Click here to read Part 9.
In this series, I’m using James Weatherall’s book The Physics of Wall Street
to walk through modern financial theory, using that magnificently misguided work as an object lesson in how not to think about finance.
The Physics of Wall Street
opens with an account of mathematician Jim Simons’ hedge fund Renaissance Technologies. Although Simons is among the half-dozen wealthiest and most famous investors in the world today, Weatherall assures us we never heard of him. Imagine sitting down to write a book on a subject and realizing that you’ve never heard of one of the most prominent practitioners in the field. Most people would take that as evidence they should do more research before writing. Weatherall arrogantly assumes that if he hasn’t heard of Jim Simons, no one else has, either.
The book insists Simons is the greatest investor ever, specifically greater than Warren Buffett, because one of his funds, Medallion, multiplied money 25 to 1 from 1988 to 1999, and some of his other funds made money in years when the stock market went down. I’m abstracting the facts from about two pages of overheated imprecise hype that make it hard to determine exactly what Jim Simons’ record is, or why Weatherall thinks it’s so impressive.
Jim Simons may well be the greatest investor ever, but if so, it’s not for the reasons Weatherall uncovered (“uncovered” is perhaps the wrong word since Weatherall’s account appears to be lifted almost entirely from Wikipedia). I can think of two obvious metrics for the title. One is total dollars earned above matched investments of similar risks over a career. Another is statistical outperformance, measured by something like Sharpe ratio (average return minus the risk-free rate, divided by standard deviation) of the investor minus Sharpe ratio of the market, times the square root of the number of years over which you measured.
Suppose you plotted all investors on a chart with statistical outperformance on the horizontal axis and total excess dollars earned on the vertical axis. Jim Simons would not be the highest; Warren Buffett, for example, would be much higher. But Jim Simons would be to the right of Warren Buffet; Simons' returns were far more consistent. There would be other investors to the right of Jim Simons -- Ed Thorp, for example. But Jim Simons would be higher; he has made far more total excess dollars. In fact, there would be no one both higher and to the right of Jim Simons. That would make him at least a candidate for greatest investor in the world.
The reason a lot of people would make him their choice is that there is no one close to him on the graph. He made much more money than anyone with any statistical performance near his, and has much better statistical performance than anyone who made close to as many dollars. He’s like a Babe Ruth who was both a great pitcher and a great hitter.
It’s hard to combine great statistical outperformance with large dollars. If you invest small amounts, you can wait for only the best opportunities, and attack them in the optimal size. With more money, you have to go after lesser opportunities, and sometimes invest more than the size that would produce the maximum Sharpe ratio. Other attractive investments are ignored because you can’t invest enough size to make it worthwhile from your portfolio perspective. Large investors must to do things to gain or retain assets under management that are not optimal from a risk-adjusted performance perspective, and they will be more constrained by regulation and more hampered by disclosure.
Weatherall is arrogant enough to claim he knows the secret to Simons’ success, despite never having met Simons and gotten information only from a hagiography in Institutional Investor
from 2000, plus a chapter in Sebastion Mallory’s excellent More Money Than God
. I have met Simons and I know well a lot of people who try similar things, with considerable success, if not at Simons’ level. I have also had extensive conversations with people who worked at Renaissance, and people who have seen its trading in real time and thought long and hard about their observations. I don’t know Simons' secret, although I know it isn’t the one Weatherall suggests, “steering clear of financial experts.”
Therefore, while I question Weatherall’s explanation and reasoning, I have no quarrel with his conclusion. But before we declare the contest finished, next week I’ll look at some other strong candidates for the world's greatest investor title.