The money poured in, crazy money. Pension funds across America, burned by the dot-com collapse in 2000, rushed into hedge funds, the favored vehicle of the quants, entrusting their members' retirement savings to this group of secretive and opaque investors. Cliff Asness's hedge fund, AQR, had started with $1 billion in 1998. By mid-2007, its assets under management neared $40 billion. Citadel's kitty topped $20 billion. In 2005, Jim Simons announced that Renaissance would launch a fund that could juggle a record $100 billion in assets. Boaz Weinstein, just thirty-three, was wielding roughly $30 billion worth of positions for Deutsche Bank.
The growth had come rapid-fire. In 1990, hedge funds held $39 billion in assets. By 2000, the amount had leapt to $490 billion, and by 2007 it had exploded to $2 trillion. And those figures didn't capture the hundreds of billions of hedge fund dollars marshaled by banks such as Morgan Stanley, Goldman Sachs, Citigroup, Lehman Brothers, Bear Stearns, and Deutsche Bank, which were rapidly transforming from staid white-shoe bank companies into hot-rod hedge fund vehicles fixated on the fast buck—or the trillions more in leverage that juiced their returns like anabolic steroids.
The Great Hedge Fund Bubble—for it was a true bubble—was one of the most frenzied gold rushes of all time. Thousands of hedge fund jockeys became wealthy beyond their wildest dreams. One of the quickest tickets to the party was a background in math and computer science. On Wall Street Poker Night in 2006, Simons, Griffin, Asness, Muller, and Weinstein sat at the top of the heap, living outsized lives of private jets, luxury yachts, and sprawling mansions.
A year later, each of the players in the room that night would find himself in the crosshairs of one of the most brutal market meltdowns ever seen, one they had helped to create. Indeed, in their search for Truth, in their quest for alpha, the quants had unwittingly primed the bomb and lit the fuse for the financial catastrophe that began to explode in spectacular fashion in August 2007.
The result was possibly the biggest, fastest, and strangest financial collapse ever seen, and the starting point for the worst global economic crisis since the Great Depression.
Amazingly, not one of the quants, despite their chart-topping IQs, their walls of degrees, their impressive Ph.D.'s, their billions of wealth earned by anticipating every bob and weave the market threw their way, their decades studying every statistical quirk of the market under the sun, saw the train wreck coming.
How could they have missed it? What went wrong?
A hint to the answer was captured centuries ago by a man whose name emblazoned the poker chips the quants wagered with that night: Isaac Newton. After losing £20,000 on a vast Ponzi scheme known as the South Sea Bubble in 1720, Newton observed: "I can calculate the motion of heavenly bodies but not the madness of people."
From The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It; © 2010 by Scott Patterson. Excerpt reprinted with the permission of the publisher.
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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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