Why we dream

This is something that I've been meaning to synthesize for some time now. I've been developing this theory since my (personal) foray into behavioral finance which eventually broadened my interest to encompass cognitive psychology. I would love input from any psychology or biology specialists that might encounter this entry. This is what I sent to my school's psychology research department:


To whom it may concern:

I am an undergraduate economics student at _______. The purpose of this email is to detail a portion of my speculative research in what might best be classified as "computational cognitive psychology", and to determine whether my work has merit or is at all original in the field. Specifically, what I outline below is my view on dreams and sleep, and the utilitarian/evolutionary purpose behind them. Please note that what follows is hardly analytically intense, and experiential methods of research might be difficult to support my claims, if at all possible. In addition, my only formal education in psychology has been through an introductory course, and specific terms I utilize might denote different meanings in formal papers. I am contacting Dr. ____ as I was unable to find a more suitable fit for the research I am potentially interested in pursing further.

NB: The following is quite lengthy and presents a pseudo-abstract of what I would imagine possible further work would entail.

Broad, guiding questions I seek to answer: Why do humans dream? What purpose do dreams serve in conscious states of the human mind?

The amount of cognitive processing the human mind must endure on a daily basis is overwhelming in scope. From a cursory point of view, it must constantly respond appropriately to sensory information and construct a sufficient model of reality to do so. While beings with less cognitive capacity such as insects have been biologically programmed over time to develop appropriate instinctive responses to stimuli necessary to survive, the human mind constructs a far more elaborate and complex view of reality and possesses a higher-level of thought processing by which to view the world.

This allows humans to accept abstract, propositional truths about reality such as a multitude of physical laws that are difficult to experientially observe (the earth revolving around the sun, etc). However, my contention is that a large proportion of modeling is also derived from simulations of artificially constructed realities (simulations of behavioral or social interactions). These are learned empirically, in conjunction with propositional truths (heuristics). For example, an individual driving a car can intuitively accept "rules" governing driving:that the gas pedal moves the car, the stop sign signifies a stopping action, etc. It must also behaviorally learn the various outcomes and consequences any action he can potentially take produces. IE he must empirically learn and experience what to do when a pedestrian jumps in front of his car while he is driving, as the components that comprise this experience are vast in nature, and are inefficiently taught as a propositional truth such as where to position his eyes, whether to keep his hand on the wheel, to take the foot off the gas pedal, etc. Thus, he must be able to simulate beforehand the infinite number of actions (and their implications) he can take in any given situation in conjunction with accepted and broadly encompassing "rules"; this is, in effect, reality.

My hypothesis is that dreams serve as the medium by which humans must simulate these processes and components of reality. The sheer overwhelming scope of possibilities and actions one can take when applying propositional rules is best modeled through simulations in the form of dreams. It allows humans to test outrageous claims as well as possible actions one can take in order to form a coherent model of reality in waking life. It can prevent disastrous outcomes: in the car example, deciding to close one's eyes when a pedestrian walks in front of the moving car could prove to be dreadful. From a computational viewpoint, the only way to construct an appropriate, or perhaps optimal, response is to test possible actions in simulation as the cognitive processing required if one were forced into the situation in reality would be inefficient, inappropriate, or too slow to respond . Dreams serve to establish and construct a set of rules in order to properly map reality and figure out proper behavioral responses.

Although my preliminary research into other professionals' works has implicitly already suggested that (primarily via the work of Dr. Revonsuo) dreams are used as a form of threat constructions (IE simulations that represent potentially dangerous scenarios, "nightmares"), I feel my work is original in that it encompasses a wider range of not only the entire distribution of dreams, but also reality as a whole rather than only threatening scenarios in waking life. In essence, I would argue that dreaming presents a framework for modeling all of reality; this also explains why we have non-threat construction dreams.The reason I might laugh after experiencing a dream in which I am flying with wings (a scenario that I presumably would not need to prepare for in waking life) is that I am implicitly able to recognize that it was a simulation with absurd rules that I can consciously reject in reality; it was merely my mind hypothesis-testing an outrageous possibility in simulation which now recognizes its ludicrousness.

I also hope that potential research relating to this abstract might be able to serve as a possible psychopharmacological remedy to mentally ill patients, primarily schizophrenics. A hypothesis that might be tested is whether dream-enhancing or altering medication might be used as an appropriate treatment for patients that have difficulty differentiating between reality and fiction (perhaps their dream simulations are so vivid that the mind is unable to perceive reality and is unable to control or recognize absurd simulations in conscious life). This might be further supported by the fact that schizophrenics have been proven to daydream in an uncontrollable manner with extreme vividness. Computationally recognizing when it is acceptable to dream might be a prerequisite to mental sanity in at least some cases.

I apologize for the length of this email as well as any inadvertent naivete on my part as once again I have little formal education in psychology as an academic field. Although an evidence based analytical approach to substantiating my claims with rigorous statistical backing might be difficult to accomplish, my hope is that the reader of this preliminary theory views it as a bit more than armchair philosophizing or a creative interpretation of the excellent movie "Inception". Once again, the purpose of writing this email is to determine whether comprehensive research is appropriate to further advance my ideas.

Thank you for taking the time to read this.

Sincerely,
Angad

Preliminary Economic Paper

The impact of economic deleveraging on our nation's growth has long been perceived as prohibitive and worrisome. As consumers and the private sector withdraw unto themselves (reducing aggregate spending and growth), the threat of deflation becomes a real and present danger. It is certainly an infallible truth that the proper remedy to economic stagnation is to increase the overall money supply. Printing and placing money in the hands of economic agents is an established method of incentivizing overall growth; however, the problem lies in the distribution of said money. Empirically we have settled on fiscal solutions to this dilemma and thus we have government-based measures such as bailouts and tax cuts. The inherent drawback in each of these methods is that any fiscal solution in which the government cherry-picks recipients of money or tax relief lends itself to uneven distribution and/or a perception of unfairness. Inevitably, aside from the massive political challenge of legislating a sound solution, one can expect a sizable political backlash from targeted interest groups, inefficiencies in the cost and overhead of implementing such a full-scale project, uncontrollable inflation following the fiscal measure, and even the pursuit of consumers seeking a free bailout through government aid(rent-seeking behavior). In light of these structural barriers, I humbly propose the following:

Allow every taxpayer to receive a loan from the Federal Reserve the amount necessary for that individual to pay his federal taxes at a specified interest rate set by the Federal Reserve.

I will henceforth refer to this program as the "Reserve Loan Program" (RLP). It is well-substantiated that monetary policy offers the ability to radically alter economic climate for at least a temporary period of time, and it is on this principle that RLP resides. Briefly, low interest rates increase monetary base, lower each bank's cost of funds, and thus provides an incentive for consumers to borrow given their decreased long-term cost of taking out a loan. In a stable economic environment, this process lends itself to an increase in money velocity and a stimulant to the overall economy. However, when the risk of severe recession is high, banks grow weary of issuing loans at a lower risk-free rate borrowers are willing to accept as illiquid assets available to them potentially hold more (resale/rate of return) value than new loans banks may issue. In addition to dramatically increasing credit spreads in an environment in which capital market liquidity is already low, banks feel a need to hoard money when the threat of deflation looms as each dollar they hold will presumably increase in value.

RLP avoids such shortcomings by supplying credit directly to consumers rather than through banking intermediaries. It also has the added benefit of leaving no permanent mark on the government's current fiscal budget. While the implications of reducing Federal debt a non-negligible amount is beyond the scope of this proposal, it is at the very least popular with the political public and decreases our obligations to nations and financial institutions we are indebted to. Furthermore, when governmental mechanisms such as bailouts are introduced, an egregious amount of money is shoved into the economy with no way of retrieving it, implying a future threat of soaring inflation following the economic recovery. As a self-correcting calibration tool, RLP automatically restructures itself depending on the current economic climate. When the economy is slumping, and consumers' need for immediate money is high (with banks unwilling to issue out loans at rates borrowers will accept), individuals are likely to accept a loan for their taxes; conversely, when the economy is overheated, the demand for immediate money is low and rational borrowers have little need to request a loan.

Finally, RLP should also function as a substantial source of government revenue if the interest rate is determined at a sufficient and fair rate, as consumers will be paying interest on their taxes should they choose to borrow. Some might argue that RLP further perpetuates the current crisis because individuals and agencies are already indebted and defaulting on current loans. However, it is critical to recognize that RLP is inherently fully scalable: those with the largest incomes (and thus greatest impact on economic climate and government revenue) are the ones receiving the largest loan amounts. In addition, this is not an explicit reason to prefer government spending over RLP; any bailout or government spending mechanism will be implicitly backed by future tax revenue. In the worst case scenario in which consumers default on their tax loans under RLP, future government spending will be implicitly backed by past tax receivables rather than future revenue with no unfavorable externality.

It is my humble belief that RLP can be implemented in a pragmatic manner without endless political negotiation or upheaval. Details such as administration methods, determination of the interest rate placed on RLP loans, and maximum loan amounts can be determined in a manner that is relatively similar to status quo methods by academic professionals. Another objection that might be raised is that RLP necessitates a multi-layered bureaucracy in order to be fully implemented. A simple solution to this might be to merely add an option at the end of a tax return if the taxpayer wishes to take out a loan, thus reducing the need for additional government employees or structuring.

I sincerely wish that RLP may be implemented not only for the current administration, but sets a precedent for future administrations to come. My hope is that this policy can spread even outside the United States to regions such as Latin America where the fiscal remedy to crises often leads to rampant hyperinflation. With the advent of a reliable, stable, and efficient monetary system in recessionary times, governments can focus on larger-scale issues such as global warming, health care, or energy independence.

Optimal Position Sizing

Here I describe a conceptual framework for investing that I call Optimal Market-Neutral Investing (OMNI). I don't believe that it's entirely new - certainly you see people implementing similar schemes and I believe all great value investors understand the benefits of this technique at least to some degree, whether they explain it in this manner or not. Thus, while I came up with it as primarily a prescriptive tool for myself, it's also descriptive of best practices.

Let's first clarify - what does it mean to be market-neutral? Many would describe it as having a balanced position of longs and shorts in such a way that whether the stock market as a whole goes up or not does not, on average, affect, the value of your position measured in your native currency. Yet, clearly you do care what the market does - if the market suddenly decides that the stocks you bought are worth much less and the stocks you shorted are worth much more, you lose a lot of money even if your estimate of the value of your position doesn't change.

My definition is quite different - when I say market-neutral, I literally mean you do not care what the market does. But how could you possibly not care what the market does? It's simple. Say there's some stock X priced at $10 that you think should be valued at $15. In short, you expect the stock price (adjusted for time value of money) should reach $15. So you buy some amount of X at $10, because it's clearly undervalued. But observe this - if the stock goes up to $11, you've realized gain (and would sell some part of your position, reflecting your decreased expected rate of return on the position) and if the stock goes down to $9, your edge goes up, which allows you to add to your position with an increased expectation for that additional purchase. You can solve for the position size at any given price point that leaves you market-neutral, given some set of assumptions (this includes the possibility that price action is indicative of change in value) regarding price and value.

The precise math I feel is not that important (though I may elaborate later). On no stock can we estimate all the required numerical parameters precisely enough for the explicit math to be all that helpful. The point is that for any stock that you feel is undervalued (which implies that you have some ability to compute its value independent of the market price), there's some position size greater than zero that leaves you market neutral. If the price goes up, you realize gains, if the price goes down, you're being given a larger opportunity. While we can't compute this precisely, our intuition - even emotions - can be used to arrive at this number. After all, you know when you care or not. Thus, the position size is precisely the amount at which you're neither rooting for the stock price to go up, nor down.

This is a difficult balance - part of the reason that most people are poor at investing is that people fundamentally like rooting for things to happen. We pick sides when we watch sports, even if we don't have a natural rooting interest. We root for specific people to succeed in reality shows. The specific psychological reasons for this are beyond the scope of this post, but rooting for something is entertaining for most of us. Yet, rooting for things to happen makes us biased. Almost no human has the ability to see the world in an unbiased way when he strongly prefers one outcome over another. Thus, even without any other benefit, OMNI allows one to always stay in a neutral state of mind, which allows for clearer thinking.

The other reason OMNI is preferable over other forms of value investing is if your investment basis is that some stock is undervalued, this gives you no meaningful basis for predicting its short-term price action. Note that over the short-term, the price volatility far outweighs the expected return due to valuation. Even with a fairly optimal scenario - say your stock is expected to outperform by 10% a year - that's just 4bp or 0.04% a day, which is easily overwhelmed by typical daily volatility (it's certainly not all that uncommon for stocks to go down 5-10% in one day without a significant change in valuation - that's 100+ times the expected return). In other words, any additional exposure over the amount that puts you at market-neutral does not meet any reasonable value investor's short-term risk-reward ratio. Having a strong conviction of one's valuation does not change this. The more certain you're of your valuation, the more likely that you would root for the price to go down, as opposed to up, which means the position sizing can be greater but that does not mean you need to position yourself in such a way where you must root for the price to go up. It means you're at a point where you can't take advantage of any further price declines - in other words, you're not that sure about your valuation after all and you're exposed to short-term price action, over which you have no control.

While I described this from the perspective of a long-only equity investor, everything here applies to nearly all forms of value investing, including (especially!) fixed income arbitrage, shorting based on valuation, derivatives or any other instruments. In conclusion, if you are investing primarily on the basis of value and ever find yourself hoping for the market to move in your favor in the short term, it's very likely that your risk management needs work. Certainly, almost all risk management failures by value/arbitrage-based investors (LTCM comes to mind) can probably be attributed to large deviations from OMNI.

ty phone booth. tip of the hat to you.

Also, I know I haven't been posting hands in the last few posts...that's because I haven't been spewing too often or been playing poorly. The purpose of creating this was to hold myself accountable to poker deficiencies, of which none are present at the moment so don't be hatin.

Book Reviews: Intermarket Analysis by Murphy and Market Wizards by Jack S.

In my opinion, these are the two books trading novices should read first. Market Wizards is written for the average layman-the technical terms are sparse, but enough to familiarize yourself with the very basics if you have Wikipedia by your side, and is more of a character study of traders themselves. Perhaps it is just me, but one of the most intriguing aspects of anything I've enjoyed is the profiles of individuals partaking in that activity. Eccentric personalities abound in this classic tome, and you really get a feel for the type of people who are attracted to trading. When reading this, you should continually be asking yourself how well you can identify with the people being interviewed. You will never succeed as a trader if you don't have the right mindset or personality for it: Can you cope with continual losses lasting up to several months? Are you willing go with your gut when you find a profitable position? Do you have the discipline to follow your system when every technical indicator and chart is telling you to go the opposite direction? This book is a must for anyone beginning to consider trading for a living.

Intermarket Analysis appeals to a broader demographic: it hardly focuses at all on trading or strategies, but is more like an indepth look at macroeconomic tendencies. For traders, many people recommended me to read Pring or Murphy on technical analysis to begin with. I strongly disagree with this advice and feel that narrows your market analysis and could have you barking up the wrong tree for several years. Intermarket analysis focuses on the fundamentals of market movements and is increasingly important in this day and age given the rising economic prosperities of other countries, something a lot of people can relate to if they follow global news at all. What happens to the aggregate price of commodities as the dollar weakens? How do other countries benefit (or suffer in some cases) when America raises interest rates? How can we use bond and yield curve charts to forecast economic conditions? Really, this book focuses heavily on how currencies, commodities, bonds, and stocks are all inter-related, a key concept I know many overlook.