Tuesday, June 07, 2011

Decision Making v. Risk Analysis

In the decision making process, it is common to weigh risk against reward.

In this article I ask: "Which is more important: The distribution of decision making or the form of risk analysis?"

I hold that the distribution of decision making of greater importance.

Modern thinkers tend to hold that risk analysis is more important than the distribution of the decision making process.

My first observation is that most of our decisions don't involve a substantial risk. For example the decision between polka-doted wallpaper and zebra-striped wallpaper is a decision of aesthetics. They both cost the same and they both look fabulous.

The decision between the Mexican Restaurant and Chinese Restaurant does not involve risk analysis. Some might argue there's a risk involved in going to the sushi bar.

I argue that the defining characteristic of the free market is the distribution of the decision making process. In the free market, the decision making process is pushed to all of the free minds actively engaged in the market. In a working free market people, people are involved in an ongoing process of adjusting the property they own.

The process of adjusting one's personal property involves weighing risk and reward. However, I find that the process of the free mind is much more about defining one's values than it is about the mathematical analysis of risk.

Of course, all important decisions involve risk and reward. So it is possible for an economist to draw up an economic model that claims we are all entrenched in an epic dialectical conflict between risk and reward.

For the last half century, economists and investors have been obsessed with risk.

We've developed a massive grab bag of tools to analyze and mitigate risks. The tool bag includes insurance, hedge funds, government backed insurance for mortgages, mortgage backed re-insurance, CDOs, credit default swaps, centralized exchanges, short selling, and a plethora of derivatives.

The economic collapse of 2008 shows that when we put all of these tools together, we simply created an unstable house of cards that undermined the productive sector and while making a small number of people incredibly rich.

This modern emphasis on the dialectical conflict between risk and reward seems to have led to a top instable market.

Our efforts to analyze and mitigate risk led to top down centralized solutions that actually created deeper systemic risk than we would have epxerienced in a true free market.

In my opinion we would do well to drop our obsession with the dialectical conflict between risk and reward and concentrate instead on finding ways to distribute the decision making process.

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