Paul Wilmott Wants To Retrain and Reform Wall Street's Quants 198
theodp writes "What if an aeronautics engineer couldn't reconcile his elegant design for a state-of-the-art jumbo jet with Newton's second law of motion and decided to tweak the equation to fit his design? In a way, Newsweek reports, this is what's happened in quantitative finance, which is in desperate need of reform. And 49-year-old Oxford-trained mathematician Paul Wilmott — arguably the most influential quant today — thinks he knows where to start. With his CQF program, Wilmott is out to save the quants from themselves and the rest of us from their future destruction. 'We need to get back to testing models rather than revering them,' says Wilmott. 'That's hard work, but this idea that there are these great principles governing finance and that correlations can just be plucked out of the air is totally false.'"
how about reforming pay? (Score:3, Interesting)
How about bringing their pay down in line with the pay of others (engineers and scientists) that do analysis of a similar level of difficulty? This is just a guess, but it would seem increased pay attracts people who want to make more money, not those that are genuinely interested in solving the problems in a field.
Hang on... (Score:5, Interesting)
I'm a long way from New York, so someone correct me if I'm wrong[*], but I've always understood the problem to lie more with the people feeding data into the equations, rather than with the equations themselves.
Now, I accept that risk calculations consisted of a great deal of voodoo because, as Taleb [fooledbyrandomness.com] tells us, they tended to ignore 'Black Swan' [wikipedia.org] events (where the 1 in a million catastrophe wasn't going to happen just yet) and saw patterns where only chaos existed, but as I understand it, the core of the problem was simple greed: money-hungry mortgage and securities dealers deliberately feeding bad data into the system.
So-called quants may be decidedly imperfect, but if someone's willing to game the system to make a buck, nothing the quant does can stop it.
If Wilmott doesn't have an answer to that, I fear that his efforts will only obscure the real problem.
Re:Hang on... (Score:3, Interesting)
Admittedly without reading TFA, that sounds like his point - that what "quants" should be doing is developing good empirically good heuristic models rather than wanking over what are essentially hypothetical analytical ones based on complete SWAG parameters, where the parameters supplied by salesmen will invevitably be optimistic best case ones (and that's putting it charitably).
Re:You can't blame it all on the qunats. (Score:5, Interesting)
...you always reach a point where there's this one number that is completely made up...
***Try a sensitivity analysis using Monte Carlo techniques. That sounds hard but it isn't. Take the parameter that you have doubts about and give it a distribution (Gaussian or rectangular or something) with the mean at your best guess and the std deviation chosen to be big enough to cover the range it might reasonably vary over.
***Use Gaussian if you have an idea of what the parameter probably is but aren't exactly sure, rectangular if you really have no idea. A rectangular distribution says "I have no idea, the parameter could be anywhere within this particular range."
***Then run your analysis a million times with the parameter selected randomly from it's distribution for each run.
***That gives you a stochastic dataset of results. You can run simple stats on that data set to find the mean and std dev of the result value. You will then know how sensitive your results are to your poorly understood input parameter. If your 2-sigma output tells you the expected rate of return on a particular investment varies between -50% to +50% then you will know your model is pretty much useless and you will be doing a better job than the vast majority of professional analysts.
****Monte Carlo is great for those of us who don't care to learn the arcane minutiae of stat math. If you have a working model it takes an hour or two to extend it so you get stochastic results. Note that it's no harder to give a distribution to all your input parameters not just one. In which case you will be doing the kind of work that people who make 500 grand a year do.
Re:Hang on... (Score:4, Interesting)
You're not wrong, but I think the author referenced in the original post and you are addressed different parts of the whole problem of financial markets. The willingness of financial services salespeople - mortgage brokers, stock brokers, etc - to basically lie their asses off because there's so much money on the line is one problem.
"Quant" analysis of financial markets is, really, another, related problem. The same moral hazard of too much money to make cutting corners worth it exists, but the basic problem here is that many "quant" models are bullshit. Quantitive models for derivative securities can be realistically valued -- if and only if the risk of the underlying primary asset has been properly assessed (along with several other critical assumptions about the marketplace for the security -- but that's the JUDGMENTAL assumption fundamentally inherent in the models.)
Risk assessment is not actually that difficult -- insurance is built on the ability to do risk assessment. The real problem with the current financial problems were that NO ONE KNEW WHAT THE UNDERLYING PRIMARY ASSETS WERE and everyone operated on the belief that Nothing Could Ever Possibly Go Wrong (because no one could prove otherwise, because no one knew what the hell was actually going on).
This is and was every bit as monumentally stupid an assumption in the financial realm as it is engineering, computer programming, science, or any other real-world discipline.
I think what Wilmott is proposing is the development of models that are more reactive to real-world inputs, models that are much more Bayesian in nature in their ability to refine and revise their predictive nature based on actual events.
Comment removed (Score:2, Interesting)
Re:The elephant in the room (Score:3, Interesting)
The reason why we have economic problems is the same old one from the beginning of time -- good old fashioned human greed.
Agreed. But 50% of that problem is that people have absolutely no idea what money is. It makes taking it away from them dead simple.
the formula which distroyed wall street (Score:4, Interesting)
We did test the results... (Score:3, Interesting)
It just cost us tens trillion dollars to figure out that 30 years of free trading investment oriented capitalism wrecks your manufacturing base, leaves your country hopelessly in debt, and all these so-called free enterprise guys bitching about the UAW making 40k a year are actually not so free enterprise after all, when it comes to bailing them out, or protecting their businesses.
Picking up nickels in front of a bulldozer (Score:5, Interesting)
The reason why the quants ignore Black Swan events is that they are not financially impacted by them to any real extent. They make their living from making small amounts of money using lots and lots of leverage. But I prefer Buffett's metaphor for this sort of practice: picking up nickels in front of a bulldozer.
As long as "quants" can pick up "nickels" in front of a bulldozer for a few years, they can retire and never have to work again, even if their parent companies (and the companies they borrow from) go bankrupt. Those "nickels" are many millions, their percentage of those "nickels" are still high enough to retire on. Of course, they risk billions in the process.
I suspect the only way to really curb the practice would be to either limit amounts of leverage or cause complete bankruptcy/imprisonment/physical harm somehow to those responsible when the bulldozer (the black swan) eventually comes along. Of course, these laws can't really be applied to those responsible for the GFC. Laws can and probably will be created, and then after a few generations those laws will be repealed as the creation of a few old fuddy duddies who didn't understand whatever "new economy" comes along, and the cycle will repeat.
Comment removed (Score:4, Interesting)
Just Gamble ... That works... (Score:3, Interesting)
Trillion dollar bet [pbs.org] now why did the world trade center get attacked, not once but twice...
Re:You can't blame it all on the qunats. (Score:1, Interesting)
Sure, you can do that. Blind Monte Carlo simulation sometimes catches reasonable behaviors and gives some glimpse into possible outcomes. But face it, using this kind of technique --- unless backed by a proven physical model, like molecular dynamics --- ***is*** a primary and definitive admission, no, confession, that you don't have ***any*** understanding of the underlying phenomena and that you've given up trying to do ***any*** science about them.
No offence.
Re:The elephant in the room (Score:3, Interesting)
Exactly! The situation in the economy, AIG, failing companies, the layoffs, outsourcing etc. is caused mostly if not entirely by corporate psychopaths which have a natural tendency to angle themselves into leadership position (they are very charismatic and manipulative) from which they can achieve the greatest benefit FOR THEMSELVES at the expense of others. Their total lack of "conscience" makes it so that any damage from their actions for them is unimportant. Even if it affects hundreds of millions of people. Even if the profit is tiny.
Check out Snakes in suits [amazon.com]
In case you have not been suspecting something already, that is.
Re:How about... (Score:3, Interesting)
Another way is as a self sufficient yeoman farmer society, hailed by Thomas Jefferson and Isaac Newton. But these days farming is impossible because of low market price of food, and high cost of property taxes. In absence of high property taxes the yeoman farming society would be possible, but vulnerable to external attack because of insufficient defense funding. Also there is not enough land for everyone, as the Malthusian catastrophe hits. The population does not know how to practice self check and grows out of bounds without abusive control measures. In a sense abuse is a necessity to maintain balance. That is the most unfortunate thing of all as far as human happiness goes, and is the root cause of competition wars and suffering in the end, because there is not enough of
A massive scale small business based society where everyone is an employer is next to impossible to work out, because non farming individuals are not self sufficient because they are dependent on food. They can't say time-out and not participate for a few years as self sufficient yeoman farmers could, and retain their own free will, their free unbiased vote, because small business people have to purchase their own food and are therefore dependent on others, they are drawn into "Da game" by necessity to feed. Economy as a whole is vulnerable to the phenomenon of "economies of scale," and if you have to participate in "Da game" by necessity, you will lose out to those who are stronger, and we're back to the strong get stronger and weak get weaker, abuse and retaliation for abuse. If you're self sufficient, then you simply are not forced to participate in "Da game" and then "Da game" doesn't exist, because you can sell things for practically free too, and "economies of scale" can't abuse their power. I've always said "don't hate da playa, hate da game, bitch!"
So in the absence of self sufficient individuals in society - which is unworkable anyway because of Malthusian issues and defense funding reasons - the only way to ensure overall human happiness on a large scale is to ensure a dominant middle class through collective cooperation and bargaining, to have economies of scale institutions, and the participants - very few but very powerful individuals called employers to be in balance with the very many individuals but each having relatively little power, at the discussion table. If either the union or the employer get stronger, things go out of balance. If anything, the balance going out of whack by the employer getting stronger, we would have a dictatorship society with tremendous human suffering, but it's still sustainable, and things get
what quants know (Score:3, Interesting)
Re:Hang on... (Score:3, Interesting)
It was somewhere in-between. The model as such worked OK, but only if you assUmeD that each individual loan's probabilities acted in a vacuum. The fundamental flaw in the model is that there are some obvious cases where the loans will act in a coordinated manner that were simply (and pointedly) ignored, such as a bubble bursting.
THEN, knowingly using the flawed model, they plugged in increasingly dubious numbers and even fed the practically fictional result back in to the flawed model to get more rosy numbers that had no imaginable connection to reality. The one thing they WERE careful with was making sure it was nearly impossible to PROVE legally that they were knowingly acting in a way that would crash the economy in order to grab a pile of cash and get out just before the train wreck.
Re:Wow! (Score:2, Interesting)
EXACTLY...
I work in the financial world, and I do modeling, and I understand the quants because I do much of the same work that the quants do. Except I am an algo-trader.
The reality with all of this quant stuff is that it works until it doesn't. This is the crux of the problem and I would say a large part of the industry JUST DOES NOT GET IT... For example the comment to test models is hogwash. This financial engineering is not science. Its a scientific approach to madness of crowds. And the reality is that crowds can be mad and they will do irrational things that will just blow our minds.
Think about this, the Darwin awards gives awards to those humans that do REALLY stupid things. I for one am truly amazed, not at the stupidity, but at the shear creativity. I mean really, who on earth would think of that. And it is that creativity that blows up models, and blew up the entire financial market.
The models that the quants used worked until they did not. Sure there are many saying, "hey I told you so." Yeah whatever, humanity is stupid and will do stupid things because whenever we are told it can't be done, or should not be done we do it anyways.
In fact I think it is a good trait to have in humanity. Granted there are moments where we wish we did not have so many idiots.
Here is an example, George Bush and Iraq. I argued on the day of the invasion with a good friend of mine that it was stupid, idiotic for the exact reasons of why it is failing. I argued Sadam is a bad guy no doubt, but toppling Sadam will result in a quagmire. And I personally don't think it is worth it. My friend argued otherwise with weapons, etc, etc.
But, and here is the big but... WHAT IF it did work? What if everything worked out? It could have happened. What then? But you don't know that until you try it! For to try and fail is human! And nothing will ever avoid that...
Re:Hang on... (Score:3, Interesting)
" ... as I understand it, the core of the problem was simple greed: money-hungry mortgage and securities dealers deliberately feeding bad data into the system. ... So-called quants may be decidedly imperfect, but if someone's willing to game the system to make a buck, nothing the quant does can stop it. ..."
Good point, but I think you may be attributing too much of what happened in '07 (in the US) /08 (everywhere) to bad intentions, not that they don't exist. All my research about the mortgage crisis essentially boils down to there was a motive to sell to poor borrowers because most of the "good" borrowers already had their mortgages during the earlier part of the 21st century, if not before. You can't sell more homes than people need, at least to the financially prudent. So, there was incentive to sell bad mortgages to bad borrowers, because they could be packaged and re-sold as a form of derivative, eliminating the risk to the original mortgage lender from default.
Those derivatives were packaged in a way that the true nature of the underlying mortgages was obscured or totally hidden. Of course, like the insurance industry where every player buys some of every other player's risk while selling some of it's own, because each company is more solvent that way, some of these same lenders were buying other's derivatives, which were just as shaky, but somehow they managed to deceive themselves into thinking they were actually made up of sound mortgages.
There's the massive self-deception based on greed you may be alluding to, but I don't think it follows that everyone in the bank knew that there was any self-deception going on (ie those whose job it was to run the models). Certainly they were on the books as good, sound mortgage-backed paper; certainly the shareholders may have believed the deception; certainly there was a house of cards being built.
But, I don't think those who collect and feed the data were that much in the loop (to be as deliberate as you suggest); the problem being no-one, and I mean no-one, knew the scope or the actual value of these derivatives. Nobody, not banks, not the Fed, not Economists, could know the true nature of this wildcat, unregulated mortgage-backed security market (and thus this input). I believe that at the peak, the value of these derivatives exceeded one year's GNP of the US; in other words a huge unregulated market indeed.
The data had to be guessed at using "the best information available at the time" which is a fairly fundamental method of business transactions; you don't wait forever for perfect data because opportunity is lost if you do.
Ideally such a huge, unregulated market is reined in by regulators who do know that anything in the financial sector that is too big is going to run the risk of taking down markets, banks, investors, and economies. Greenspan has said out loud that he had too much faith in the banking and security industry and let it go too big for too long. Hindsight is 20:20, but a "Wild West" mentality in every aspect of a market is not necessarily best ... the very first corporations about 600 years ago eventually caused so much havoc that for a few hundred years the whole concept was made illegal. That was a result of too few corporations, but the essence of a huge unregulated market is found there, because the few that did exist were the market, and one had a disproportionate (in today's terms) effect on others.
That's the natural result of unregulated markets: a great creator of wealth was legislated out of existence when better controls would have allowed society to benefit for a long time had they been properly understood at the time. But that's another topic.
You are fundamentally correct and it's an insightful comment. It's my belief that whatever bad inputs in the model, regardless of the avarice and greed of the players, existed because no-one had good data to put in.
Re:Wow! (Score:3, Interesting)
All human decisions - even the most abstract or "rational" - have an emotional component; this has been experimentally measured.
Yes! I'm off-topic now but it is wonderful to see this assertion expressed on Slashdot. There's a tendency here to treat emotion as an uncomfortable byproduct of being a meat-sack.
In truth all the progress we have made is driven by emotion: we feel desire for some things (food, sex, Insightful moderations) and it gives us pleasure to try to figure other things out, which is really a desire for knowledge. We follow the creeds and models we do because we like them, and often the difference between philosophies comes down to which most emphasizes the parts of reality that each of us sees as being most important. This state of being engenders a lot of wrongheadedness--as current circumstances show--but without emotion we have no impetus to do anything at all.