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[V.PERCY] 1 29 April 2012 Bets, Expected Gains and Taxes: An Investment Framework in the Age of Convergence Finance.

For every benefit you receive a tax is levied. Ralph Waldo Emerson

Equifinality not only refers to the convergent nature of complex systems such as the Economy, where different paths can achieve a similar end-state, but constitutes a key concept to assess how uncertain such a system can be. Our Technology is an extension of us -and thus, an extension of Nature. Our Economy builds upon our Technology. Convergence Finance lies in the realization that the methods of the behavioral sciences are finally unifying, and they exploit the same phenomena and share the intrinsic nature of the mechanisms that we use to understand the physical and natural realms. A convergent financial framework would, then: 1.Identify a final strategic outcome -investment returns, geopolitical, etc. 2.Work backwards -using a heuristics based approach and adaptive techniques to model the Behavioral Game. 3.Obtain the time domain (or frequency domain) control chart- the player strategy. Then, use statistical process control limits as risk triggers. The Question that I am seeking to answer: Can an adaptable investment framework derived from the methods of complex systems enhance stability and reduce risk, in a fundamentally uncertain world? I. THE PRINCIPLE 1. On The Neural Infrastructure of the Convergent Economy Lets begin by combining two concepts proposed by W. Brian Arthur a) First, the combinatorial and evolutionary nature of Technology. According to Arthurs analysis, Technology creates itself from itself and all technologies are descended from earlier technologies. B) Second, that

[V.PERCY] 2 Digitization is creating a second Economy thats vast, automatic, and invisiblethereby bringing the biggest change since the Industrial Revolution. On another evolutionary analysis concerned with game theory, H.Gintis explains how the Economy is a complex non-linear dynamic system, and demonstrates that strategic interaction is born from elementary evolutionary forces. At this moment in history, the rather evident observation that increasingly and dynamically markets re-shape and re-size their interconnected elements by response to what appears to be sensing from context, speaks for the causality, and probably, for the methods that are applicable to solve the issue of adapting investing strategies to an uncertain environment.

Patterns are a recurring theme in Nature. However, for some reason most of our methodologies to deal with investment related decision making have been based on predictive models predictions on uncertain events. We are facing a synchronization problem: how to align the long cycles from Nature with the short cycles of the Economy. In broader terms, we could use a clock signal, namely ethics, policy or any similar. But still the frequencies will be different and rarely in phase. The need for error control and phase correction becomes evident.

Figure 1: Solution curves for a stable limit cycle, in a physical system (Astrom and Murray). The phase chart on the left shows that the trajectory for the system rapidly converges to the stable limit cycle. The time domain plots on the right show that the states do not converge to the solution but instead maintain a constant phase error. Note that even if the frequencies are the same, key events are rarely fully aligned.

2. A Behavioral Game Theory Approach to Investment

[V.PERCY] 3 The cognitive processes behind human behaviour, and the conflicts that arise from constrains in the context of strategic interaction have been the subject of study by game theorists for the past 60 years. But different scopes and different time horizons make any analysis from the psychological or economics disciples alone incomplete; as Hayek would put it: Laws are the rules of the game. We should identify unifying rules, and converging strategies. Context is then, of primary importance. Lets discuss for a moment one of the key components of our new, interconnected Economy. C.Nesson explains that the international nature of the Internet often conflicts with national differences in law, social values, and public policy. Within national boundaries, local ordinances add another layer of discord. And many governments have been caught off-guard by the Net's explosive growth. Some concern and confusion can be attributed to laws developed for earlier forms of media and business transactions. But where there is potential risk and chaos, there is also palpitating opportunity -it all depends in our ability to devise and implement mechanisms that are adaptable. Working in context requires focus and perspective -you can always be focused, but in the wrong issues. Take for instance a typical Hawk vs Dove game- I will use it here in a novel way but it serves to illustrate our point:

Table 1: Hawk-Dove game payouts matrix.

Lets suppose than a Internet games provider is struggling with the decision of allocating development and production resources to a projects road-map designed to regain gamers trust after a series of technology glitches. This company can easily over spend to build features that will attract and retain hawks (sophisticated players), whereas targeting doves (beatable players) can achieve a similar effect -hawks will follow doves because of the secured value v vis-a-vis the implied cost (v-c)/2 of facing another hawk. Product offering and risk become less relevant for

[V.PERCY] 4 hawks when theres a promise of more doves- which translates in reduced acquisition expenses for the games provider company. 3. Theory of Control applied to Adaptive Systems I will revisit the role of law, policy and institutions in the fabric of context later on. Now lets turn our attention to the techniques available to observe and control the phenomena present in context. Much have been said about the weeks and months previous to the roll-out of the 2008 financial crisis, but if we were to find an analogy for the uninitiated, we would say something such as: it was similar to driving a car with the eyes closed- perhaps there were signs, we could feel the rush of the speed and our vehicles loosing stability, but ultimately the system was not under control- there was no effective feedback and time responsive correction processes in place. Here is where the theory of control of physical systems becomes relevant to finance: feedback provides robustness to uncertainty. As strm and Murray explain in their study of feedback systems: By measuring the difference between the sensed value of a regulated signal and its desired value, we can supply a corrective action. Or, we could drive with our eyes open. Simply put, feedback systems are defined by the return to the input by a part of the output of a process. The controlled output signal is fed back for use in the control computation. Then the difference error signal is used to adjust the input to the process in order to bring the process measured value back to a desired set-point. The benefits are clear: a feedback controller can adjust process outputs based on history and rate of change of the error signal, increase stability, accuracy and tuning. Now, of the many types of feedback controllers that have been developed for applications ranging from machine control, Internet traffic management or biomolecular modeling, one is of great interest for the purpose of our study: The PID controller. The basic PID controller has the form

where u is the control signal and e is the control error. The control signal is thus a sum of three terms: a proportional term that is proportional to the error, an integral term that is proportional to the integral of the error, and a derivative term that is proportional to the derivative of the error.

So, what makes PID control special? The fact that it can handle past, present and future.

Figure 2: Visual representation of the PID controllers effect on a given time span, according to Astrom and Murray.

Now lets review this characteristic in detail, and for this I will start introducing concepts of the frequency domain. The effect of the first term (the proportional term P) is lifting gain with no change in phase -so it works in the present, the error is multiplied by a constant kp and the controlled quantity becomes proportional to it. The integral term I causes the output to ramp and eliminates the steady state error, lifting gain at low frequency (with the effect of infinite gain plus phase lag). To learn from the past the error is integrated over a period of time then multiplied by a constant ki and added to the controlled quantity; eventually a well tuned feedback controller loop process settles at set-point. Finally, the derivative term D where the derivative action is characterized by a parameter kd anticipates where the process is going by considering the derivative of the controller input (error). The effect is high gain at low frequency plus phase lead at high frequency. So, the derivative term serves to handle the future; the first derivative over time is multiplied and multiplied by a constant kp, and added to the controlled quantity. The derivative term controls the response to a change in the system (the larger the term, the more the controller responds to changes in the output -hence, a predictive controller). Sabatini, Rossolini and Gandolfi have been pioneering applications of PID control to finance during the past 5 years. Notably, they have developed a model where portfolio assets rebalancing is dictated by an asset selection technique consisting in the optimization of risk adjusted return -specifically, risk adjusted return is induced towards stability (is controlled). The fact that their model actually works speaks for itself about the interconnected nature of the

[V.PERCY] 6 Economy and Technology -we may say that the way in which Technology (created by us, and from itself) grasps physical phenomena probable draws some parallels to the way behavioral systems (such as markets) evolve using those phenomena. However, models based on pure PID control hit a wall at some point. What about the case of alternative investments, where information is not standardized or readily available as it is for the stock market, how to work around issues related to set-point setting, how to timely make sense of emerging patterns? This kind of issue is also present in many industrial processes that possess some complex properties such as non-linearity, and time-varying properties. A conventional PID controller with fixed parameters may usually derive poor control performance in those cases. An alternative to deal with the control of such complex processes is to use adaptive control schemes, where neural networks have been proved to be a promising approach. I argue that a similar approach is valid to solve the issue of adaptability in the case of alternative investments. Tan and Dang propose a generalized non-linear PID controller based on neural networks (GNPID), with learning training using a PID gradient descent algorithm with momentum term (PIDGDM) to solve physical problems such as reactor control. My opinion is that due to its convergent and adaptable properties, this and similar algorithms are ideal to solve problems in the finance realm, specially when historic information is unavailable or asymmetric.

Figure 3: Architecture of PID gradient descent method based on a neural network model is described by y(t) = NM[X(t),W] where X is the state vector, W is the weight matrix, J describes the process under optimization and the gradient dJ/dW is the system error. Adapted from Tan and Dang.

[V.PERCY] 7 The performance of the controller depends upon the mapping N. Assuming that the structure of the nonlinear mapping N is pre-defined, the controller may be specified by adjusting the parameter-matrix W to minimize the performance index of the feedback system. A learning algorithm (PIDGDM) is used to train the parameter-matrix W, based on the information obtained from the system performance. The behavior of the nonlinear PID controller depends not only on the PID inputs but also on the nonlinear mapping from the inputs to its output. Based on the system performance information, the learning mechanism can adjust the weights of the neural networks to approximate the mapping from the controller inputs to its outputs. 4. The Cyclical Nature of Strength and Opportunity As I introduced previously, working in the frequency domain can benefit our analysis; therefore we should continue developing our arguments using thought experiments that can easily be described by cyclicalities, and are derived from real life situations both at the micro and macro levels. To illustrate the point, lets start by reviewing a practical concept proposed by Mike Caro, a modern theorist of mind games: In life, strength is sometimes circular. Therefore, the conqueror can be an underdog to an entity too weak even to defeat what has been already conquered. For instance, in the following hand of the holdem variation of poker:

Figure 4: Caros concept.

What happens in practice is that b) Wins 53% of the time against a), and by hierarchy c) naturally beats b). Still, c) is not the definitive winner as it would appear, since a) wins 54% of the time against it. What we are seeing is an overlap in strength -rotation in the natural underdog position, and strength adaptation according to context.


To extend our analysis, lets now consider another kind of game: the case of international cooperation, institutions, and provision of common pool resources. From the consumption perspective, common pool resources are available to all States, independently if they contribute to their production or not, but from the supply side, States have little incentive to produce them, since they can not exclude non contributors from their use. The two variables defining a common pool resource are the stock variable (which is the core resource, for instance water) and the flow variable (the limited quantity of extractable marginal units, for instance the cubic meters per second that can be utilized). What makes the situation really problematic is the effect of crowding: their availability is diminished by consumption, so conflicts often arise when it comes to defining ownership in the management of the flow since the stock is somehow perceived of a public nature. Tropical Andean glaciers are disappearing at a rate of around 10% per decade. They have nearly disappeared from Venezuela, and the rest of the South American countries that can directly or indirectly (by flow management) use their water have conflicting interests: Bolivia needs the glacier for its ski resorts and possibly subsistence farmers, Ecuador and Peru would like to pipe the water to supply their thirsty cities and agriculture activities, and also in the case of Peru, a thriving mining industry. In the other side, Brazil is perhaps more interested in the hydroelectric generation potential of the re-routed rivers, albeit the environmental consequences. The competition for water in the Andes is a clear example of how the painful trade-offs faced when trying to allocate common pool resources (where uses vary from food production, energy production, provide local residents either from the rural side or the cities with drinking water, or support growth of economic activities driven by multinationals) can only be made greater by the potential for the disruption of peace between States. In their representation of characteristics and uses of different types of goods as games of strategic interaction, Aaggarwal and Dupont propose a taxonomy based on varying levels of benefits, costs for goods, and resources for actors. Their logic is that a government might engage in foreign aid or some sort of international cooperation in order to gain the good of a preferential access market or any other common economic, natural or social goals, or just for the sake of continuing enjoying the good of geopolitical stability: then goods become the stakes

[V.PERCY] 9 that countries seek in international relations. The general approach and special case (applied to common pool resources) of this framework is shown below, schematized for two actors/States:

Table 2: In the example adapted from Aaggarwal and Dupont we see that just by assigning sample values it is possible to notice that crowding makes the game tend to a mixed Hawk-Dove/Prisoners Dilemma type of game (in which, by definition, not acting is the worst possible outcome if plain mistrust will encourage passing the responsibility). The provision of the good is facilitated if one State has the capacity to provide the good unilaterally, which is the case of having only one equilibrium in the mixed game (State 1 providing the good and State 2 not contributing to it). And, if neither State can provide the good, or both States have similar capacities, crowding tends to reduce the likelihood of the provision of goods and increases the need for some kind of institutional solution.

[V.PERCY] 10 Now, what happens when the dynamics are affected by the introduction of more participant States, or even indirectly related States, as is usually the case in the context of an international organization? In the report Confronting Climate Change: A Strategy for U.S. Foreign Policy Michael Levi and his team at the Council on Foreign Relations explain that climate policy presents opportunities to strengthen important parts of the economy and create jobs, to rebuild U.S. partnerships and alliances, and to bolster energy security. In our example on the control of Andean water this may very well mean that the discussion on a Panamerican forum will become extremely complex -the dynamics will change just by the position of the United States towards a political inclination (i.e pro left governments in Bolivia, Ecuador) or towards a confronting position of strength (due to its scale and BRIC status, the relative independence of Brazil in matters of foreign policy). Here we are faced again to circularity: the State who had the upper hand may not have it anymore. Ostrom calls for adaptive governance methods for the management of common pool resources. Now it is time to extend our initial formulation of adaptive control, using the unified game theoretical framework explained before as learning matrix, and introducing a concept of quantum mechanics, the probability amplitude, to seek ways to handle the uncertainty brought by circularity. To do so, I will first assume that convergence in the PID based control system is mainly dictated by economical factors and their (social and environmental) proxy metrics, and that other social and environmental factors will have the capacity of triggering out-of-control states once an additional feedback block is included. The effect of Technology is present here at various levels, since the discussion would not develop in the first place if the technology to unlock the flow variable of the common pool resource is not existent. From quantum mechanics we know that quantum probability is expressed in terms of complex probability amplitudes, then, several interesting principles are applicable: interferences between probability amplitudes enable incorporation of conjunction and disjunction errors (these interferences can be used to address the contextuality of concepts in decision making), the nonseparability of quantum-like states leads to the possibility of addressing decision making in a non-decompositional way (account for concept combinations), and even work based on nonlinear Schrodinger equation allows to incorporate feedback processes.

[V.PERCY] 11 Then, in principle, we could use quantum probabilities concepts to model our complete controller design. Technology inherits its circular nature from us, so does the Economy Interactive Decision (Gaming) only makes this evident. 5. The Convergence Finance Principle As our Technology (and thus, our Economy) increasingly adopts evolutionary traits, financial stability and sustained value creation will become more dependant on the convergence of strategies across the economic, social and environmental domains. Because of the inherent uncertainty of complex systems contexts, the methods derived to control risk should be adaptive rather than pure predictive, focused on probability patterns rather than in deterministic models. II. THE METHOD 1. Modeling the Framework Design involves always a trade-off of sensitivities at different frequencies (i.e if you want amplitude, your time response will be slower). This fact from Nature take us to consider a broader definition of taxes, beyond the mere fiscal realm -is it possible to determine when and how the boundaries of wellness and financial risk can go beyond control, and therefore the stability and returns of an investment strategy get compromised? The following methodology intends to solve the puzzle: a. We should identify our desired strategic outcome: Rather than setting blind investment goals that are largely ignorant of the effect of externalities and context, we could, by using the right game theoretical framework, model the geopolitical and economic scenarios that most adequately describe the dynamics of the system under study and are more likely to match our investment objectives. b.Then we should work backwards -using a heuristics based approach (such as the PID controller) and adaptive techniques (for instance, neural networks) - to model the behavioral game:

[V.PERCY] 12 Traditional valuation techniques (i.e present value of cash flows, or PVCF) are a rather linear approach to a non-linear problem, in the Convergence Finance Framework PVCF is just a component (specifically the integral component) of the overall solution. The plant block is the investment process, where the adaptive PID controller follows specific payouts to Bets that are placed in the past but based on expected value (the integral component is mostly historical), earnings are a matter of the present (therefore proportional to any adjustments of the current conditions), and the unavoidable and broader tax, something that can be reasonable managed by the predictive effect (derivative component) of a more comprehensive model.

Figure 5: Generic structure for a Multi-layered Feed-forward Back-propagation Neural Network; such a NN might be suitable to implement the adaptive control algorithm, to discover the quantity of hidden neurons and approximate the patterns given by the original game matrix.

c.Obtain the time domain (or frequency domain) control chart: Finally, the output at settling time provides the optimal investment strategy.

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Figure 6: Control chart for a sample parameter on an arbitrary investment process with transfer function of the form G(s)=1/(1+s)(1+as)(1+a^2s)(1+a^3s), where kp=1.5 ki=2.78, kd=1.52, a=0.1. This simulation was generated using a Sysquake application from Piguet and Sarl. The steady-state after settling time (6.1) represents the point of convergence.

2. Adding Robustness to the Process of Risk Management Determining the stability of systems interconnected by feedback can be accomplished using loop analysis. Specifically, I propose a combination of the Nyquist criterion, which provides a

[V.PERCY] 14 measure of the degree of stability through the definition of stability margins, and the Circle criterion, which provides a tool to analyse absolute stability for a time varying non-linearity (which would be the case for most investment decisions in a complex systems context).

Figure 7: Stability plots for the system described in Figure 6 provide a description of robustness and performance of the system, allowing adjustments to the investment strategy by additive changes. The interpretation of stability plots is a topic of advance control systems and it is a vast subject, background literature is provided in the references section.

[V.PERCY] 15 As we have seen, one of the advantages of the Convergence Finance Framework is that the scenarios can be simulated and adjusted for stability with simple drag-and-drop type of tools, which is suitable both for planning and during tracking performance (i.e adjusting for selectivity vs diversification, reduction of operational risk, etc). For added robustness, I now propose the use of statistical process control limits as risk triggers.

Figure 7: Standard statistical process control systems rules, the graphs include the upper control limits and lower control limits.

The logic is that beyond limits value is jeopardized, so following a set of statistical rules, an alarm can be set to alert about the potential risks. The addition of a Process Control Systems (PCS) block will enhance the inherent risk control of the PID based system, and include an extra layer of security when response time might be delayed in face of uncertain, new developments (i.e the rate of evolution in artificial intelligence systems vs the rate in adjustment of human

[V.PERCY] 16 ethics). The limits of the PCS engine might be given by pure environmental, financial or wellness constrains. Although providing a numerical demonstration is out of the scope for this paper, it is my opinion that such an engine might be implemented harnessing the distributed processing power of social networks to emulated a qubit based machine, that can render results using quantum probabilities rather than traditional statistical methods. 3. Possible Applications and Final Remarks The intend of this paper has been to lay down the foundations for the new field of Convergence Finance, specifically the formulation of a framework that based on concepts from neural networks, quantum computation and evolutionary game theory, can provide adaptable risk control mechanisms for alternative investments. The study of the mechanisms of opportunity and their associated methods of convergence in an Economy that is neurally intelligent, with connections constantly growing and adapting, is just beginning. Convergence Finance will allow us to overcome the limitations of our current computational systems (based mostly on digital, fundamentally deterministic logic) and the handicaps of investors criteria (in a complex systems context, common sense may not make sense anymore), to solve some of the great puzzles of our time: How to device a risk responsive Impact Investment strategy (possibly a matter of adapting the game strategy in the learning matrix of our controller, so that the values vs value based strategy is clearly weighted?), or, How to face the policy and systemic challenges brought by globalization (such as working backwards to draft the complex policy for ensuring Stability of the Financial System vs Stability of the Financial System Markets, as in the Eurozone vs European Union case), and many more.

Works Cited
Aggarwal, V. K., & Dupont, C. (1999). Goods, Games, and Institutions. International Political Science Review, 20(4), 393409. doi:10.1177/0192512199204005 Arthur, W. B. (2009). The Nature of Technology: What It Is and How It Evolves (p. 256). Free Press.

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Arthur, W. B. (2011). The second economy. McKinsey Quarterly. strm, Karl and Hgglund,Tore (2005). Advanced PID Control. ISA - The Instrumentation, Systems, and Automation Society. strm, Karl Johan and Murray, Richard M. (2008) Feedback Systems: An Introduction for Scientists and Engineers. Princeton University Press , Princeton, NJ. Busemeyer, J. R. (2008). Introduction to Quantum Probability for Social and Behavioral Scientists, 135. Mike Caro, Mike. (n.d.). (2001) Caros Conception. Poker Digest magazine. Gintis, H. (2009). The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences. Princeton University Press. Leopold, Wendy. Water crisis in Andes is challenge for U.S. security establishment, Peru. (n.d.). Retrieved June 17, 2012, from Levi, Michael et all. Confronting climate change - Council on Foreign Relations. (n.d.). Retrieved June 17, 2012, from Ostrom, E. (2008). The Challenge of Common-Pool Resources. Environment: Science and Policy for Sustainable Development, 50(4), 821. Retrieved from Sabatini, A., & Rossolini, M. (2008). The process of portfolio construction Asset allocation : - strategic asset allocation - tactical asset allocation G . A . M Model : a new tactical asset allocation technique PID feedback controller theory Applications and future research, 169. Tan, Yonghong., & Dang, Xuanju . (n.d.). Generalised nonlinear PID controller based on neural networks. Control, (1), 16.