Continuing the discussion about networks, finance, trading and economics ...
Physicists and the financial markets
Physicists have been lured into the financial market for decades, prized for their insights and data-crunching skills. But in a time of turbulence, flash crashes and high-frequency trading, can they really spot things that others miss?
' Gene Stanley raises his fork, holds it out flat, a few inches above his plate of risotto. “The majority of traders still use Gaussian models and, when something outside the Gaussian happens, they have all these phrases, like ‘outliers’, but the main phrase is ‘shit happens’.” He stares at his raised cutlery.
“Now, if we saw the forks start to levitate, it would be bizarre to say, ‘oh, shit happens’, but they do, that’s what they say. They say, ‘oh, you can’t predict everything’.”
With a chuckle, Stanley tucks back into his food. ‘These complex systems are not systematically predictable. They’re only predictable in some regimes’
The famous bell curve described by Carl Friedrich Gauss, the humble normal distribution that underlies so many statistical models, might explain most phenomena in a financial market but Stanley, professor of physics at Boston University, is interested in the levitating forks, the outliers, the “black swans” of Nassim Nicholas Taleb’s description.
This is the territory of econophysics, a discipline that sometimes sounds less like a collaboration between physics and economics and more like an attempted takeover of the latter by the former. By using the techniques of physics – poring through vast quantities of data in order to build models from the ground up, searching for patterns and, ultimately, for laws – econophysicists such as Stanley are trying to explain things that traditional financial theories do not.
In the past five years alone, investors have had to endure a US housing market collapse, a global credit crunch and a stock market “flash crash”. That is a lot of flying cutlery. When future historians debate the genealogy of chickens and eggs up to the credit crisis, one question will be whether rocket scientists came to finance because of its increasing complexity or whether finance became increasingly complex because of the rocket scientists.
Banks and hedge funds have lured physicists for more than two decades, from the shrinking ranks of academic science or from corporate research departments such as Bell Labs in the US. The heads of trading desks were hungry for anyone who could bring new theory to the chaos of the markets or who could model the price of complex derivatives the same way they could divine laws for the physical world. Little wonder. Vast fortunes can accrue to the most successful of these number crunchers, the so-called “ quants” who can spot the market patterns that others cannot. Renaissance Technologies, the Long Island, New York-based hedge fund created by former codebreaker Jim Simons, now manages $39bn and provides a comfortable career for those trained as physicists, mathematicians and computer scientists.
Yet for some of those who have crossed over or undertaken research collaborations with traders, there remains a belief that the insights of physics have been imperfectly applied.
“I think a lot of physicists were probably hired for the wrong reasons,” says Jean-Philippe Bouchaud, a statistical physicist and professor at Ecole Polytechnique outside Paris who, for two decades, has run one of France’s most successful hedge funds. More absorbed the financial orthodoxy than were able to change it. “They were not left enough intellectual space to criticise the Gaussian world they were asked to absorb as quickly as possible. We just had no time to say, ‘this seems fishy to me and I want to think it through’. The dogma effect of the [financial] community was very, very strong before 2008.”
~~~ It may be that the high-water mark for physicists transferring to Wall Street has passed. If it is big data sets that attract them, like children to a sandbox, these are hardly exclusive to finance in an era of cloud-connected internet-enabled information overload.
Yet Wall Street continues to appreciate physicists’ facility – and imagination – with numbers, says Gene Stanley, and there is both intellectual challenge to be had and money to be made from finance. He has former students, and no doubt future collaborators, climbing the ranks at Goldman Sachs. His son, too, parlayed a physics degree from MIT into a job at the bank that pays a multiple of his professor’s salary.
Over dinner near Boston University, Stanley is rueful. The financial crisis was foundation-shaking, and brought renewed interest in econophysics and in interdisciplinary approaches to understanding a complex world. But how much can it possibly change finance? “If I was forced to retire every time I made a mistake, I would be very, very careful,” he says. “If you make a catastrophic mistake in finance, the worst that can happen is you are fired. But people there have saved enough money they can retire at almost any age after 35.”
In other words, traders can shrug and say “shit happens”. If the Gaussian distribution predicts 99 per cent of what happens, that may be plenty good enough for them. For the rest of us, not so much.'
[Emphasis added]
Jim |
