Workbook for Volume 1 - Part IV – Section #32: Foundational Papers from the 20th Century, Post-World War II (14 of 15) – Bengen, Fernhholz, Ferh & Schmidt
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For returning readers and subscribers: This post introduces a Revised Version for Volume 1 - Part IV – Section #32: Foundational Papers from the 20th Century, Post-World War II (14 of 15) – Bengen, Fernhholz, Ferh & Schmidt
Summary:
Volume 1 - Part IV – Section #32: Foundational Papers from the 20th Century, Post-World War II (14 of 15) – Bengen, Fernhholz, Ferh & Schmidt - During the 1990s, the increasing anticipation of problems related to funding the retirement of the Baby Boom generation brought practitioners, such as William P. Bengen, and E. Robert Fernholz, to take the lead away from academics. While academics continued to look for normative solutions within the constraints of the “Axioms, Assumptions & Hypotheses” of Financial Economics, these practitioners developed descriptive models, and heuristics based on empirical observations. Academic researchers - such as Ernst Fehr & Klaus M. Schmidt’s paper published in 1999, and titled “A Theory of Fairness, Competition and Cooperation” - kept working on a a reconciliation of the restrictive assumptions of “Homo economicus” with empirically observed social preferences for fairness and cooperation. However, this work kept to the original framing from Bernoulli 1738 that leads to increasingly complex utility functions. On the other hand, a paper published in 2019 by Ole Peters & Alex Adamou, “The evolutionary advantage of cooperation” changes the framing of the problem in order to solve “The Puzzle of Cooperation”. First, Peters & Adamou show that the traditional, evolutionary justifications to explain the “Puzzle of Cooperation” include: (i) An assumed net fitness gain that exceeds the costs from transactions based on cooperation, or that (ii) A portion of this net fitness gain comes back to the donor over time. Their reframing, based on Ergodicity Economics, focuses on the typical nature of evolutionary processes, as noisy, multiplicative growth processes where: (i) The formula for the “Time Average” growth rate of a multiplicative “Growth Dynamic” shows the negative impact of fluctuations from variance, ḡ= μ – [(σ^2)/2], but (ii) The matching formula for the growth rate of the “Expected Value” does not include such an effect: g(<x>) = μ. This means that, while individuals cannot access the “Ensemble Average” growth rate on their own but instead access the lower “Time Average” growth rate: (i) They can improve their individual outcome through cooperation because it lowers the level of variance, and (ii) Increasing the number of cooperators increases the “Time Average” growth rate of the wealth process to the limit of the “Ensemble Average” growth rate. Thus, without an appeal to the Bernoulli 1738 framing of a utility function based on external psychological forces, EE’s growth rate of cooperators outpaces the growth rate of non-cooperators.
Developing…
”CTRI by Francois Gadenne” writes a business book in three volumes, published serially on Substack for public peer-review. The book connects the dots of life-enhancing practices for the next generation, free of controlling algorithms, based on the lifetime experience of a retirement age entrepreneur, & continuously updated with insights from reading Wealth, Health, & Statistics research papers on behalf of large companies as the co-founder of CTRI.