They Tried to Outsmart Wall Street

New York Times ^ | March 9, 2009 | Dennis Overbye

[Lorianne]

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.

[Arguendo]

Good article.

[smokingfrog]

I think one of those geeks created a black hole that sucked all the $$$ out of Wall St.

[who_would_fardels_bear]

It would have been nice if the author had made a stronger distinction between those activities that contribute to wealth creation, and those activities that merely transfer wealth from unlucky betters to lucky ones.

We are told by the shills of hedge funds and crony capitalists that there is no reasonable way to separate investment from speculation and so we should not try.

They go on to argue that speculation actually helps and should even be encouraged, when in fact the latest economic calamity shows otherwise.

Quants who help venture capitalists to make reasoned investments, or who help corporations to properly price bonds, etc. should be praised.

Those that merely scan billions of financial transactions to come up with the financial equivalent of a card counting scheme should be sent back to the minors where their skills can be better used coming up with fantasy league player acquisition strategies.

[who_would_fardels_bear]

... and we were worried about CERN!

[Free Vulcan]

Interesting article. Sometimes these guys are so smart they can’t see the forest for the trees.

[Frantzie]

Another quant or hedge fund burned by fat tails of standard distribution?

[Frantzie]

Another quant or hedge fund burned by fat tails of standard distribution?

[Arguendo]

They go on to argue that speculation actually helps and should even be encouraged, when in fact the latest economic calamity shows otherwise.

Your statement is too sweeping. Speculation can be valuable; it's leveraged speculation by people who can't afford that potential losses that is dangerous. Keep in mind that most banks did not believe they were engaging in speculation even though they were, and that was the problem, not the fact that speculation was taking place by itself.

[freespirited]

Do some people take the models too seriously? “Not the smart people,” he said.

I've never taken the models seriously because I have never found one that factors in key variables: the corruption, cheating, and constant rule-breaking.

[PGR88]

Maybe it’s not relevant, but all I could think is that Stalin or Mao would have had these guys locked away in Siberia or the Gobi Desert, using them to design missiles or nuclear warheads.

Is the point of the article that as smart as these people may be, they are still just tools in the service of something they can’t control?

[BobbyT]

Now let’s not drag his color into this...

[Raster Man]

Here’s a news flash to all of the quants: you have spent your life studying models and developing models, but in the last year, it is been shown that YOUR MODELS AREN’T WORTH SQUAT.

You have wasted your lives on models that only worked when the market is going up. You would have bben better off devoting your lives to better society by working on alternative energy, national security, cure for cancer, etc. Instead, you are the Captain Hazelwoods of the financial markets.

[grey_whiskers]

That's the problem. If your method is based on "hey, nobody else has noticed this yet' (monotonically increasing prices), and you don't adjust for everyone else piling on, what had been a black swan becomes...inevitable. The bubble bursts. And the arrogance of the quants leading to everyone making the same bets with each other's money? Massive deflation as nobody can make good on their losing bets, and the winners don't get paid by the bankrupt losers.

I tend to agree with Feynman: "It doesn't matter how good your theory is, it doesn't matter how smart you are. If your theory doesn't agree with experiment, it's WRONG."

Cheers!