Editor's note: The following column is the first part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable
, a new book by James Owen Weatherall.
Many people will recognize the arrogance of some physicists captured in the comic panel below by Randall Munroe, also known as xkcd, who happens to be a physicist himself (the original
has some additional amusing mouse-over text). Not all physicists act this way, of course, but it’s a particular flavor of arrogance seldom found in non-physicists. I suspect it springs from the astonishing success of 20th century physics in explaining mysteries of the universe, commanding gigantic research budgets (the United States spent more money on nuclear weapons than the combined value of all physical assets in the country, excluding real estate, and the Soviet Union bankrupted itself trying to keep up—plus many billions more were spent on physics adventures including space exploration and colliders) and building weapons of unparalleled mass destruction. Knowledge, money, and the power to destroy all life on Earth can go to anyone’s head.
I have had the honor to discuss mathematical finance with some of the great physicists in the world, including Richard Feynman and Murray Gell-Mann, and also with the physicist most accomplished in finance, Emanuel Derman. None of them act anything like the physicist in the comic. Emanuel is actually humble, and while no one would apply that adjective to Feynman or Gell-Mann, both were intensely interested in learning about new fields, and judicious in their opinions—hanging-judge “judicious” perhaps—very, very firm but open-minded and fair.
I have more often had the lesser honor of discussing the same topics with physicists of fainter accomplishment in physics and finance. Some of them listened as carefully as the superstars above, others were as tone deaf as the xkcd version. Physicist Dr. James Owen Weatherall sets a new standard, however. His new book, The Physics of Wall Street
, must rank among the most arrogant books of all time.
“Arrogant” does not imply “stupid.” The author is clearly a very smart guy, just one who has not devoted five brain cells to thinking about finance, nor five minutes of real attention to any person who knows anything about it. He has done the world an important service. His book contains the crudest forms of the basic errors many people with quantitative training and zero experience in any form of risk-taking make when first considering finance. He expresses these classic errors with unusual clarity and firmness. This provides me with the opportunity to use him as a Euthyphro to my Socrates (yes, I am no less arrogant than Weatherall, but in the field of finance I know much more).
Over the last 60 years, the world has evolved from a financial system based on credit-backed, national-government-issued paper money firmly linked to physical gold to a borderless derivatives economy. Weatherall’s thesis is that physicists are responsible for this change.
Defending that claim is a tall order. The 60 years divides naturally into four 15-year periods. From 1950 to 1965, the basic theory was developed. From 1965 to 1980 a second generation of researchers gathered massive empirical data and lobbied for legal and regulatory changes like the elimination of the gold standard, the introduction of financial futures and options trading, the “big bang” reforms breaking institutional oligopolies, deregulation of financial services, reduction in financial repression, and democratization of financial markets. Also in this period, students trained in these ideas built successful businesses, bypassing the traditional financial system: index funds instead of broker-managed accounts, money market funds instead of bank accounts, electronic trading instead of manual orders, securitization rather than intermediated funding, and many others. These changes paved the way for the total renovation of the financial system from 1980 to 1995. I compare this to the digital cameras versus film cameras. The casual user might not notice much difference. Both have lenses and flashes and buttons to push for a picture. Both run on batteries, in some cases the same batteries. Some models look pretty similar, and the final products look very similar. Both types of camera are used to take pictures of vacations and parties and events. But the underlying technology is totally different. Also, the 1995-era digital camera has since evolved into radically different types of devices.
Finally, in the fourth period from 1995 to 2010 we saw the new financial system expand explosively. Consequences, both good and bad, were enormous.
The problem for The Physics of Wall Street
is few physicists were involved in the process at all until the latter years of the 1980s—that is more than halfway through the third period. Given that it took a few years to gain much influence, it’s fair to say that the role of physicists was largely restricted to the period of expansion. This was not a period of major innovation, the basic ideas, tools and institutions were in place by 1995. And even in the fourth period, physicists were not over-represented compared to people in other quantitative fields, nor were ideas imported from physics particularly important.
The thesis defense is brilliantly simple. Weatherall clearly read Justin Fox’s excellent book, The Myth of the Rational Market
. He summarizes Justin’s account, leaving out every person with any training in economics or finance. There is one small exception, the economist Paul Samuelson is mentioned, but only for his role in the rediscovery of Louis Bachelier’s work, not for his original research in finance, nor for his innovations in practical investing.
This audacious plan falls short. Of the people discussed in The Physics of Finance
who made contributions before the late 1980s, all were mathematicians, statisticians, or people trained in some other non-physics quantitative field. M. F. M. Osborne is the only exception, the only pre-1987 physicist. While Osborne’s work was extremely important—and drew directly on his training in physics—he is not enough by himself to award all the credit for modern quantitative finance to physicists. I think it’s most accurate to say that Osborne did work similar to a number of other researchers (particularly the great statistician Maurice Kendall). He broadened the understanding of that work through his physics worldview, but he was not essential to the development of finance.
So far the case is weak—if you leave out anyone trained in economics or finance and count all quantitative people as physicists then physics was central to the development of modern finance—but not arrogant. That quality begins to reveal itself in next week’s installment, subtitled: “Random Walk, is that really all there is?"
No positions in stocks mentioned.
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