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Paul Wilmott Wants To Retrain and Reform Wall Street's Quants
theodp writes "What if an aeronautics engineer couldn't reconcile his elegant design for a state-of-the-art jumbo jet with Newton's second law of motion and decided to tweak the equation to fit his design? In a way, Newsweek reports, this is what's happened in quantitative finance, which is in desperate need of reform. And 49-year-old Oxford-trained mathematician Paul Wilmott — arguably the most influential quant today — thinks he knows where to start. With his CQF program, Wilmott is out to save the quants from themselves and the rest of us from their future destruction. 'We need to get back to testing models rather than revering them,' says Wilmott. 'That's hard work, but this idea that there are these great principles governing finance and that correlations can just be plucked out of the air is totally false.'"
What a concept! Basing conclusions on experimental evidence from testing via trial and error rather than warping reality to fit your business model. That's incredible!
"I have never let my schooling interfere with my education." --Mark Twain
... getting back to the real economy? Many financial products don't add anything to the real economy at all.
Quants only produce models that act in the way that traders expect, and traders do not want bad news. I've done a small bit of modelling before and you always reach a point where there's this one number that is completely made up, and you kinda set things up so the trader makes the call. In this sense, all these models that everyone talks about are not so much as analysis tools as they are communications tools - you sorta code the insight of the trader as to how he or she thinks the market will move. It's a very human business, not one of a bunch of computers run amok. Quants that say otherwise are just full of themselves...
This is my sig.
The idea that Wilmott is the most influential quant is ludicrous, though he is clearly very adept at self promotion. This story is purely an advertisement for his vastly overpriced CQF course.
His idea is to 'test models' ? Amazing.
How about bringing their pay down in line with the pay of others (engineers and scientists) that do analysis of a similar level of difficulty? This is just a guess, but it would seem increased pay attracts people who want to make more money, not those that are genuinely interested in solving the problems in a field.
Nice strawman.
This is just far cry for that happened at big banks and investment firms at the end of the last year. Quants failed, markets crashed beyond believe and below even the worst predictions. Now what Mr. Useless quant, change your theories or bye bye.
I'm a long way from New York, so someone correct me if I'm wrong[*], but I've always understood the problem to lie more with the people feeding data into the equations, rather than with the equations themselves.
Now, I accept that risk calculations consisted of a great deal of voodoo because, as Taleb tells us, they tended to ignore 'Black Swan' events (where the 1 in a million catastrophe wasn't going to happen just yet) and saw patterns where only chaos existed, but as I understand it, the core of the problem was simple greed: money-hungry mortgage and securities dealers deliberately feeding bad data into the system.
So-called quants may be decidedly imperfect, but if someone's willing to game the system to make a buck, nothing the quant does can stop it.
If Wilmott doesn't have an answer to that, I fear that his efforts will only obscure the real problem.
Crumb's Corollary: Never bring a knife to a bun fight.
Who needs people with certificates in oxymorons?
You know, this is just tinkering. It's a way of passing the buck. It's a way of devolving blame. It MUST be the equations, or the software, or some geek or some technological prblem that caused the economics failures.
It wasn't. It isn't.
The reason why we have economic problems is the same old one from the beginning of time -- good old fashioned human greed.
Equations, and new software isn't going to change that. What you need to do is ensure that the people operating systems and processes are ethical and honest. It's really that simple, and also, unfortunately, that difficult.
The problem with economics is that is probably more a sociological study than a idealized science.
Economics talks of supply and demand and perfect markets.
Yet we all know the advertising and social herd behavior affect purchases much more than any real needs or demands.
Nice idea, but Wilmot seems to have forgotten the most basic law of finance---nothing matters so long as you're making lots of money. Does he really think that the Quants on Wall Street and in London care about robust models and statistical significance? No! We're talking about used car salespersons in $5,000.00 suits. The financial industry is completely amoral. The only law is the law of the jungle. You can't confuse greed with a lack of quality control.
You mean being scientific about it? And strictly controlling the inputs so that it isn't just garbage in/garbage out? Crazy talk.
Based on recent experience, Wall Street *WANTS* a big black box that they can crank numbers through and give the answer they desire. They don't want reality or common sense. I mean, how else to explain what they did?
Good luck with it, but excuse me for being so cynical to think that Wall Street won't be interested in something if it interferes with profits and greed. That includes anything based on actual reality.
It's your money they are paying themselves with, not their own. Until YOU sit up and take notice, then actually DO something you're going to continue to get robbed. But hey, I'm making money off you as well, so don't worry about it "nothing to see here, move along".
Deleted
In another time, this would have been called what it is: theocracy, rule by theory.
Oh sure, they can try to be inductive, but there is always that old "correlation doesn't imply causation" gotcha isn't there?
The real solution to this problem with the social sciences was almost addressed by the Protestant culture that founded the US -- the Laboratory of the States -- but the incorporation of the slave states in the 1700s, with the resulting Amendment from Hell, the 14th, in the 1800s killed off that option entirely when "social science" sunk its fangs into the body politc in the 1900s.
"The Union" means everyone is a slave to the theocrats posing as theoreticians.
So now we're running uncontrolled experiments on nonconsenting human subjects in the guise of "public policy" of "liberal democracy" -- tyranny of the majority limited only by a vague laundry list of selectively enforced human rights.
Seastead this.
Good article showing there is a good side to quantitative finance (in addition to the now obvious bad side). My take on this topic is here: http://www.win-vector.com/blog/2009/03/it-is-not-all-the-quants-fault/
The intrinsic softness of social science is that their hypotheses tend to be used for explaining why, not for experimental testing.
The problem with the quants is different. They use statistics to come up with codifiable procedures to generate "magic numbers" that are used to simplify valuation of financial instruments. Statistically derived magic numbers should always come with some kind of "goodness" measure, such as a confidence interval, which tells you the liklihood that your magic number is being usefully descriptive or predictive.
Hardest part is controling the emotions of greed and fear. When things are working, it is temping to make bigger bets. If the bets are too large, they will wipe out the account, or even fund when the natural and normal losses hit.
Risk Managment often goes out the window during good times.
Mathematical models always only work in a certain range As Newtonian mechanics well for smaller velocities and macroscopic bodies it has to be replaced for large velocities or in smaller scales. Exponential growth laws have to be replaced by logistic growth. etc Models are especially popular in probability theory. The text mentions Gaussian Copula function, the "rocket fuel" for collateralized debt obligation, which is cited as one of the reasons for the finance disaster. See "The formula that killed Wall street".
I'm been reading this guy's blog recently, and he has some interesting thoughts on why economists didn't predict the global financial crisis, and how their approach is completely wrong. He's an academic at an Australian university whose predictions of late seem pretty damn close to the truth. He puts together economic models using differential equations - an approach that seems to be very different from most other economists. He essentially says that excessive private debt is to blame for our economic problems.
http://www.debtdeflation.com/blogs
Here's two of the more interesting entries:
DebtWatch - Oct 08
DebtWatch - Dec 08
It just cost us tens trillion dollars to figure out that 30 years of free trading investment oriented capitalism wrecks your manufacturing base, leaves your country hopelessly in debt, and all these so-called free enterprise guys bitching about the UAW making 40k a year are actually not so free enterprise after all, when it comes to bailing them out, or protecting their businesses.
This is my sig.
The reason why the quants ignore Black Swan events is that they are not financially impacted by them to any real extent. They make their living from making small amounts of money using lots and lots of leverage. But I prefer Buffett's metaphor for this sort of practice: picking up nickels in front of a bulldozer.
As long as "quants" can pick up "nickels" in front of a bulldozer for a few years, they can retire and never have to work again, even if their parent companies (and the companies they borrow from) go bankrupt. Those "nickels" are many millions, their percentage of those "nickels" are still high enough to retire on. Of course, they risk billions in the process.
I suspect the only way to really curb the practice would be to either limit amounts of leverage or cause complete bankruptcy/imprisonment/physical harm somehow to those responsible when the bulldozer (the black swan) eventually comes along. Of course, these laws can't really be applied to those responsible for the GFC. Laws can and probably will be created, and then after a few generations those laws will be repealed as the creation of a few old fuddy duddies who didn't understand whatever "new economy" comes along, and the cycle will repeat.
If I have seen further it is by stealing the Intellectual Property of giants.
Wall Street Is just Las Vegas with better clothes. All the day traders and other 'quick money" guys have rendered the idea of having an actual investment in a company because you believe they are going to do well in the future and desiring to be a part of that passe. They have also trained corporations to "damn everything but the quarterly reports!" causing long term damage and even failure to a company in return for short term profits.
We need to get the day traders out, and the investors back in. perhaps by setting up a tax than penalizes anyone who buys stocks for very quick turnovers and rewards those that hold onto a stock for a set period. Because real long term growth of a company takes investment. Investment and the building of infrastructure, training of employees, construction of new buildings, etc and all of these things cost. In the current Wall Street model such investments show up on the quarterly report and torpedo the stock. We should legalize gambling for those that want to take a shot at the quick cash and leave investing in the growth of businesses to investors that are willing to look at the long term picture, not simply the quarterly report.
ACs don't waste your time replying, your posts are never seen by me.
Trillion dollar bet now why did the world trade center get attacked, not once but twice...
Why is everyone blaming the mathematics for the financial problems? Its quite clear that its the industry as a whole is at fault. Greed and corruption are in all facets of the industry. I have a feeling that alot of so-called quants and finance professionals are completely under-qualified for what they do. It has been my experience that most people in finance and business are diletants that just took business in college so they could have it easier than the engineers and science majors. I am sure that a REAL mathematician that specializes in finance could handle the uncertainty in the models accordingly. -I am a mathematician, but my specialty has nothing to do with finance.
That brings me to an interesting point, / . is just "the ramblings of socially-inept, technology-literate news-mongers".
John
I think there is a misperception that quants just run wild with models with catastrophic results and that they are naive when it comes to practical matters. However, quants are also taught about "model risk" to include things like: wrong assumptions, poor estimation of parameters, errors in discretization, etc. Let's also not forget the positive social value of financial innovation. It helps you borrow at lower rates, pay less for insurance, etc. There were a few problems that led to this financial crisis and I think quants played a relatiely minor role.
every one, no exceptions
F=m$? I'd like to see that.
#Computers do not appreciate sarcasm
it's if having a model is right. There's no reason to assume that prior market data contains information that can accurately predict the market in the future.
Are you serious? Your post sounds like just the kind of hand-waving that is done to produce bad quants and bad models. It's a good parody, though: the reality is that just munging together a bunch of hacks doesn't produce any deeper understanding of reality, and thus the model will still suck.
I can think of no better use of tax policy than that of regressively taxing short-term investing.
Over-the-top Response Guy! Giving "Over-the-Top Responses" since 1970.
According to SciAM economics is not a science because it was incoherently built on generalizing physics equations (since invalidated) to a magical concept called "utility" resulting is a system that has no real predictive capacity and is constantly update only after the model proves to be worthless.
rather than prediction. All models are both true and false to a greater or lesser extent and must be used with care. All models must be parametrized and those parameters are often uncertain.
In his classic work "Numerical Methods for Scientists and Engineers" Richard W. Hamming put it this way: "The purpose of computing is insight, not numbers."
And if you don't know who he is, shame on you.
If you believe your models, you're fooling yourself.
putting the 'B' in LGBTQ+
While I am not finding fault with your post, per se, I do think you are overcomplicating the situation, richg74: this is simply a reverse insurance risk pool, i.e., instead of spreading the risk across the greatest pool, the risk is being compounded to infinity (I'm stealing this phrase from others, etc.) - such that an infinite number of credit default swaps may be bought, created, etc., against one borrower, which dramatically skews the risk, not hedges against it. It is basically a fraud scheme, nothing anti-risk about it......
Wall Street, or more accurately, the financial business, isn't a science. Its about selling product. The models provide what a friend of mine in the biz calls "a compelling story" used to move the product.
This latest fiasco is a perfect demonstration of that principle. Investors (wealthy individuals, pension funds, sovereign wealth funds, etc.) demanded a supply of high return, zero risk paper. Investment banks produced things like mortgage-backed securities, where the risk could be stripped out of one class of investments and lumped into the lower classes. Then it was up to the industry to find a way to peddle the lower class (high risk) paper to suckers. Bond rating agencies, insurance schemes (like AIG's CDS products) were created to move the junk. Models were tweaked to convince investors that the bottom slices of mortgage securities were just as good as the good stuff (which wasn't for sale to common investors).
We went after Bernie Madoff's early investors for the money they cashed out of his Ponzi scheme in order to make good some of the losses suffered by later participants. But I see no such attempts to round up all the CDO paper (the good stuff, that is) and disassemble what was essentially a Ponzi scheme of risk. I'm skeptical of any attempts to "fix" models as yet another explanation of why we will have to shoulder down side that wealthy investors don't want.
Have gnu, will travel.
Then whoever wrote that is a moron. It's the equivalent of saying that psychology is not a science because Freud made shit up. There are certainly psychologists who are as full of shit as Freud (likewise with economists) but that does not make psychology not a science.
A subject does not fall into science or not science. Methodology employed is what defines science. Some work in economics is science, and some is not, the same as in psychology.
I make millions every year in the market. I don't do anything more complex than watch charts, read some news letters from technical analysists, and read blogs from people who use common sense, emotional control and the balls to go against the grain.
All these formulas are for pussies. Stick to your spread sheets and leave the money making to real men.
Or don't. Cause the more of you there are, the more money I'll make.
Do you really want to make finance honest? If so, the penalties for gaming the system must be severe.
Since we have a federal death penalty in the US, the question is why do we not use it for large scale financial crime? I am certain that if someone commits a crime that wipes out a billion or more dollars, some person will die as a result. Suicide, homelessness, no medical care, emotional stress, heart attacks, stroke. This can be proven using mortality statistics.
In fact, the death penalty is not a legal option for this kind of crime. I talked to someone about it, and they pointed out that the Supreme Court ruled that child rape does not warrant a death sentence, so it would not be justified for financial crime. And I personalty am opposed to the death penalty under any circumstances. There is far to great a chance that an innocent person will be killed since the system is imperfect.
I raise execution as an example to show how ineffective the current penalties are. So a major Wall Street player makes half or a third of a billion dollars and runs their business into the ground because they were cheating everyone, and suddenly the have a net worth of only $100 million. Do you think that they will end up sleeping in a cardboard box or have to stop taking vital medications or not be able to send their kids to college? If they are fined by the SEC, they don't have to pay the fine themselves, it is covered by insurance that their business paid for. It's like fines in sports, the team picks up the freight.
Actually, tax payers pick up the tab one way or another, because it all becomes a tax write off. The insurance against fines is a tax deduction. This is why it is so difficult to limit executive compensation. In current practice, a company buys a huge life insurance policy on the officers, with the company as the beneficiary. They pay huge bonuses, and they know that when the execs die they will get a lot of that money back. And everyone else subsidies this, because it all is tax deduction for the company.
So fines are meaningless, and even financial ruin leaves the top bracket as multimillionaires. Should anyone be surprised that corrupt self serving practices are the norm? And lets face it, there is no meaningful criminal prosecution. Sure, they'll go after Madoff and Stanford, who are obvious crooks, but they will never file criminal charges against anyone who's company didn't go belly up. So they go after Mozilo from Countrywide Financial, and they might get him for giving favorable loans to congress members, or taking profit out of his company when he knew it was going down the tubes. He might get off. If he does get convicted, it will be because he didn't follow the rules that keep Wall Street crooks rich no matter how inept and corrupt they behave.
Insiders who follow the rules will never be criminally charged no matter what they do. No one at Solomon will be charged, or B. of A. or Citi Bank. No one at the rating agencies (Standard and Poore, Moodies, etc.) will have to pay for their mistakes. The ratings agencies were paid whores. They gave AAA ratings to virtually every piece of toxic sludge out there and they made a ton of money doing it, and as far as I know there are no criminal or civil SEC investigations going on at all. When ther CEOs appeared before Congress, they gave a set of meaningless apologies and pale excuses, and then talked about how they were going to improve their procedures so it wouldn't happen next time. Why are these people still in charge and why are these companies still in business? How come the FBI didn't seize their records and charge them with criminal conspiracy? They are a massive case of pure fail, and they are getting away with it. Yes, there are class action lawsuits, but those will take 5 or 10 years and the only people who will get anything are the lawyers.
So there is no downside to business corruption unless you are a stupid crook. A person with mid level intelligence can steal a fortune and retire rich. Is it any surprise that we face financial ruin?
I call BS. You can't test hypotheses with historical data and moreover you are almost certainly dealing with a chaotic system with plenty of feedback into itself. This isn't science, it's model making of the worst kind, just more of what he's complaining about really.
Sure, traditional "economics" is, was and always will be total and complete BS, but so is saying that you're going to get "empirical" with historical data- the behavior of the market in the past.
Read the Black Swan. Certainly this guy has. Too bad he didn't take away from it the lessons the author was trying to convey- economics is BS and quants are totally FOS, but for a reason- you can't do science on economic "data" or "behavior" at all.
There's a huge difference between models in Newton's world and models in the financial world - feedback. A model that is successful in the real world will always be successful within its parameters. In the financial world, a successful model actually changes the parameters of the world it is modeling. Financial markets work on expectations. A good model changes the expectations of the system which changes its behavior. This feedback effect thus can invalidate the model over time.
It really isn't valid to compare physical models to financial models. Financial models behave much more like models in the social sciences.
Basically what the 'Quants' have done is borrowed some terms from matematics and reapplyed it to the financial world. It's validity being lent a quasi-autthority, as it's based on mathematic tools used in physics, and what could be more scientific than that.
:]
Trouble is, the financial world can't be modeled or predicted the same way the phisical world can. It works more like the utterances of a shaman. If the shaman predicts the stock is going to go up, and people believe him, and buy, then the stock does indeed go up. If people lose faith in the shamans utterances, then in olden days he would be flung into a volcano, or in our culture, he resigns and joins an international think thank. So what Paul Wilmott really means is how to restore investors faith in the high priests of finance, the Quants.
Of course the trick is in not actually predicting anything. That's where the Black-Scholes model comes in. By slicing and dicing the base equity into packages (I hereby name quantums), it becomes impossible to actually value or quantify the real and actual value of your particular pile of quantums. The only thing you get to rely on is 'a standard normal cumulative distribution function', which no-one really understands, or the word of the Quant. And if you complain you lost money, the Quant replies, you didn't read the numbers properly. You might as well slaughter a chicken and try and read the entrails.
IF anyone wants an inside look at the world of the Quants and dicing-and-slicing, then check out Liars Porker, by Michael Lewis
Lastly, some time ago someone did a test. They created two sets of investors and compared results over a period. One was a respected finance house, the other was a monkey, the monkey won