck with that. Some might argue that the potential for great discoveries outweighs all these low expectations; guts for glory as it were. By my calculations, moving to Hollywood and getting a job as a waiter in hopes of becoming a celebrity has a higher probability of success than hoping to become an immortal in the world of physics. How many great breakthroughs in physics have you heard of in the last 50 years? Can anyone name any? Yet, there are 47,000 members of the American physical society, each one of them at least secretly hoping at one time or another to win the lottery. I guess probability theory isn’t taught correctly in physics grad school. That’s probably a factor in why nobody understands quantum mechanics. A fun irony of all this: their career choice makes modern physicists much more the gamblers than, say, quants. I’d like to think this is because quants understand CAPM.
When you come to appreciate the fact that life inherently involves randomness and gambling, you can start taking risks that make sense. The casino is a great metaphor for life; potentially filled with fun and games, but random and with a mean expectation of zero. Once you understand that your life is governed by the laws of probability rather than Cartesian determinism, it becomes easier to accept the vicissitudes of fate. Once you realize that most decisions in life involve significant risk and uncertainty, you can start making intelligent decisions about your life. Once you understand the applications of CAPM to your life, you can realize your own efficient frontier. People may think I’m some sort of mad scientist for advocating treating your life as a gambling game, but you can see this at work in many individual lives.
If life worked according to Cartesian determinism, you’d expect chess players to do very well in life, and gamblers to do poorly. What we observe in life is the exact opposite. Great chess players who are capable of calculating complex moves many steps ahead have horrible chaotic lives. They think they can plan things and understand the world using determinism, and this world view fails them. Poor Bobby Fischer, one of the greatest chess wizards who ever lived, had a miserable life. His belief in determinism turned him into a raving madman, hardly capable of the simplest of human interactions. Gary Kasparov, a man capable of beating supercomputers at chess, tried his hand at Russian politics and failed miserably. By contrast, the colossi who rest their feet upon the world of politics, finance and industry are gamblers: almost every last one of them. From Julius Caesar to T. Boone Pickens; games of chance have taught great men how to win in life using probability theory. Gambling games teach you to remain calm in the face of fortune and keep your wits about you, as you wait for the right time to place your bets. Autistic deterministic games like chess may train logic and the memory, but they teach you nothing about life.
“It is a great piece of skill to know how to guide your luck even while waiting for it.” -Baltasar Gracian