1a Jesse's thought on gambling:
As a caveman Mormon, this is my moral definition of gambling. Gambling redistributes something on the basis of chance, without producing anything of value in the process. Granted, there’s an element of chance in everything in life, but most commerce we engage in produces something. If five people stick all their money in a pot, and one gets it, there's no more money, and nothing’s been created. If five people pool their money and buy an interest in a textile company, who uses the money to weave thread into shirts and sell it, they have been involved in creating something, and have hopefully profited. Because the capital used traditional investing is used to create something, I don't consider it gambling. When I buy a stock, the equity I give to the company is usually used to produce something. Gambling doesn’t create anything except the experience of gambling.
If you’re just paying for the experience, as Jesse’s poker implies, gambling still takes from someone else in order to enhance one’s position. In the case of a slot machine, you’ll get something not because you deserved it, worked for it, but entirely because of chance—that is, someone else paid for it. Or in other cases, someone else paid you because you or were just luckier or smarter (had a better understanding of the odds) than them. That seems to take advantage of unlucky/dumb people. I realize this oversimplifies things a LOT, but its my simple metric.
2. Leverage:
I had trouble believing that quants nearly destroyed wall street. I do not have trouble believing that lots of big mortgages, overvalued homes, Fannie Mae, and mortgage securitization did. We bought our home in Vegas when prices were going up 5% a month. Over the course of a few years the price doubled; now it would sell for less than we bought it. About 1 in every 70 homes received a foreclosure filing this April in Vegas. It is upsetting.
6. I like Greenspan's quote a lot: “I found a flaw...in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.” The May 6, 2010 Flash Crash drop in the stock prices that happened one day last month was interesting. The markets at that moment requiring an immediate downward readjustment would not match Greenspan's pre-crash model, though I imagine some bears out there were waiting for it.
7. It seemed that the moral was “greed is bad” and those really greedy guys who tried to make a lot of money ate it big, and boy, they sure had it coming. While I think greed is bad, I'm not convinced that quants are. I also wish there was an epilogue, as I imagine most of the “quants” are probably doing ok. I watched an interview with the author of a book called More Money than God that seems to represent the quants in a more favorable light, which I plan on reading. I enjoyed the book, but I admit I was glad to read Jesse's post.
Monday, June 28, 2010
Saturday, June 5, 2010
Quants
1) Is Wall Street moral?
No. Are there moral people working on Wall St? Yes, I'd imagine. Do they allow their morality to affect their strategies? I imagine they wouldn't succeed if they allowed morality to influence them significantly. I guess that's the crux; Wall St. measures success in monetary gains. Money is an inherently amoral metric of success. So in that sense I would say Wall St. lacks morality.
That said, I think it would be a mistake to compel Wall St. to be "moral." I think a better question (although probably still not a very good one) is "Is Wall St. fair?" Fair is about as difficult to define in a rigorous way as moral, but I think it's plausible that society would be better off as a whole if Wall St. were more fair.
2) Does the solution have something to do with leverage?
Echoing Jesse, the solution to what exactly? Drastic rises and falls in aggregate stocks? I imagine bubbles will happen whether the government more strictly regulates leverage or not. To the question of whether hedge funds were at all regulated in their use of leverage, I don't know an absolute answer. But Patterson certainly gives the impression that they were internally regulated, either through overarching strategies (when they resided in investment banks) or through external pressues (as in the "run on the bank" deleveraging that Patterson describes in the last third of the book).
The issue of a hedge fund's (or an investment bank's) failure causing a hole in the economy that hurts lots of people "who didn't necessarily have it coming to them" I suppose that's sort of what I meant by "fair." You'd like the costs to be borne more heavily by the main actors rather than peripheral actors (presumably the staid retirment 401k investors, or the small business owners who can't make payroll because there's a credit crunch). But what you're perceiving as a lack of fairness (again, I'm not sure I'd define it that way) cuts both ways; during the boom years, small investors and small businesses benefitted from the cheap credit that was being generated primarily for the big players.
3) Did the quants really play as big of a role in the crash as Patterson makes out?
It seems unlikely to me that the Quants really played as significant a role as Patterson makes out. If I were assigning blame, it'd be 1) to the Fed for keeping interest rates too low for too long, 2) to the ratings agencies who weren't sufficiently reactive to the creation of new products and 3) to the government agencies who should have been more capably overseeing at least the foreign markets for US products.
4) Should the quants have seen it coming?
Do you mean "should they have been able to see it coming" or "were they wrong not to see it coming?" I would certainly say no to the second case, but a qualified yes to the first. At least from the analysis Patterson provides (which I recognize is not only incomplete, but likely biased) it seems like several of the strategies failed to learn adequately from the fall of LTCM. At least in Patterson's telling, it was viewed as an aberration that was statistically unlikely ever to occur again (lightning doesn't strike in the same place twice). If that's truly the case, then I would say anyone generating a market model that fails to explain what happened in the lead-up to the failure of LTCM was being myopic.
As an additional point, I know Patterson heaps contempt on the VAR and the Gaussian cupola, and probably rightly so. But it seems like there are regimes where the approximations work quite well. Perhaps some of those Phyics PhDs could come up with some sort of near field-far field approach to the markets, and particularly discover if there's a phase transition between the two.
5) Adaptive Market Hypothesis.
I thought the AMH (and the related "ecological" approach out of Sante Fe) were a little bit silly. Not that evolutionary algorithms or models can't perform well, but I didn't see (at least from Patterson's brief descriptions) any sort of rigorous analysis of why they should work.
Another note on modeling; where are the game theoretic models? If there's a shortcoming of the EMH, I would say it's in its failure to adequately model the impact of homogeneous strategies. Again, in the simultaneous deleveraging that occurred in Oct. 2007 (and throughout 2008) it seems like having an adversarial model (something akin to a multi-stage Prisoner's Dilemma) would have improved performance. But who knows; maybe that's exactly what triggered the deleveraging. Some company that decided they would deleverage first and stick everyone else with the sucker's payoff.
6) The last lines of the book are:
"Just look: exotic leveraged vehicles marketed to the masses worldwide, hedge fun ds gaming their returns, lightning-fast computerized trading robots, predatory ninja algorithms hunting liquidity in dark pools...Here come the quants."
This encapuslates much of what I don't like about the book. Patterson's moral (if there is one) is a cautionary tale about the harm in being overly certain. But then he lauds "non-Quant" investors like Warren Buffett and Bill Gross because they do things "the right way" in a certain sense. But the idea that theirs is "the right way" betrays (to me at least) the same sense of hubris and certainty in his own "rightness." After spending all book knocking the quants for believing in "the Truth," here's Patterson himself, in the final pages, looking to prophets like Taleb and Gross as conduits of the Truth. And he seems oblivious to the fact that he's doing, which is sort of disheartening.
7) What is the moral to Patterson's narrative?
See my answer to (6).
I did really enjoy the book. I didn't think I would after the first chapter, guessing it would suffer from the "Tracy Kidder" disease of overly flowery lauding of the protagonists. But once it got down to business, so to speak, I really felt it picked up and pulled me in.
Thanks for a great read!
No. Are there moral people working on Wall St? Yes, I'd imagine. Do they allow their morality to affect their strategies? I imagine they wouldn't succeed if they allowed morality to influence them significantly. I guess that's the crux; Wall St. measures success in monetary gains. Money is an inherently amoral metric of success. So in that sense I would say Wall St. lacks morality.
That said, I think it would be a mistake to compel Wall St. to be "moral." I think a better question (although probably still not a very good one) is "Is Wall St. fair?" Fair is about as difficult to define in a rigorous way as moral, but I think it's plausible that society would be better off as a whole if Wall St. were more fair.
2) Does the solution have something to do with leverage?
Echoing Jesse, the solution to what exactly? Drastic rises and falls in aggregate stocks? I imagine bubbles will happen whether the government more strictly regulates leverage or not. To the question of whether hedge funds were at all regulated in their use of leverage, I don't know an absolute answer. But Patterson certainly gives the impression that they were internally regulated, either through overarching strategies (when they resided in investment banks) or through external pressues (as in the "run on the bank" deleveraging that Patterson describes in the last third of the book).
The issue of a hedge fund's (or an investment bank's) failure causing a hole in the economy that hurts lots of people "who didn't necessarily have it coming to them" I suppose that's sort of what I meant by "fair." You'd like the costs to be borne more heavily by the main actors rather than peripheral actors (presumably the staid retirment 401k investors, or the small business owners who can't make payroll because there's a credit crunch). But what you're perceiving as a lack of fairness (again, I'm not sure I'd define it that way) cuts both ways; during the boom years, small investors and small businesses benefitted from the cheap credit that was being generated primarily for the big players.
3) Did the quants really play as big of a role in the crash as Patterson makes out?
It seems unlikely to me that the Quants really played as significant a role as Patterson makes out. If I were assigning blame, it'd be 1) to the Fed for keeping interest rates too low for too long, 2) to the ratings agencies who weren't sufficiently reactive to the creation of new products and 3) to the government agencies who should have been more capably overseeing at least the foreign markets for US products.
4) Should the quants have seen it coming?
Do you mean "should they have been able to see it coming" or "were they wrong not to see it coming?" I would certainly say no to the second case, but a qualified yes to the first. At least from the analysis Patterson provides (which I recognize is not only incomplete, but likely biased) it seems like several of the strategies failed to learn adequately from the fall of LTCM. At least in Patterson's telling, it was viewed as an aberration that was statistically unlikely ever to occur again (lightning doesn't strike in the same place twice). If that's truly the case, then I would say anyone generating a market model that fails to explain what happened in the lead-up to the failure of LTCM was being myopic.
As an additional point, I know Patterson heaps contempt on the VAR and the Gaussian cupola, and probably rightly so. But it seems like there are regimes where the approximations work quite well. Perhaps some of those Phyics PhDs could come up with some sort of near field-far field approach to the markets, and particularly discover if there's a phase transition between the two.
5) Adaptive Market Hypothesis.
I thought the AMH (and the related "ecological" approach out of Sante Fe) were a little bit silly. Not that evolutionary algorithms or models can't perform well, but I didn't see (at least from Patterson's brief descriptions) any sort of rigorous analysis of why they should work.
Another note on modeling; where are the game theoretic models? If there's a shortcoming of the EMH, I would say it's in its failure to adequately model the impact of homogeneous strategies. Again, in the simultaneous deleveraging that occurred in Oct. 2007 (and throughout 2008) it seems like having an adversarial model (something akin to a multi-stage Prisoner's Dilemma) would have improved performance. But who knows; maybe that's exactly what triggered the deleveraging. Some company that decided they would deleverage first and stick everyone else with the sucker's payoff.
6) The last lines of the book are:
"Just look: exotic leveraged vehicles marketed to the masses worldwide, hedge fun ds gaming their returns, lightning-fast computerized trading robots, predatory ninja algorithms hunting liquidity in dark pools...Here come the quants."
This encapuslates much of what I don't like about the book. Patterson's moral (if there is one) is a cautionary tale about the harm in being overly certain. But then he lauds "non-Quant" investors like Warren Buffett and Bill Gross because they do things "the right way" in a certain sense. But the idea that theirs is "the right way" betrays (to me at least) the same sense of hubris and certainty in his own "rightness." After spending all book knocking the quants for believing in "the Truth," here's Patterson himself, in the final pages, looking to prophets like Taleb and Gross as conduits of the Truth. And he seems oblivious to the fact that he's doing, which is sort of disheartening.
7) What is the moral to Patterson's narrative?
See my answer to (6).
I did really enjoy the book. I didn't think I would after the first chapter, guessing it would suffer from the "Tracy Kidder" disease of overly flowery lauding of the protagonists. But once it got down to business, so to speak, I really felt it picked up and pulled me in.
Thanks for a great read!
Tuesday, June 1, 2010
I swear I didn't do it!
Thanks to Karl for posing a few questions to provide some structure to the discussion. As a preface I should make clear / remind that I am considered a "quant" by some people and work for/manage what most would consider a "hedge fund". I have met Cliff Asness (one of the "players") and am friendly with Boaz Weinstein (another "player"). So I am hardly an objective witness.
Before answering Karl's questions I'll start with my overall view of the book---namely that the author has no idea what he's talking about. He makes obvious that he doesn't know what quants are or what they do, and he has very little grasp of what happened in financial markets over the last few years. He's misinformed but with a strong (and populist) opinion, which makes for a dangerous combination.
1. Wall St is not moral. But are most people/professions? Commerce generally exists to make participants to a transaction better off. This is also the purpose of "Wall St". Yes it is full of egotistical, hedonistic gamblers. I'm not sure why that's relevant, except for schadenfreude, but even that is a failure here as the "quants" actually did very well in the crisis of the last few years (as I said, the author is fairly misinformed here).
1a. What is the line between investing and exploitation or gambling? I'm not sure where "exploitation" enters here as a possibility. The counterparties to transactions on Wall St are typically multi-billion dollar institutions, so it's hard for me to understand exactly how they are "exploited". Maybe the taxpayers are exploited because of the relationship between Wall St and the federal government (hint: not both working hard to help average taxpayer)?
More interesting to me is the difference between gambling and investing. Frankly I've never really been sure of this (but then again I've never really had an internal moral aversion to gambling). Life is full of decision-making with uncertainty. Is spending money on graduate school gambling? Buying a house? Buying home-owner's insurance? Waiting to get my transmission fixed? All of these have implications for my financial well-being. Maybe part of them is not gambling (part of the result is near certain) but that still leaves part of it as gambling. Most non-professional investors lose far more money picking stocks than they ever could in Las Vegas, yet view the former as prudent and honorable and the latter as scandalous and immoral. In both cases the deck is stacked against them, they on average give money away, and are doing it for no reason than to make money. On the other hand, if I play poker (which I enjoy doing from time to time) I on average make (small) money and do it primarily because I find it intellectually stimulating. As I said, I've never really understood this, so I'd be glad to hear others' thoughts.
2. The solution to what? It'd be helpful to know what we're solving before prescribing a solution.
"Leverage" is actually pretty hard to define. How levered is your car insurance company? If even 10% of their customers totaled their cars on the same day, they'd be insolvent. So is this imprudent "leverage"? Too often these terms are thrown around without proper context.
Was leverage in hedge funds a cause of the crisis? Not in the slightest. Of course that's because hedge funds had almost nothing to do with the crisis, especially quant hedge funds, but you'd never know that from reading this book. Can anyone name a single hedge fund that went under during this crisis that had any effect whatsoever on the rest of the market?
Leverage in banks? Now we're getting warmer. Govt regulation allowed banks to take on significant leverage but made it worse by arbitrary modifications to how that leverage was calculated (mark-to-market rules, etc). Regulation also allowed institutions to abdicate the responsibility for risk management in investments as they simply owned as much appropriately rated stuff as regulation would allow. "The govt says I can own up to 20% AAA securities, this is AAA, so I'm fine".
Leverage in the govt-sponsored enterprises (Fannie Mae, Freddie Mac) and residential real estate market...bingo! If we're discussing outlawing anyone putting less than 30% down on their home then we're talking about something with real teeth...though somehow a bit less popular politically...
3. Quants if anything made the crisis less severe. Patterson is clueless but pushes a narrative that most people will find intuitive. Quants buy and sell things based on models of their value. The people who exacerbated the problems bought based on ratings/regulatory capital requirements. Again, can anyone name a single hedge fund whose demise had any effect whatsoever on the markets? It's really stunning how off-target this book is.
I'll skip the other questions as their answers would mostly refer to what I've already written. In sum I obviously didn't find the book too enlightening and think it mostly confuses what really happened. Of course to write what I think really happened would take more time than I have, but if any of you are ever in town and want to grab lunch...
June Book--Alice
Based on the comments, I'm going to pick A Town Like Alice. Sorry Alvin--as a consolation, you could watch the 1950s movie on YouTube. There are a few things about the book that I feel I should disclose: the characters are rather flat; the second half is, I'm told, a little boring; and you should skim the end of chapter 7.
Homo Politicus http://www.amazon.com/Homo-Politicus-Strange-Tribes-Government/dp/0385517505 was tedious, politically biased, and felt like a tabloid Magazine featuring only ugly evil people. It reminded me, however, how much I like DC but dislike Potomac Man.
The Drunkard's Walk http://www.amazon.com/Drunkards-Walk-Randomness-Rules-Lives/dp/0375424040 felt like a well-written statistics primer until the last chapter, which was very interesting. It was interesting to have read this book prior to The Quants
The Nine http://www.amazon.com/Nine-Inside-Secret-World-Supreme/dp/0385516401#noop (ever so slightly dated Supreme Court expose, and though I've not read it, likely politically charged)
A Town Like Alice http://www.amazon.com/Town-Like-Alice-Nevil-Shute/dp/0345353749 (mostly fictional WWII story)
Right Ho, Jeeves http://www.amazon.com/Right-Ho-Jeeves-Audio-Editions/dp/1572704233/ref=sr_1_1?ie=UTF8&s=books&qid=1275410088&sr=1-1
PG Wodehouse is one of the funniest people ever to have lived; Jeeves, I think, is best on audio book.
Homo Politicus http://www.amazon.com/Homo-Politicus-Strange-Tribes-Government/dp/0385517505 was tedious, politically biased, and felt like a tabloid Magazine featuring only ugly evil people. It reminded me, however, how much I like DC but dislike Potomac Man.
The Drunkard's Walk http://www.amazon.com/Drunkards-Walk-Randomness-Rules-Lives/dp/0375424040 felt like a well-written statistics primer until the last chapter, which was very interesting. It was interesting to have read this book prior to The Quants
The Nine http://www.amazon.com/Nine-Inside-Secret-World-Supreme/dp/0385516401#noop (ever so slightly dated Supreme Court expose, and though I've not read it, likely politically charged)
A Town Like Alice http://www.amazon.com/Town-Like-Alice-Nevil-Shute/dp/0345353749 (mostly fictional WWII story)
Right Ho, Jeeves http://www.amazon.com/Right-Ho-Jeeves-Audio-Editions/dp/1572704233/ref=sr_1_1?ie=UTF8&s=books&qid=1275410088&sr=1-1
PG Wodehouse is one of the funniest people ever to have lived; Jeeves, I think, is best on audio book.
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