The UnRules The UnRules Man, Machines and the Quest to Master Markets IGOR TULCHINSKY This edition first published 2018 © 2018 Igor Tulchinsky Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley publishes in a variety of print and electronic formats and by print-on- demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. 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It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Library of Congress Cataloging-in-Publication Data Names: Tulchinsky, Igor, 1966– author. Title: The unrules : man, machines and the quest to master markets / by Igor Tulchinsky. Description: Chichester, West Sussex, United Kingdom : John Wiley & Sons, 2018. | Includes index. | Identifiers: LCCN 2018003403 (print) | LCCN 2018005290 (ebook) | ISBN 9781119372110 (pdf) | ISBN 9781119372127 (epub) | ISBN 9781119372103 (cloth) Subjects: LCSH: Success in business. | Strategic planning. | Information technology. | Information society. | Tulchinsky, Igor, 1966– Classification: LCC HF5386 (ebook) | LCC HF5386 .T82865 2018 (print) | DDC 650.1—dc23 LC record available at https://lccn.loc.gov/2018003403 Cover Design: Ed Johnson Set in 13/15pt and ITC Garamond Std by SPi Global, Chennai, India Printed simultaneously in the US, Great Britain and Singapore. 10 9 8 7 6 5 4 3 2 1 Contents Foreword vii Preface xi CHAPTER 1 Quake 1 CHAPTER 2 The UnRule that Rules the Rest 11 CHAPTER 3 Parallel Universes 21 CHAPTER 4 Signal and Noise 33 CHAPTER 5 Waves 49 CHAPTER 6 Correlation 63 CHAPTER 7 Scaling Up 79 CHAPTER 8 An Exponential World 95 CHAPTER 9 Quant Biology 109 CHAPTER 10 The Age of Prediction 125 Index 137 v Foreword gor Tulchinsky and I had very different formative experiences. I His childhood was constrained by the spiritual oppression of life in the Soviet Union, while mine was enriched by the opportunities available to middle-class kids in 1950s’ America. Yet we had much in common: caring parents, a love of reading, and a fascination with math. As one of today’s leading quantitative investors, Igor under- stands better than most the numbers that underlie dynamic markets. “Markets can be seen as waves,” he writes. “They resemble the reg- ular oscillations of a musical instrument.” That’s a valid observation, although different from the way I came to learn about business and finance. As a college student, I was influenced by the writings of the late Nobel Laureate Gary Becker, and by personal experiences that made me realize how many aspiring entrepreneurs – especially minorities and women – were being denied access to capital. Igor’s approach has relied on rigorous and sophisticated math- ematical analysis to identify trading opportunities. This might seem very different from a reliance on theories of human capital – the talent, training, and experiences of people – and the effects of soci- etal trends on business success that I use. But in reality, we both seek to predict the most likely future based on what we observe. Understanding numbers and understanding people can both yield important insights that contribute to financial success. And we concur on several important points that are discussed in this book: • All markets contain risk, and without risk there are no gains. Careful research can discover the price of risk more accurately. vii viii Foreword • Markets also contain psychological traps, such as confusing correlation with causation. If most people are ensnared by these traps, an objective investor who follows the research – like the proverbial one-eyed man in the land of the blind – has an advantage. • The best investors seek and distill advice from widely diverse sources. • The study of markets and the study of biology have much in common. Each is a data-driven information science; each uses predictive algorithms in seeking a needle in a haystack of data. As Igor points out, the next great disease breakthrough might be discovered using the same mathematical techniques he uses to analyze financial data. • Talent is distributed around the world. Genius lives everywhere. Igor and I both also believe in history’s important lessons. A 2010 book about financial markets said that “real estate prices col- lapsed, credit dried up and house building stopped.” That sounds like a description of 2008. But it actually refers to 1792, during the administration of George Washington. More recently, stock mar- kets dropped sharply, banks curtailed lending, and unemployment rose to double digits. Again, that wasn’t 2008, it was 1974. Live long enough and you begin to appreciate what remains constant through cycles of history. Yet also note that history isn’t a sine wave that repeats patterns exactly; it’s more like a helix – similar events return in a different orbit. This is why research is crucial. Investors who conduct careful research are usually better insu- lated against inevitable market downturns. They understand that the value of debt securities underpins all capital markets, that lever- age is a dangerous tool in volatile markets, that ratings are not always a reliable measure of credit quality, that interest rates are not predictable, and that government actions often distort markets. Although these basic investing principles change little over time, the tools of finance have changed dramatically. When I studied quantitative economics at Berkeley in the 1960s, computers were expensive, relatively inaccessible, room-sized machines with little power to model investment scenarios. By 1976 processing was speedier, but the storage cost for the IBM System/370 that my Foreword ix business installed was still $1 million per megabyte. Today data processing is millions of times faster, available to nearly anyone on earth, with virtually infinite storage in the cloud at a cost that approaches zero. This technology revolution has changed the world in many fields. Its impact on biomedical research and precision medicine, for example, has accelerated clinical science and saved untold num- bers of lives. There is great opportunity for it to advance beyond its current state through partnerships such as the WorldQuant Initiative for Quantitative Prediction at Weill Cornell, which Igor founded. In the area of finance and investing, Igor and his colleagues now can do what 1960s’ finance students could only dream of – simulate reality by creating millions of algorithms (called alphas) that iden- tify trading opportunities with remarkable speed and accuracy. Although we see markets through different lenses, Igor and I are in complete agreement on one of the most important social issues of our time: providing a path to a meaningful life for every worker, no matter how much traditional work is disrupted by advancing technology. In 2017 we co-authored a Wall Street Journal opinion article about the challenges of automation and artificial intelligence. We concluded that digital innovation and robots are opening new possibilities for workers and that the future workplace can pro- vide the opportunity for lives of purpose. We believe, in short, that technology leverages human capital and that wisely deployed tech- nology creates more jobs than it destroys. The key, of course, is to provide abundant opportunities for training and retraining. The workplace of the future can already be seen in the inter- national operations of Igor’s company, WorldQuant. Separately, the WorldQuant Foundation’s WorldQuant University offers students a tuition-free online master’s degree program in financial engineer- ing. By providing opportunities for a diverse group of bright people who are willing to work hard toward a clear goal, Igor is expanding human capital and helping assure a more prosperous tomorrow. The UnRules is a valuable guide for getting there. Michael Milken Chairman of the Milken Institute Preface eople who know me well are aware that I’m a man of few P words. In fact, I joke that you only have so many words in life, and when you use them up, you die. Of course, now that I’ve writ- ten this book, I’m living dangerously. When we are born, our languages are bestowed upon us. I was born in the Soviet Union, in Minsk, now the capital of Belarus, and I grew up speaking Russian.