Saturday, October 27, 2007

Down the Rabbit Hole

It's a rainy day here in Manhattan. Perfect weather to stay in and read a good post on the "Demise of the Quants" by my fellow bloggist and tetchy ranter Baruch over at Ultimi Barbarorum1. Fire up the coffee pot, break out a dictionary, and read it. You'll learn something.

Unless he2 is actually perma-deb Tinsley Mortimer playing an incredibly elaborate joke on us all3, Baruch appears to invest in equities for an unnamed Swiss financial institution which shall remain nameless. (I will give him the benefit of the doubt and credit for his obvious native intelligence to conclude that it is not my favorite Schweizerdeutsch whipping boy, UBS.) He writes in reaction to a semi-triumphalist article on the quant meltdown this August in MIT's Technology Review magazine and his own informed reflections.

Most of what he says rings true, and—best of all—unlike Your weasely little ticket-scalping middleman Faithful Correspondent, he actually appears to invest for a living and therefore presumably knows what he is talking about. Like I said, read it.

I read the same MIT article recently, too. However, my strongest reaction had less to do with the trials and travails of a bunch of overpaid ex-nerds and more to do with the apparent epistemological and ontological underpinnings of the Grand Quant Paradigm: namely, that in financial markets, math is what matters. In its strongest form, this intellectual substrate can be characterized as described in the MIT piece:
Beneath all this beats the great hope of the quants: namely, that the financial world can be understood only through math. They have tried to discover the underlying structures of financial markets, much as academics have unlocked the mysteries of the physical world. The more quants learn, however, the farther away a unified theory of finance seems. Human behavior, as manifested in the financial markets, simply resists quantification, at least for now.

"At least for now." Classic.

I find it hard to believe that anyone with an IQ over 60 could believe such shit, but I am humble enough to know that even I can be mistaken.

* * *

Gosh, where do I begin?

Stripping away the sloppy journalistic overkill ("the financial world can be understood only through math" [emphasis mine]) and the drive-by analogy to physics ("a unified theory of finance") still leaves me with the gaping howler that at least some of these knuckleheads believe the financial markets can be understood primarily through math. This, as the man said, is nonsense. Even the eminence grise and pioneering quant Emanuel Derman has figured this out, although it is not clear he has figured out why:

Quantitative finance "superficially resembles physics," he says, "but the efficacy is very different. In physics, you can do things to 10 significant figures and get the right answer. In finance, you're lucky if you can tell up from down."

Interestingly enough, the repeated references to physics in the article are instructive, since that—plus pure mathematics—happens to be the academic background of many if not most of the quants practicing today. (Über quant and sesquitillionaire James Simons of Renaissance Technologies is a world class mathematician who co-authored the Chern-Simons theory on geometric invariants, widely used in string theory. No innumerate slouch he.) Their influence shows. Perhaps the most widely known formulation in mathematical finance—and arguably one of its foundational theories—is the famous Black-Scholes theory of option pricing, which holds as its central insight the assumption that a security price propagates through time based upon geometric Brownian motion, like the molecules in a gas.

By any measure, B-S4, along with its numerous variants and competitors, is a phenomenally successful theory, one that describes and enforces price relationships among cash securities and their derivatives in markets trading trillions of dollars every day. If anything has the status of Holy Writ in financial markets today, it is the Black-Scholes model. But Black-Scholes did not create the derivatives market; it is a heuristic construct which describes the arbitrage relationships and conventions which market participants use to trade these securities. The equity options market, while small, predated Fischer Black's and Myron Scholes' little exercise by some years, and seemed to function quite nicely before it had a rigorous quasi-physical theoretical underpinning. (In fact, if memory serves, Black and Scholes tried their hand at trading options using the insights from their formula and got their very large heads handed to them by the unenlightened louts in the options pit.)

Write this down: Black-Scholes works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that's how prices should work. It is a convention, not a physical or financial law. This is the central epistemological trap that quants fall into when they conflate the tools, techniques, and ontological assumptions of physics, which attempts to describe that which is (more or less independent of us humans), with those of mathematical finance, which attempts to descibe how human beings trade and value financial instruments and their derivatives.

It is a true and remarkable fact that mathematics, in the words of physicist Eugene Wigner, is "unreasonably effective" in describing substantial swathes of the physical world. (If you do not find this fact remarkable, even disturbing, I would posit that you understand neither math nor physics. Think again.) But at least part of the reason mathematics has been so effective to date in helping us understand the physical world must be due to how well-behaved the physical world is. Math can describe the orbits of the planets and the fissioning of an atom with astonishing accuracy, but that is because the questions we are trying to answer in these particular cases are so narrow. We can ignore mountains of superfluous data (presuming, for example, that the color of an orbiting planet does not affect its orbit) in order to use math to answer what turn out to be relatively simple questions.

But this approach breaks down in the social sphere, where the interacting particles under investigation happen to be living, breathing people with opinions, conscious and unconscious biases, and adjustable rate mortgages. Financial markets are social systems, comprised of the countless interactions of conscious (and self-conscious) agents. It is Heisenberg's Uncertainty Principle—according to which the experimental observation of a small enough physical particle affects the outcome of the experiment itself—writ large. Look back at the central point of Ultimi Barbarorum's discussion of the quant strategy blow-up. By all accounts, the data seem to indicate that these clever boys and girls arbitraged away the persistent mean-reversion tendencies they so carefully identified in the first place by crowding into the same pairwise stock and sector trades as everybody else. Then, when the subprime doo-doo hit the fan, cross-sector contagion induced by market wide leverage and other connections blew those carefully researched historical relationships clean out of the water. It wasn't arbitrage or Brownian motion at work here. It was panic. Gas molecules in a box don't all rush for the exit at the same time when you open a hatch; people do.

Anyway, I'll finish my rant with an exchange from the quant conference the MIT article described which I find illuminating:

"How many [people in the room] think spreads will widen?" [conference leader Leslie Rahl] asked.

The hands of about half the smartest people on Wall Street shot up.

"And how many think they'll narrow?"

The other half—equally smart—raised their hands.

"Well," she said. "That's what makes a market."

Equally smart, indeed.

1 Don't ask. Better yet, read the site. It has something to do with Dutch-Portugese-Jewish philosopher Baruch de Spinoza ranting about some very naughty people in the mists of time. Hey, what did you expect the guy who publishes "The Epicurean Dealmaker" to read in his spare time? Gawker?
2 Come on, now, girls, don't get your panties in a twist. Surely it is a safe assumption that "Baruch" is packing the Y chromosome, isn't it? After all, UB is a finance site, on the internet. Need I say more?
3 What are the odds? Hmmm.
4 Sorry. Couldn't resist. By the way, aren't footnotes great?
© 2007 The Epicurean Dealmaker. All rights reserved.