Zeroing Out

Related to (Eliezer Yudkowsky at Less Wrong): An Equilibrium of No Free Energy

Related to (Satvik Beri at Less Wrong): Competitive Truth Seeking

Follow-up to: Leaders of Men

I

Markets

Suppose you have an insight about Google. The efficient market hypothesis says you can’t make a profit. Your insight is not a new insight. The market has already priced it in. You know no more about Google’s future price than you did before.

That’s the bad news. That’s also the good news: If you didn’t have that insight , you wouldn’t know any less about Google’s future price. Efficient market!

I call this zeroing out. Your ignorance is not punished.

This means any unique knowledge you do find will be rewarded. If you get good Google news first, you don’t need to know anything else. Buy, buy, buy!

From Leaders of Men:

It is much, much easier to pick out a way in which a system is sub-optimal, than it is to implement or run that system at anything like its current level of optimization.

A corollary of this:

It is much, much easier to find a bias in a complex model, than it is to build an equally good model.

“I built a better model of Google’s future profits than the market” is a hard sell. “I found a factor the market isn’t properly accounting for” or “I got this news and figured out what it means before the market could price it in” is still a tough sell – it’s Google – but it’s less impossible.

Taking difficulty down, consider odds on the winner of a football game. Both tasks are now realistic. You would still have a much easier task figuring out “Alabama wins more often than people think” than “Alabama is 95.3% to win.”

The easiest way to beat consensus opinion is to use consensus opinion as an input.

It’s easy to beat the wisdom of the crowd a little – average your opinion into the crowd.

II

Hiring

Hiring an engineer is trickier. Assume a consensus interview process.

Satvik suggests focusing on finding candidates like Bob, who does poorly on interviews but is an excellent employee, rather than candidates like Alex, who is an excellent employee and also an excellent interview. Alex likely won’t take the job, but Bob will. Alternatively, demand for Alex is higher, so Alex’s market price is higher than Bob’s. Optimize for finding Bob.

The problem is Charlie. Think this guy. Charlie interviews badly and he’d be a terrible employee. You do not want to hire Charlie, and he’ll take any job he can get. The consensus interview process correctly exposes Charlie’s awfulness. Your process failing to reject Charlie would be very bad, and most applicants are Charlies.

If you started with a standard ‘consensus interview process score’ from a central interviewing firm, you could look for signs of bias in that process without understanding the process. You don’t have that.

If a flaw is caught by the consensus process, and you don’t check for it, you’ll end up with a lot of people with that flaw. Sometimes that’s good – the flaw is quirky and meaningless – but usually this is bad. By checking for such flaws, the consensus forces you to check for them, even if they are rare. If everyone else tests for cocaine addiction, and you don’t check, you’ll hire a lot of cocaine addicts.

You get favorable selection for Bobs, but adverse selection for Charlies.

So you ask coding questions, check references and so on. You redo all the work to regain the missing signal from the consensus. You also need to identify the kind of ‘bad at interviewing’ or other feature that the consensus punishes more than it should.

You have to build the entire model of Bob to know he’s Bob and not Charlie. Much harder.

The ‘score of 0’  from using the consensus method starts to look good. You can do better, but doing even that well is hard!

III

Buying Cereal

You decide to buy Cheerios. There are three box sizes.

If the boxes are priced ‘correctly’, you know that the small box costs more per ounce than the medium box, which costs more per ounce than the big box.

Knowing the price is ‘correct’ simplifies things greatly. If you currently have a high value on a small box – maybe you have little storage space, or are trying a new brand – you can buy a small box. If you can properly use a bigger box, you can buy a bigger box and save. No math required.

Then one day producers realized we were relying on such heuristics, so they started using mixed strategies. Usually they would price the boxes naturally, but sometimes the bigger box would be more expensive per ounce, or the small box would cost almost as much as the big box.

In the first case, we could rely on bias – which solution worked relatively better for us? In the second case, we have to build a value model complete with numbers. Much harder.

IV

One to Zero

Zeroing out is a wonderful thing. Where you have measures and signals that are sufficiently credible, you can abstract all aspects of a problem away except the ones you care about.

In the Google example, we can zero out everything at the start, allowing us to safely bring in genuine new information (if we somehow had that), or to decide whether we want to own shares in a company like Google.

In the cereal example, we could zero out everything except box size versus price per ounce. Products were identical. We prefer to zero that out too, but found we couldn’t safely do that.

In the hiring example, our goal is to zero out employee quality so that we can isolate and model interviewing skill. What we actually care about is interviewing skill given employee quality. We must establish the virtual market price for the employee’s quality first. Then we look at skill.

This illustrates the danger of adverse selection when modeling prices. We can think of interviewing as generating a fair price for the new employee, and comparing to market price. If Charlie is a cocaine addict, and you don’t know that but the market does, you’ll reliably overpay for lots of Charlies.

Attempting to form a model from scratch creates a burden of omniscience. You have to throw out all the social information. Every mistake you make and everything you overlook punishes you. Combined with negative selection this leads to many costly and embarrassing errors. Thus it is often right to abstract away as much as you can, or copy the consensus view or method in most aspects, to focus where you can improve. Often one must fully model the existing system, even its mistakes, to understand what its outputs mean – if you know that something costs $50 but ‘should’ cost $75, you’ll know something is up, and shouldn’t decide how much you value the product until you’ve found that missing information.

Advertisements
This entry was posted in Economic Analysis, Rationality and tagged , , , . Bookmark the permalink.

6 Responses to Zeroing Out

  1. Peter Gerdes says:

    Great post! Makes me wonder why we don’t have something like interview firms that perform a single interview/resume evaluation system much like the SAT system. As your post points out even if imperfect such a system could offer a great deal of value.

  2. Pingback: Rational Feed – deluks917

  3. benquo says:

    As I understand it, your argument is that the efficient market hypothesis can be used to make it easier to make money, under some circumstances. If you have private information about an asset (favorable or unfavorable), and pricing is efficient, then you expect to make money (going long or short respectively) with no additional information about the underlying price of that asset. In other words, arbitrageurs make money on anticipating expected changes in relative pricing, not on knowing the true value of things.

    What makes employment decisions hard is that there is no analogue to the public market-clearing price, so instead, in order to use private information, you need to be able to approximate what the baseline market decision would have been.

    (Comment cross-posted from LesserWrong)

    • benquo says:

      An additional complication it might be worth disentangling: in employment, you aren’t purchasing for resale, you’re purchasing for use.

    • TheZvi says:

      I agree that this is the central concept – sufficiently good markets allow you to ‘get away with’ not knowing things. However, I don’t think it’s necessary to think of it as arbitrage. You can certainly make money faster/better in many cases by selling/covering once your information is priced in, but buy-and-hold or buy-and-use (e.g. the non-stock examples) works too. Being able to ‘trust’ the prices in an important sense lets you go about your day.

      (By default I’m going to respond here rather than LesserWrong when I can)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s