"Beware of geeks bearing formulas" - Warren Buffet
Tom Davos
March 10, 2009
They Tried to Outsmart Wall Street
By DENNIS OVERBYE
Emanuel Derman expected to feel a letdown when he left particle physics
for a job on Wall Street in 1985.
After all, for almost 20 years, as a graduate student at Columbia and a
postdoctoral fellow at institutions like Oxford and the University of
Colorado, he had been a spear carrier in the quest to unify the forces of
nature and establish the elusive and Einsteinian theory of everything,
hobnobbing with Nobel laureates and other distinguished thinkers. How
could managing money compare?
But the letdown never happened. Instead he fell in love with a corner of
finance that dealt with stock options.
Options theory is kind of deep in some way. It was very elegant; it had
the quality of physics, Dr. Derman explained recently with a tinge of
wistfulness, sitting in his office at Columbia, where he is now a
professor of finance and a risk management consultant with Prisma Capital
Partners.
Dr. Derman, who spent 17 years at Goldman Sachs and became managing
director, was a forerunner of the many physicists and other scientists who
have flooded Wall Street in recent years, moving from a world in which a
discrepancy of a few percentage points in a measurement can mean a Nobel
Prize or unending mockery to a world in which a few percent one way can
land you in jail and a few percent the other way can win you your own
private Caribbean island.
They are known as quants because they do quantitative finance. Seduced
by a vision of mathematical elegance underlying some of the messiest of
human activities, they apply skills they once hoped to use to untangle
string theory or the nervous system to making money.
This flood seems to be continuing, unabated by the ongoing economic
collapse in this country and abroad. Last fall students filled a giant
classroom at M.I.T. to overflowing for an evening workshop called So You
Want to Be a Quant. Some quants analyze the stock market. Others churn
out the computer models that analyze otherwise unmeasurable risks and
profits of arcane deals, or run their own hedge funds and sift through
vast universes of data for the slight disparities that can give them an
edge.
Still others have opened an academic front, using complexity theory or
artificial intelligence to better understand the behavior of humans in
markets. In December the physics Web site arXiv.org, where physicists post
their papers, added a section for papers on finance. Submissions on
subjects like the superstatistics of labor productivity and stochastic
volatility models have been streaming in.
Quants occupy a revealing niche in modern capitalism. They make a lot of
money but not as much as the traders who tease them and treat them like
geeks. Until recently they rarely made partner at places like Goldman
Sachs. In some quarters they get blamed for the current breakdown All I
can say is, beware of geeks bearing formulas, Warren Buffett said on The
Charlie Rose Show last fall. Even the quants tend to agree that what they
do is not quite science.
As Dr. Derman put it in his book My Life as a Quant: Reflections on
Physics and Finance, In physics there may one day be a Theory of
Everything; in finance and the social sciences, youre lucky if there is a
useable theory of anything.
Asked to compare her work to physics, one quant, who requested anonymity
because her company had not given her permission to talk to reporters,
termed the market a wild beast that cannot be controlled, and then
added: Its not like building a bridge. If youre right more than half
the time youre winning the game. There are a thousand physicists on Wall
Street, she estimated, and many, she said, talk nostalgically about
science. They sold their souls to the devil, she said, adding, I
havent met many quants who said they were in finance because they were in
love with finance.
The Physics of Money
Physicists began to follow the jobs from academia to Wall Street in the
late 1970s, when the post-Sputnik boom in science spending had tapered off
and the college teaching ranks had been filled with graduates from the
1960s. The result, as Dr. Derman said, was a pipeline with no jobs at the
end. Things got even worse after the cold war ended and Congress canceled
the Superconducting Supercollider, which would have been the worlds
biggest particle accelerator, in 1993.
They arrived on Wall Street in the midst of a financial revolution. Among
other things, galloping inflation had made finances more complicated and
risky, and it required increasingly sophisticated mathematical expertise
to parse even simple investments like bonds. Enter the quant.
Bonds have a price and a stream of payments a lot of numbers, said Dr.
Derman, whose first job was to write a computer program to calculate the
prices of bond options. The first time he tried to show it off, the screen
froze, but his boss was fascinated anyway by the graphical user interface,
a novelty on Wall Street at the time.
Stock options, however, were where this revolution was to have its
greatest, and paradigmatic, success. In the 1970s the late Fischer Black
of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of
Harvard had figured out how to price and hedge these options in a way that
seemed to guarantee profits. The so-called Black-Scholes model has been
the quants gold standard ever since.
In the old days, Dr. Derman explained, if you thought a stock was going to
go up, an option was a good deal. But with Black-Scholes, it doesnt
matter where the stock is going. Assuming that the price of the stock
fluctuates randomly from day to day, the model provides a prescription for
you to still win by buying and selling the underlying stock and its bonds.
If youre a trading desk, Dr. Derman explained, you dont care if it
goes up or down; you still have a recipe.
The Black-Scholes equation resembles the kinds of differential equations
physicists use to represent heat diffusion and other random processes in
nature. Except, instead of molecules or atoms bouncing around randomly, it
is the price of the underlying stock.
The price of a stock option, Dr. Derman explained, can be interpreted as a
prediction by the market about how much bounce, or volatility, stock
prices will have in the future.
But it gets more complicated than that. For example, markets are not
perfectly efficient prices do not always adjust to right level and
people are not perfectly rational. Indeed, Dr. Derman said, the idea of a
right level is a bit of a fiction. As a result, prices do not
fluctuate according to Brownian motion. Rather, he said: Markets tend to
drift upward or cascade down. You get slow rises and dramatic falls.
One consequence of this is something called the volatility smile, in
which options that benefit from market drops cost more than options that
benefit from market rises.
Another consequence is that when you need financial models the most on
days like Black Monday in 1987 when the Dow dropped 20 percent they
might break down. The risks of relying on simple models are heightened by
investors desire to increase their leverage by playing with borrowed
money. In that case one bad bet can doom a hedge fund. Dr. Merton and Dr.
Scholes won the Nobel in economic science in 1997 for the stock options
model. Only a year later Long Term Capital Management, a highly leveraged
hedge fund whose directors included the two Nobelists, collapsed and had
to be bailed out to the tune of $3.65 billion by a group of banks.
Afterward, a Merrill Lynch memorandum noted that the financial models may
provide a greater sense of security than warranted; therefore reliance on
these models should be limited.
That was a lesson apparently not learned.
Respect for Nerds
Given the state of the world, you might ask whether quants have any idea
at all what they are doing.
Comparing quants to the scientists who had built the atomic bomb and
therefore had a duty to warn the world of its dangers, a group of Wall
Streeters and academics, led by Mike Brown, a former chairman of Nasdaq
and chief financial officer of Microsoft, published a critique of modern
finance on the Web site Edge.org last fall calling on scientists to
reinvent economics.
Lee Smolin, a physicist at the Perimeter Institute for Theoretical Physics
in Waterloo, Ontario, who was one of the authors, said, What is amazing
to me as I learn about this is how flimsy was the theoretical basis of the
claims that derivatives and other complex financial instruments reduced
risk, when their use in fact brought on instabilities.
But it is not so easy to get new ideas into the economic literature, many
quants complain. J. Doyne Farmer, a physicist and professor at the Santa
Fe Institute, and the founder and former chief scientist of the Prediction
Company, said he was shocked when he started reading finance literature at
how backward it was, comparing it to Middle-Ages theories of fire. They
were talking about phlogiston not the right metaphor, Dr. Farmer said.
One of the most outspoken critics is Nassim Nicholas Taleb, a former
trader and now a professor at New York University. He got a rock-star
reception at the World Economic Forum in Davos this winter. In his
best-selling book The Black Swan (Random House, 2007), Dr. Taleb, who
made a fortune trading currency on Black Monday, argues that finance and
history are dominated by rare and unpredictable events.
Every trader will tell you that every risk manager is a fraud, he said,
and options traders used to get along fine before Black-Scholes. We never
had any respect for nerds.
Dr. Taleb has waged war against one element of modern economics in
particular: the assumption that price fluctuations follow the familiar
bell curve that describes, say, IQ scores or heights in a population, with
a mean change and increasingly rare chances of larger or smaller ones,
according to so-called Gaussian statistics named for the German
mathematician Friedrich Gauss.
But many systems in nature, and finance, appear to be better described by
the fractal statistics popularized by Benoit Mandelbrot of IBM, which look
the same at every scale. An example is the 80-20 rule that 20 percent of
the people do 80 percent of the work, or have 80 percent of the money.
Within the blessed 20 percent the same rule applies, and so on. As a
result the odds of game-changing outliers like Bill Gatess fortune or a
Black Monday are actually much greater than the quant models predict,
rendering quants useless or even dangerous, Dr. Taleb said.
I think physicists should go back to the physics department and leave
Wall Street alone, he said.
When Dr. Taleb asked someone to come up and debate him at a meeting of
risk managers in Boston not too long ago, all he got was silence.
Recalling the moment, Dr. Taleb grumbled, Nobody will argue with me.
Dr. Derman, who likes to say it is the models that are simple, not the
world, maintains they can be a useful guide to thinking as long as you do
not confuse them with real science an approach Dr. Taleb scorned as
schizophrenic.
Dr. Derman said, Nobody ever took these models as playing chess with God.
Do some people take the models too seriously? Not the smart people, he
said.
Quants say that they should not be blamed for the actions of traders. They
say they have been in the forefront of pointing out the models
shortcomings.
I regard quants to be the good guys, said Eric R. Weinstein, a
mathematical physicist who helps run the Natron Group, a hedge fund in
Manhattan. We did try to warn people, he said. This is a crisis caused
by business decisions. This isnt the result of pointy-headed guys from
fancy schools who didnt understand volatility or correlation.
Nigel Goldenfeld, a physics professor at the University of Illinois and
founder of NumeriX, which sells investment software, compared the
financial meltdown to the Challenger space shuttle explosion, saying it
was a failure of management and communication.
Prisoners of Wall Street
By their activities, quants admit that despite their misgivings they have
at least given cover to some of the wilder schemes of their bosses,
allowing traders to conduct business in a quasi-scientific language and
take risks they did not understand.
Dr. Goldenfeld of Illinois said that when he posted scholarly articles,
some of which were critical of financial models, on his companys Web
site, salespeople told him to take them down. The argument, he explained,
was that it made our company look bad to be associating with Jeremiahs
saying that the models were all wrong.
Dr. Goldenfeld took them down. In business, he explained, unlike in
science, the customers are always right.
Quants, in short, are part of the system. They get paid, a Faustian
bargain everybody makes, said Satyajit Das, a former trader and financial
consultant in Australia, who likes to refer to them as prisoners of Wall
Street.
What do we use models for? Mr. Das asked rhetorically. Making money,
he answered. Thats not what science is about.
The recent debacle has only increased the hunger for scientists on Wall
Street, according to Andrew Lo, an M.I.T. professor of financial
engineering who organized the workshop there, with a panel of veteran
quants.
The problem is not that there are too many physicists on Wall Street, he
said, but that there are not enough. A graduate, he told the young
recruits, can make $75,000 to $250,000 a year as a quant but can also be
fired if things go sour. He said an investment banker had told him that
Wall Street was not looking for Ph.D.s, but what he called P.S.D.s
poor, smart and a deep desire to get rich.
He ended his presentation with a joke that has been told around M.I.T. for
a long time, but seemed newly relevant; What do you call a nerd in 10
years? Boss.