A Review of the Quants

Book Review The Value of Nothing: A Review of The Quants Reviewed by David Steinsaltz The Quants believing that “this Scott Patterson time is different” Crown Business, 2010 [15]. The most re- US$27.00, 352 pages cent round of ex- ISBN-13: 978-0307453372 cuses was pro- vided, if not directly Scott Patterson, former financial journalist for by mathematicians, The Wall Street Journal, has written a book-length then under the ban- love letter to quantitative finance and its practi- ner of mathematics, tioners. To judge by some comments posted on and the crisis that amazon.com and elsewhere, though—“naïve”, ensued was of ter- “mathematically illiterate”, “sensationalism”, rifying proportions. “bumbling idiot”—the love is not requited. Of For this reason alone course, the book is not really about the sort of The Quants would people who write comments on the websites of deserve the attention online retailers. The “quants” of Patterson’s title of the mathemati- are a handful of capitalist potentates, supremely cal community. Few successful and influential practitioners of math- readers will be bored, and most will learn some ematically inspired finance. Putting to one side things that are worth knowing about the world a certain oversensitivity to criticism and the un- and about the place of mathematics in the world. questionably sensationalist subtitle—“How a New This book joins a long list of recent popular Breed of Math Whizzes Conquered Wall Street and or semipopular titles on quantitative finance and Nearly Destroyed It”—many who identify with the its practitioners. It is not the best in all respects, job title “quant” are very far removed from the certainly not as a technical primer. Its approach world of Patterson’s conquering heroes and from can seem infuriatingly nonanalytical and apolitical, Patterson’s enthusiasm for them. While the book even willfully obtuse at times. But it is intelligent makes little pretence of reflecting their careers and serious, by and large, and its relentless focus or their experience, it probably offends by imply- on the look and feel of the rarefied quant world, ing—with little evidence—that the managers and although a limited perspective, is a valuable one, the menials share a unified mathematical culture and one that requires the skills of a talented jour- and mindset. nalist, which Patterson obviously is. But the managers, and their real and perceived The quants, as Patterson describes them, relationship to mathematics, do make an impor- “couldn’t care less about a company’s ‘fundamen- tant story. Economic historians teach us that one tals’, amorphous qualities such as the morale of indispensable ingredient in a financial crisis is its employees or the cut of its chief executive’s jib. an excuse for ignoring the lessons of the past, That was for the dinosaurs of Wall Street […] who for overriding the traditional safeguards, for focused on factors such as what a company actually made and whether it made it well. Quants were David Steinsaltz is University Lecturer in Statistics and Tuto- agnostic on such matters, devoting themselves rial Fellow in Mathematics and Statistics at Worcester College, instead to predicting whether a company’s stock University of Oxford. His email address is steinsal@ would move up or down based on a dizzying array stats.ox.ac.uk. MAY 2011 NOTICES OF THE AMS 699 of numeric variables.” It’s an old story, actually. stock purchases, futures contracts—differ only in A similar conflict embroiled the earliest attempts, name from gambling. Indeed (see [4, Chapter 3.2]) three centuries ago, to expand the nascent life insurance in the sixteenth and seventeenth probability theory beyond its disreputable origins centuries was often a short-term bet on the life in games of chance. Historian Lorraine Daston of some famous person. Usually the accusation writes, “The mathematicians created a new ap- is lobbed from the left, to be dismissed by the fi- proach to the subject that challenged the previous nanciers as propaganda, ignorant of the vital work practice of risk, legal and otherwise. [ …] It was as performed by capital markets. It is a surprise to see if the jurists and the commercial class they wrote how many of today’s leading financiers—not all of for lived in a world of fine-grained detail where them mathematical types—have come to embody regularities were partial at best […] The mathema- this accusation. “Every day they went head-to-head ticians, in contrast, apparently lived in a world on Wall Street, facing off in a computerized game strictly governed by invariable laws that could be of high-stakes poker in financial markets around expressed as the function of a small number of the globe, measuring one another’s wins and losses variables” [4, Chapter 3.1]. from afar, but here [in their quant poker games] In that twilight struggle, B. Gnedenko has ar- was a chance to measure their mettle face-to-face.” gued [11], the probabilists were routed. From the It is not the least of the paradoxes that Patter- early gambling studies there followed a profusion son’s protagonists eagerly seek risk in gambling, of “papers devoted to applications in various while their core mathematical models presume branches of the natural sciences and public life. that investors pay a premium to dispose of risk. Many of these had so little validity that they were The contradiction does not seem to register on considered ‘mathematically scandalous affairs’. Patterson, who throughout seems entranced by Disenchantment followed and among Western these sharp operators using financial markets as European mathematicians probability theory began a gambling den. to be thought of as some kind of mathematical After probability and compound interest, the entertainment hardly deserving serious attention.” key financial principle underlying the quant mod- Probability’s association with gambling endan- els is arbitrage, the financial perpetual motion gers more than just respectability. Human beings machine generated by price discrepancies. In have natural intuitions about risk that are system- principle, if you find the same asset being sold at atically violated by cards, dice, and roulette wheels. different prices in different markets—Patterson As evolutionary psychologists have remarked, “If uses the example of gold trading for $1,000 in New humans had evolved in casinos where their win- York and $1,050 in London—you can buy in one nings translated into reproductive success, selec- market and sell in the other to generate riskless tion probably would have eliminated the gambler’s profit. Back in the day, you would need to float fallacy” [13]. In the real world, probability theory your gold bricks over the Atlantic, but today the is a specialized adjunct to more natural human only limit on your profits would be the amount of intuitions, not a substitute for them. money you could borrow and the amount of gold In Patterson’s account, modern quantitative you could buy before the New York market raises finance originated with Ed Thorp, a mathematician the price. Statistical arbitrage expands the pos- who applied the Kelly criterion to blackjack in his sibilities, by allowing for randomness. It attempts 1962 book Beat the Dealer before turning the same to extract profits from discrepancies in the future principles to finance in Beat the Market (1967). Pat- expectations of combinations of assets. Patterson terson makes clear (as do other sources) that Thorp is at his best when describing these strategies, both himself has always been the farthest thing from the mechanisms and the psychology that gives a gambler by temperament, but some of his intel- birth to them. These depend, in different ways, lectual heirs revel in high-stakes poker parties and on inefficiencies in pricing mechanisms, creating junkets to Las Vegas casinos. Describing the credit short-term disequilibria that can generate profits derivatives group at Deutsche Bank around 2000, as they reset. Patterson writes “In their downtime, Weinstein’s Unless they don’t. The book is punctuated by traders would randomly bet on just about anything crises, large and small, in which the expectation in sight: a hundred on the flip of a coin, whether fails. A casino owner needs only to pump enough it would rain in the next hour, whether the Dow money through the system and let the law of large would close up or down.” The financial markets numbers take care of the rest. In the financial are “the world’s biggest casino”. While “investors” markets all the “bets” are correlated, in hard-to- put up the money, the quants “place bets”: Bets on estimate ways, and the probabilities are only trade patterns, bets on currency exchange rates, vaguely defined, estimated by analogy with the bets on company growth and defaults, and bets on past. Not to mention that the quant strategies the bets that other traders would make. themselves alter the patterns of the markets. There is nothing new about the accusation that Pumping large quantities of borrowed money financial transactions involving risk—insurance, through these strategies can lead to a meltdown. 700 NOTICES OF THE AMS VOLUME 58, NUMBER 5 Arbitrage is a bit like dumpster diving. Lars • Special privileges. A significant por- Eighner formulated [5] three rules for safely con- tion of quant profits come from their suming discarded comestibles. The third rule: access to information and trades closed answer the question “Why was this discarded?” to ordinary investors. They have top-of- The principle of “efficient markets” says that the-line computer systems for bringing market prices already incorporate all publicly in market information, processing it, available information, so there should not be any and executing trades instantaneously. opportunities for statistical arbitrage. This prin- They work for major international in- ciple need not be true—indeed, there are good vestment banks, or they win preferred- reasons, well discussed in this book, to believe it customer treatment from the banks.

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