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.'"

Comments

Hang on...

[grcumb]

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.

Re:Hang on...

[Guil Rarey]

You're not wrong, but I think the author referenced in the original post and you are addressed different parts of the whole problem of financial markets. The willingness of financial services salespeople - mortgage brokers, stock brokers, etc - to basically lie their asses off because there's so much money on the line is one problem.

"Quant" analysis of financial markets is, really, another, related problem. The same moral hazard of too much money to make cutting corners worth it exists, but the basic problem here is that many "quant" models are bullshit. Quantitive models for derivative securities can be realistically valued -- if and only if the risk of the underlying primary asset has been properly assessed (along with several other critical assumptions about the marketplace for the security -- but that's the JUDGMENTAL assumption fundamentally inherent in the models.)

Risk assessment is not actually that difficult -- insurance is built on the ability to do risk assessment. The real problem with the current financial problems were that NO ONE KNEW WHAT THE UNDERLYING PRIMARY ASSETS WERE and everyone operated on the belief that Nothing Could Ever Possibly Go Wrong (because no one could prove otherwise, because no one knew what the hell was actually going on).

This is and was every bit as monumentally stupid an assumption in the financial realm as it is engineering, computer programming, science, or any other real-world discipline.

I think what Wilmott is proposing is the development of models that are more reactive to real-world inputs, models that are much more Bayesian in nature in their ability to refine and revise their predictive nature based on actual events.

     

Re:You can't blame it all on the qunats.

[florescent_beige]

...you always reach a point where there's this one number that is completely made up...

***Try a sensitivity analysis using Monte Carlo techniques. That sounds hard but it isn't. Take the parameter that you have doubts about and give it a distribution (Gaussian or rectangular or something) with the mean at your best guess and the std deviation chosen to be big enough to cover the range it might reasonably vary over.

***Use Gaussian if you have an idea of what the parameter probably is but aren't exactly sure, rectangular if you really have no idea. A rectangular distribution says "I have no idea, the parameter could be anywhere within this particular range."

***Then run your analysis a million times with the parameter selected randomly from it's distribution for each run.

***That gives you a stochastic dataset of results. You can run simple stats on that data set to find the mean and std dev of the result value. You will then know how sensitive your results are to your poorly understood input parameter. If your 2-sigma output tells you the expected rate of return on a particular investment varies between -50% to +50% then you will know your model is pretty much useless and you will be doing a better job than the vast majority of professional analysts.

****Monte Carlo is great for those of us who don't care to learn the arcane minutiae of stat math. If you have a working model it takes an hour or two to extend it so you get stochastic results. Note that it's no harder to give a distribution to all your input parameters not just one. In which case you will be doing the kind of work that people who make 500 grand a year do.

Picking up nickels in front of a bulldozer

[turing_m]

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.