February 26, 2010

News & Opinion: The Quants

By: 800-CEO-READ @ 2:12 AM – Filed under: Management & Workplace Culture

I've not yet finished reading Scott Patterson's The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, but I'd like to go on record now in disagreement with The Economist's review of the book. I do agree that Patterson's prose can get a bit "purple" in places, but I think his focus on the quantitative models developed and used on Wall Street over the last three decades is an important one. And the way he explores the topic—through the stories of the individuals who created those models—keeps the reader engaged in a tale that might otherwise turn too academic for most. Patterson also tells of individuals in the "quant" community who have warned against relying on the models they helped create, and he makes good use of their voices in supporting his conclusion that there is no absolute truth in those models—that there is not a science or equation with which to predict and play the market. Beyond referring to the more popular dissidents, such as Nassim Nicholas Taleb and Benoit Mandelbrot, he refers to two I have not come across, Paul Wilmott and Emanuel Derman, and their Financial Modelers' Manifesto:
It was a cross between a call to arms and a self-help guide, but it almost amounted to something of a confession: We have met the enemy, and he is us. Bad quants were the source of the meltdown. "A spectre is haunting markets—the spectre of illiquidity, frozen credit, and the failure of financial models," they began, ironically echoing Marx and Engels ... What followed was a flat denunciation of the idea that quant models can approximate the Truth:
Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. ... It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. ... The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them.
In other words, there is no single truth in the chaotic world of finance, where panics, manias, and chaotic crowd behavior can overwhelm all expectations of rationality. Models designed on the premise that the market is predictable and rational are doomed to fail. When hundreds of billions of highly leveraged dollars are riding on those models, catastrophe is looming.
That quote, I think, pretty much sums up the reason this book is important. We have all heard that the problems on Wall Street stemmed from firms over-leveraging their positions, but we don't often discuss the model they were leveraged on. The more books addressing the issue, the better—I would think. A great book on the subject that was vastly under-appreciated when it was published, and that I'm surprised hasn't come into the conversation since, is Richard Bookstaber's A Demon of Our Own Design, which we named the best Finance and Economics book of 2007 in our first annual 800-CEO-READ Business Books Awards. The book came out a year before Nassim Nicholas Taleb's more popular Black Swan, and I think it's just as important. (And both men were on Wall Street to witness the rise of "the quants" in the '80s. Both, in fact, were among their early numbers.) A Demon of Our Own Design begins tantalizingly:
While it is not true that I caused the two greatest financial crises of the late twentieth century—the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later—let's just say I was in the vicinity. If Wall Street is the economy's powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended. You don't deliberately obliterate hundreds of billions of dollars in investor money. And that is at the heart of this book—it is going to happen again.
It happened again, alright, and Patterson's book does a good job of documenting it on the other side. Patterson doesn't have the narrative genius of a Micheal Lewis or Andrew Ross Sorkin, and The Quants is no Liar's Poker or Too Big To Fail, but Scott Patterson has turned in a valiant debut effort and The Quants is a very good book.