Image: RANDOM HOUSE
[Editor's note: This excerpt from The Quants, by Scott Patterson (Crown Business, 2010), describes the 2006 Wall Street Poker Night Tournament, which featured professional poker players T. J. Cloutier and Clonie Gowen. It also featured several powerful money managers representing a new kind of Wall Streeter, the math-savvy investors known as "quants." The quants in attendance that night in 2006 included Peter Muller of Morgan Stanley, Ken Griffin of Citadel Investment Group, Cliff Asness of AQR Capital Management, Boaz Weinstein of Deutsche Bank and Jim Simons of Renaissance Technologies.]
No matter how hard they might play elsewhere, no poker game mattered more than when the gamblers around the table were their fellow quants. It was more than a battle of wits over massive pots—it was a battle of enormous egos. Every day they went head-to-head on Wall Street, facing off in a computerized game of high-stakes poker in financial markets around the globe, measuring one another's wins and losses from afar, but here was a chance to measure their mettle face-to-face. Each had his own particular strategy for beating the market. Griffin specialized in finding cheap bonds through mathematical formulas, or, via the same logic, cheap, down-on-their-luck companies ripe for the picking. Muller liked to buy and sell stocks at a superfast pace using Morgan Stanley's high-powered computers. Asness used historical tests of market trends going back decades to detect hidden patterns no one else knew about. Weinstein was a wizard with credit derivatives—securities whose value derives from some underlying asset, such as a stock or a bond. Weinstein was especially adept with a newfangled derivative known as a credit default swap, which is essentially an insurance policy on a bond.
Regardless of which signature trade each man favored, they had something far more powerful in common: an epic quest for an elusive, ethereal quality the quants sometimes referred to in hushed, reverent tones as the Truth.
The Truth was a universal secret about the way the market worked that could only be discovered through mathematics. Revealed through the study of obscure patterns in the market, the Truth was the key to unlocking billions in profits. The quants built giant machines— turbocharged computers linked to financial markets around the globe—to search for the Truth, and to deploy it in their quest to make untold fortunes. The bigger the machine, the more Truth they knew, and the more Truth they knew, the more they could bet. And from that, they reasoned, the richer they'd be. Think of white-coated scientists building ever more powerful devices to replicate conditions at the moment of the Big Bang to understand the forces at the root of creation. It was about money, of course, but it was also about proof. Each added dollar was another tiny step toward proving they had fulfilled their academic promise and uncovered the Truth.
The quants created a name for the Truth, a name that smacked of cabalistic studies of magical formulas: alpha. Alpha is a code word for an elusive skill certain individuals are endowed with that gives them the ability to consistently beat the market. It is used in contrast with another Greek term, beta, which is shorthand for plain-vanilla market returns anyone with half a brain can achieve.
To the quants, beta is bad, alpha is good. Alpha is the Truth. If you have it, you can be rich beyond your wildest dreams.
The notion of alpha, and its ephemeral promise of vast riches, was everywhere in the hedge fund world. The trade magazine of choice for hedge funds was called Alpha. A popular website frequented by the hedge fund community was called Seeking Alpha. Several of the quants in the room had already laid claim, in some form or another, to the possession of alpha. Asness named his first hedge fund, hatched inside Goldman in the mid-1990s, Global Alpha. Before moving on to Morgan in 1992, Muller had helped construct a computerized investing system called Alphabuilder for a quant farm in Berkeley called BARRA. An old poster from a 1960s film noir by Jean-Luc Godard called Alphaville hung on the walls of PDT's office in Morgan's midtown Manhattan headquarters.
But there was always a worry haunting the beauty of the quants' algorithms. Perhaps their successes weren't due to skill at all. Perhaps it was all just dumb luck, fool's gold, a good run that could come to an end on any given day. What if the markets weren't predictable? What if their computer models didn't always work? What if the truth wasn't knowable? Worse, what if there wasn't any Truth?
In their day jobs, as they searched for the Truth, channeling their hidden alpha nerds, the quants were isolated in their trading rooms and hedge funds. At the poker table, they could look one another in the eye, smiling over their cards as they tossed another ten grand worth of chips on the table and called, looking for the telltale wince of the bluffer. Sure, it was a charity event. But it was also a test. Skill at poker meant skill at trading. And it potentially meant something even more: the magical presence of alpha.
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13 Comments
Add CommentNo, the author fails to understand anything really about Quants or the nature of predictive modeling, which is essentially what they do.
Reply | Report Abuse | Link to thisThis is what is important to understand. Predictive modeling is all about finding correlations in data that can be used to predict the future, AS LONG AS the future acts like the past.
Predictive models are VERY POWERFUL tools, BUT, the use of predictive models IS A SUBSTITUTE for understanding economics. In fact, you don't have to know ANYTHING about economics to build a predictive economic model or to use one, and the fact is that these people didn't in fact really know anything about economics.
Think of a predictive model as being like a GPS. It is a piece of technology that makes it easier and more accurate to find your way from pint A to point B, and its very likely that an idiot with a GPS could find their way from point A to point B on the ocean efficiently than someone who is very skilled at navigation using maps and the stars, a compass, and dead reckoning.
That doesn't mean that the GPS user has a better understanding of navigation or geography, indeed they can easily have less understanding that the sailor skilled in older forms of navigation. And, if the GPS malfunctions they would likely have no means of correcting their course. So even if we are talking about a "genius" who (in theory) designed and built a GPS system, they may themselves be a horrible navigator.
This is what the Quants were. People who had no understanding of economics because they didn't need it, they built a tool that was able to simply find patterns and make predictions without having any need for understanding of how or why things worked the way they did. That's why they didn't see it coming, because they never understood economics, they weren't even actually exercising much intelligence. Building predictive models isn't rocket science, it mostly requires access to mountains of data and a knowledge of applied statistics that can be learned by millions of people. Yeah you have to be good at math, but really, that's about it. It was more about access to data really and taking advantage of a time when other people weren't yet using such methods. They were first movers into a high data driven statistical approach, that's it, and they were like people who could only navigate by staring at a GPS, with no knowledge of what to do with the GPS malfunctioned or to even be able to tell when they were going off course.
Read it awhile ago. Author is trying to glorify nerds who are little in themselves, who merely provided excuses for frauds to defraud and thieves to steal.
Reply | Report Abuse | Link to thisSome of these people had studied economics. Unfortunately they believed in the Neo-classical, mathematics based models instead of other more valid approaches. You know, the one in which the 'market' is always in equilibrium and prices contain all information etc, etc. Pushed by Reagan's economic advisor, Milton Friedman (who Bernanke thinks is the best mind ever and whose prescription for the Depression Bernanke is following)It was those economists who led the trapse off the cliff....lemmings. And every time some one talks about this wonderful nonexistant market they should be pointed to more recent, more relevant studies. AND BTW, all their models followed a normal distribution......gag...........
Reply | Report Abuse | Link to thisWhat all failed to understand is that mathematics is not True (big-T), though perhaps true (little-t).
Reply | Report Abuse | Link to thisLittle-t only means that given the assumptions and axioms, the math is consistent.
Big-T means that the mathematical theory accurately models the real world.
The quants' mathematics never achieved the Big-T.
Newton had it right - unless you can quantify fear and greed, the standard market view is only a partial model of reality and it won't get you far.
Reply | Report Abuse | Link to thisAn economic equivalent of the kinetic theory of gases (or Azimov's fictional Psychohistory) would be a useful model, but don't hold your breath.
These quants should loose their PhDs. They should be stripped off their degrees for failing to understand the problem at hand. After all, it is partly their "wrong theories" that lead to this meltdown (ofcourse together with deregulations and stuff ).
Reply | Report Abuse | Link to thisIt's the question, as the famous line goes on The Matrix. And that question is, how is stock market trading different from poker odds with a deck of cards?
Reply | Report Abuse | Link to thisThe answer: Assuming it's not a rigged game, assuming each hand is dealt consistently and honestly, a deck of poker cards remains constant. Cards do not change. It would take a magician to turn a Queen into a King.
However, even if the stock market is traded completely above board, consistently and honestly, the very nature of stocks can transform Queens into Kings overnight. For if a trader "corners the market," the market is mysteriously yet mathematically no longer "cornered." Odds change like a chameleon. That is what Newton was likely alluding to.
I dare say the so-called "Quants" should have been less greedy and taken what the market can "afford" to give. For example, if you could possess literally all the money in the world, that money would become instantaneously worthless. The distribution of wealth is the basis of personal wealth.
I have found that some of the stupidest people are also cunning, they use their rat-cunning (my apologies to rats) to hide their stupidity. Conversely, an intelligent person may not be cunning, and thus be hoodwinked by someone who is cunning, like Newton was. Thus, you can get someone who is stupid and cunning is also rich. It is really a matter of attitude, a dishonest attitude.
Reply | Report Abuse | Link to thisI truly appreciated rationalrevolution's comments:
Reply | Report Abuse | Link to this"This is what is important to understand. Predictive modeling is all about finding correlations in data that can be used to predict the future. AS LONG AS the future behaves like the past. Predictive models are VERY POWERFUL tools,BUT the use of predictive models IS A SUBSTITUTE for understanding economics
Now change that last word from economics to climate and think about this whole article again
DUM-de-dum-de-dum. Solution to problem:
Reply | Report Abuse | Link to this1. Make public trading of stocks, etc., 'real' by forcing buyers to hold what they buy for a given period of time; an hour, a day, a week, whatever. That'll put an end to arbitragers, buy-and-flippers and all of that sort. It'll also free mathematically-gifted individuals to the labour market and palliate America's shortage of 'intellectual labourers'.
2. To provide market liquidity, nationalize 'liquidization' by making it a low-cost (self-funding?) government service. If it makes enough money, then lower taxes.
All right, the above is KIND of tongue-in-cheek, but has anyone ever even DISCUSSED liquidity management by government?
"What went wrong?"
Reply | Report Abuse | Link to thisWrong? Wrong for whom?! Aren't the quants still 'filthy rich'? So perhaps they lost some from the top, but it's others who still pay for it..
The world is still smarting from the exorbitant gambling excesses, because the banks & governments gave free rein to those 'daring young men', who were in reality, testosterone-fuelled would-be alpha males let loose, trying to outdo each other in the mad pursuit of risking other people's money, whether real or only virtual. The Sub-prime fiasco had its roots in Clinton's empty promises to make every American, solvent or not, capable to 'own' their own house. In reality,even blind Eddy could see that where there's no work there's no money! The bankers' empty wheelings and dealings with 'rotten-apple' mortgages did the rest. As Australians put it: Finally Sh-it hit the fan.., So we were grounded with an unwanted reality shock, the 'Global Financial Crisis'.
Reply | Report Abuse | Link to thisBailing out the weakest economies with newly printed money, just to keep the banks solvent won't help; they do not deserve being saved - after what they did to the world economy with their roguish behaviour in the first place!
We do not need a Ph.D to see that any chain is only as strong as its weakest link,
what goes up must come down,
and let's watch out for that domino effect!
Many humans are clever, very few are intelligent. The difference is subtle but significant. The clever ones will be the end of us.
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