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The Wall Street meltdown might have a silver lining.
- Niall Ferguson, The Ascent of Money. Excellent and very lucid writing. I read this on a plane to Vegas (for business!), which seemed appropriate.
- Nassim Nicholas Taleb, The Black Swan. Rather more personal pique than is really necessary and some excessively broad statements, but generally he’s right on, particularly about the excessive faith in the Gaussian error distribution when modeling extreme events, the so-called “tail risk” being too low. We’ve seen this in other areas as well.
- Any others?
No I’m not talking about the schadenfreude that many are experiencing now that the investment bankers are falling from their lofty heights. That might be fun, but it’s not a silver lining. No, I’m talking about the large amount of highly talented people who became “quants” aka mathematical modelers in the finance sector now having to seek employment elsewhere.
Now don’t get me wrong, there’s a place for finance, but we as a society over-invested in it. One of the really sad things was that the greed led a lot of people to put deep and abiding faith in the models. Those of us involved in mathematical models for any length of time know from bitter personal experience: The last thing you should do is believe a model, especially if it’s your model. Models are useful, not true, and should be viewed with a great deal of skepticism, always. While I suspect that the “quants” knew this, the greedy, myopic twenty five year olds doing the trading—the ones with the right hair and a nice liberal arts degree from an Ivy or Duke—didn’t (they’re certainly not trained to evaluate such things), and given the almighty dollar coming their way I suspect a good number of the quants started believing too.
If you want a case in point, I offer up Doctors Merton and Scholes, Nobel laureates in economics, 1997, and principals of Long Term Capital Management. LTCM was a hedge fund founded by the smartest guys in the room. Unfortunately, their model was predicated on some assumptions that turned out not to be true, most importantly one about lack of correlation in various investments. This assumed other people weren’t copycats on what LTCM were doing. Whoops, funny how when the smartest cats in the room seem to have found a burrow of endless mice every other cat starts copying.
One of the giant market distortions engendered by the rise of Wall Street has been the shortage of scientists, broadly defined: Fewer Americans going to engineering, chemistry, math, statistics, economics (besides finance, that is), etc. Instead, far too many of the best and brightest young people go into finance and investment banking. Something like 20% of the graduating class of Harvard in recent years goes directly to investment banking. That’s right, a 22 year old is managing your money, hoping to retire by 35 or 40 to a house in the Hamptons, another house in Bermuda, and a third one in Tahoe, with a nice trophy wife on his arm, and the surplus of young ladies living in finance capitals are there hoping to be said trophy wife. One of the reasons to chase the Ivy degree so hard was the hope—not unreasonable—that an in would be available for Junior into a hedge fund, Lehman, etc. So this massively distorted the college admissions market, too, making otherwise solid schools seem like poor buys and encouraging many families to run up piles of debt on undergraduate educations, mostly in the hope that Junior would get the right contacts in Duke that he wouldn’t get at, say, Illinois.
I recall taking real analysis back in the mid ’90s. Hands down the smartest guy in the class was a Cal Tech educated engineer getting a PhD in Finance. Now this was just before the big model finance mania. He’d worked for a big aerospace company but with the defense budgets going down, he realized that his future lay elsewhere. This is, of course, why so many physicists ended up on Wall Street, too. I’m sure he did well but you know, finance doesn’t actually produce anything, whereas airplanes are something. It was getting so bad near the end of my tenure in grad school that I’d see students trying to “stealth” their way into finance by applying to programs in one area but taking finance classes. Getting into an actual PhD finance program was tricky and often costly but most schools will let you take a few courses in another department….
So if there is a silver lining, I hope it is this: Smart kids with math skilz considering careers in finance, please come back. The rest of the world needs you to help deal with things like, oh, climate change, looming mass extinctions, energy shortages, world hunger, transit and infrastructure, finding productive things to do now that we won’t make piles of dough on houses nobody wants, to say nothing of good old “basic science.”
As for the Ivy league liberal arts major turned investment banker who ran my admittedly modest portfolio into the ground with $200K in student loans breathing down his neck… thanks but I don’t want aioli, arugula, sprouts, grape tomatoes or olive tapenade, I’ll enjoy my schadenfreude plain and unadulterated.
For further reading:
March 10, 2009 at 6:59 am
My fellow engineers and myself have been lamenting lately about how are finance guys are ripping our business cases for new capital equipment to shreds using what we consider questionable logic. Admittedly, I would be upset if the finance guys tried to do stress calculations for my products, so I try not to take it too personally.
Made me think though – how does a finance mind see the world?
March 10, 2009 at 9:31 am
Angry Diesel Engineer wrote: “Made me think though – how does a finance mind see the world?”
Well I’m not sure exactly but they do a useful purpose because if left to our own devices, we’d rapidly outspend our resources. I was really talking about the investment banker type, though, so maybe I should have used the term “high finance.”
The crazy thing is that when you find out what most of them actually do/did—make fairly lame spreadsheets, presentations and pitch documents at all hours of the day—you start to wonder.
One other telling fact: Crises on Wall Street happen just infrequently enough to guarantee almost complete turnover among the workers. Hmmmm….
March 10, 2009 at 1:35 pm
As a “quant” not in finance, I have to agree with the following:
There’s also a really good article on Wired about the model that was key in the faulted assessment of the risk, which you can get to by clicking on my name. I’m sure some of those quants failed to question that one too.
March 10, 2009 at 1:41 pm
Ah, yes, the Gaussian copula. Here’e the link directly:
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant
BTW, the expert on all things copula is Christian Genest at U Laval:
http://archimede.mat.ulaval.ca/pages/genest/
The copula is a really good idea, but the limitations of the Gaussian in the presence of tail variation (as opposed to measuring averages, where it works well) is substantial.
There are numerous other examples in many areas of science of quite counter-intuitive behavior of transformations of the Gaussian.
March 10, 2009 at 6:28 pm
I’m not sure that the Wired article correctly captures what happens on Wall Street, and in particular, what’s gone so spectacularly wrong over the past few months.
The past few months look like a the end result of a bunch bright greedy people realizing that they can get large yearly bonuses based on the first year profit for selling multi-year financial products. Some of these bonus are large enough to retire on.
“mark-to-model” is a well know mistake. But all of the incentives lead you to it. Imagine someone managing a portfolio with a lot of long term instruments. One day a quant points out a mistake in the valuation, and that the portfolio is actually worth -$1 Billion, not +$2 billion.
From the stock holder’s point of view he’s a hero. But that’s about the only point of view from which he’s a hero.
March 12, 2009 at 2:09 pm
http://www.nytimes.com/2009/03/12/opinion/12cohan.html?pagewanted=1&ref=opinion
March 21, 2009 at 6:56 pm
Nice article about students moving back to CS, out of finance:
http://www.nytimes.com/2009/03/17/science/17comp.html?em
We’ll see if it’s a long term trend… and hopefully this ends up being a bit broader.
April 7, 2009 at 8:21 am
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April 11, 2009 at 11:27 pm
Harvard Class of 2007, and their jobs, as reported by The Crimson:
http://www.thecrimson.com/article.aspx?ref=519172