15

Small is Beautiful

The Tower of Babel

(concave) response1 : 1. Size of items falling on your head (a large stone vs small pebbles). 2. Losses under strain. 3. Quantity in a short squeeze 4. Large vs small structures...

From Antifragile, 2012:

On January 21, 2008, the Parisian bank Societ Gnrale rushed to sell in the market close to seventy billion dollars worth of stocks, a very large amount for any single "re sale." Markets were not very active (called "thin"), as it was Martin Luther King Day in the United States, and markets worldwide dropped precipitously, close to 10 percent, costing the company close to six billion dollars in losses just from their re sale. The entire point of the squeeze is that they couldnt wait, and they had no option but to turn a sale into a re sale. For they had, over the weekend, uncovered a fraud. Jerome Kerviel, a rogue back oce employee, was playing with humongous sums in the market and hiding these exposures from the main computer system. They had no choice but to sell, immediately, these stocks they didnt know they owned. Now, to see the eect of fragility from size, consider losses as a function of quantity sold. A re sale of $70 billion worth of stocks leads to a loss of $6 billion. But a re sale a tenth of the size,$7 billion would result in no loss at all, as markets would absorb the quantities without panic, maybe without even noticing. So this tells us that if, instead of having one very large bank, with Monsieur Kerviel as a rogue trader, we had ten smaller units, each with a proportional Monsieur Micro- Kerviel, and each conducted his rogue trading independently and at random times, the total losses for the ten banks would be close to nothing.

Figure 15.1: The Tower of Babel Eect: Nonlinear response to height, as taller towers are disproportionately more vulnerable to, say, earthquakes, winds, or a collision. This illustrates the case of truncated harm (limited losses).For some structures with unbounded harm the eect is even stronger.

Diseconomies of scale: In this discussion, we only consider the harm, not the benets of scale under nonlinear
1I

We will proceed, via convex transformation to show the eect of nonlinearity on the expectation.

thank Jim Gatheral for naming such nonlinear fragility the "Tower of Babel eect"

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CHAPTER 15. SMALL IS BEAUTIFUL

15.1

Unbounded fects

Convexity

Ef-

for the exercise, as any one-tailed distribution does the job). The density: p,L (x) = L x
1

We assume an unbounded harm function, where harm is a monotone (but nonlinear) function in C 2 ; so let h(x) be the simplied harm function , R+ ! R of the form h( x ) k x , (15.1) k 2 [0, 1) ,
Damage or Cost

for x

(15.2)

2 [0, 1).
Stressor

The distribution of the response to the stressor will have the distribution g = (p h)(x). Given that k the stressor is strictly positive, h(x) will be in the negative domain. Consider a second change of variable, dividing x in N equal fragments, so that the unit becomes = x/N , N 2 N 1 : N g,L,N ( ) =

(15.3)

L for k N and with > 1 + . The expectation for a section x/N :

M (N ) =
Figure 15.2: Simple Harm Functions, monotone: k = = 3 /2, 2, 3. 1,

kL N

g,L,N ( ) d = k L N (
1

1) 1

(15.4)

Let B be the size of the total unit subjected to stochastic stressor x, with (B ) = B + h(x). Let x follows a certain class of continuous probability distributions (unimodal), where the density p(x) satisfying: p(x) p(x + ) for all > 0, and x > x and p(x) p(x ) for all x < x with {x : p(x ) = arg maxx p(x)}. We can prove by the inequalities from concave transformations that, the expectation of the large units is lower or equal to that of the sum of the parts. Because of the monotonocity and concavity of h(x),
N X i=1

which leads to a simple ratio of the mean of the total losses (or damage) compared to a number of its N fragments, allowing us to extract the "convexity eect" or the degradation of the mean coming from size:
1 M ( N ) = ( M (N )

1)

(15.5)

With = 1, the convexity eect =1. With = 3/2 (what we observe in orderow and many other domains related to planning, Bouchaud et al., 2012, Flyvberg et al, 2012), the convexity eect becomes is shown in gure x.
Convexity Effects
Mean per unit 1.0

ai B )

N X i=1

( ai B ) ,

where PN ai are nonnegative normalized weights, that is, And taking expectai=1 ai = 1 and 0 ai 1. PN tions on both sides, E((B )) E ( a B ) : the i i=1 mean of a large unit under stochastic stressors degrades compared to a series of small ones. Example 1: Pareto. Let the probability distribution of x (the harm) be a simple Pareto (which matters little

0.8

0.6

0.4

0.2

N 2 4 6 8 10

15.2. A RICHER MODEL: THE GENERALIZED SIGMOID

Figure 15.3: Degradation of the mean for N=1 compared to a large N, with = 3/2

125

15.2

A Richer Model: The Generalized Sigmoid

Now consider that the losses terminate somewhere: what is broken is broken. Recall the generalized sigmoid function of chapter x, where S N (x) = PN ak k=1 bk (exp(ck x))+1 , a sum of single sigmoids. We assume as a special simplied case N = 1 and a1 = 1 so we focus on a single stressor or source of harm S (x), R+ ! [ 1, 0] where x is a positive variable to simplify and the response a negative one. S has the following form:

The only class of generalized distribution is the alpha-stable (a.k.a. Levy-Stable or Pareto-LevyMandelbrot), but it has the problem of not covering tail exponent > 2 which is what we observe in preasymptotics. As we saw it is too idealized in the real world where I can safely say it has never been encountered except in the two polar situations: Cauchy or Gaussian. An alternative, for a class of distributions that are one-tailed, is the more general form of the Pareto distribution, with scale, shape and centrality parameter, in addition to the tail exponent. Hence we will have recourse to it in the exercise. A few graphs below will show the intuition under perturbation of the various parameters. Where x is the same harm as in 15.6:

S ( x) =

1 1+e
b1 (c 1 x )

(15.6)

Figure 15.4 shows the dierent calibrations of b1 (c1 sets a displacement to the right.
Response Harm 2 4 6 8 10

k p( x ) =

1/

(x

k x

1/

+1

0.2

0.4

for x
PDF

and 0 elsewhere.

(15.7)

0.6

1.0

0.8

0.8

1.0

0.6

Figure 15.4: Consider the object broken at condition at 0

1 and in perfect

0.4

As to probability distributions of the harm, we can select from the one-tailed class with domain (0, 1) the Lognormal or a more general class of Pareto, with the advantage of witnessing the eect of changes in tail exponent.

0.2

x 2 4 6 8 10

Figure 15.5: Perturbating k