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'The Physics of Wall Street': The Most Arrogant Book in the World? Part 18


Thinking like a physicist.

Editor's note: The following column is the last 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. Click here to read Part 1.

I called James Weatherall's The Physics of Wall Street the most arrogant book in the world. I've used it as a foundation to discuss the common errors many people with quantitative training make when first thinking about finance. I conclude by considering Weatherall's main point, that the cure for financial problems is for everyone to think like a physicist.

Weatherall tells us that when he began his book, he spoke to his PhD advisor who told him it was "impossible to do science on Wall Street" because "investment banks and hedge funds are usually very secretive." Weatherall contrasts this to the openness and speed with which physicists submit their insights to peer-reviewed journals. This is the first sense in which he would like people in finance to think like physicists.

It's pretty arrogant to dismiss and entire field as unscientific on the basis of a casual opinion from an outsider. In fact, my experience is almost the complete opposite. I know of many cases of academics who are slow to reveal insights, waiting until they have developed them enough to claim substantial credit. Hoarding data and results is not uncommon. Most important communication is outside the peer-review process; by the time a finding appears in a major journal it is generally long since known among the researchers who care. While I think the peer review provides an important audit function in physics, it is more relevant to grants and promotions and credit than to the dissemination of new ideas-and electronic communication has made this even more true. Peer review is part of the administrative machinery of government-funded projects-academic, military, or bureaucratic-it has little to do with science. The great advances in physics have been the results of informal network collaboration based on personal reputations, not the quality control from anonymous referees. The ponderous rules have a cost, driving some smart people away (often into more anarchic fields like finance) and consuming time and energy that could be spent on science.

Ironically, the few firms in finance that correspond to Weatherall's advisor's view are the ones celebrated by Weatherall for their scientific foundations. Renaissance Technologies and D.E. Shaw are two of the most secretive firms in the world. Generally in finance, you need to communicate your ideas to be successful. You need people to trade with you, and often to finance you or to invest in you or to provide other services. Few people succeed by keeping some formula secret, success generally comes from creating a mutually profitable cycle, the bigger the better. You see a lot more effort on Wall Street devoted to communication than to protecting secrets.

Another reason for the openness is success in finance is objective, few people are interested in arguing about credit for ideas, and no one takes such people seriously. You go into finance to participate in an adventure, and of course to get rich, not to attach your name to a theorem or to get tenure or to win awards from outside bodies. If your idea fails, it fails-however friendly you are with a journal editor. If your idea succeeds, it succeeds; you don't need good relations with granting agencies.

I admit it is a common belief that finance is secretive. I think the reason is that it's so simple. People read the books by or about successful practitioners, or speak to them in person, and do not believe that it can be so simple to get so rich. Actually, it's more that they don't want to believe it. They are not interested personally in getting rich that way, but it's distressing to know that others do it. It's more comforting to believe that the practitioners are crooks, or that they are liars, hiding the secret of their success.

An important detail is that simple does not mean easy. It does not take a genius IQ or formal study to get rich on Wall Street, in fact those things may be more likely to slow you down than to help you. You do not need a stunning insight, or even a minor new wrinkle on an old idea. Success in trading does take skills that few people possess. In the areas I am most familiar with it takes extraordinary attention to data quality, skeptical objectivity to an uncommon degree, and rigid risk discipline. My rule of thumb is that 80% of the people who try trading don't bother to learn how to do it, 80% of the people who learn how to do it can't do it or don't want to do it, and 80% of the people who learn how and can do it fail due to inability to deal properly with risk. That means one person out of 125 succeeds in trading, yet none of the three prerequisites is a particularly unusual accomplishment.

There is room for intelligence and creativity in finance, but it's not directly related to making money. At least for people of a certain type, the financial system is by far the easiest place to change the world. Many refugees from other fields, including physics, find it liberating to work in a field so open to new ideas, so objective in evaluating them, and so influential. Another nice feature is that if you screw up, it's only money, nobody dies. It can be a lot of money, and it can cause a lot of hardship, but unlike life and death, you can make up for it tomorrow.
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