THE PHYSICS OF WALL STREET:
A Brief History of Predicting the Unpredictable,
by James Owen Weatherall,
Reviewed: 27 July 2013
The daily value of your superannuation or other financial investments is now determined by algorithms and strategies that arise from studies of casino gambling, chaos theory, the survival of migrating salmon and earthquake prediction.
Any factual economic news about interest rates, employment figures or exchange rates is no more than the latest roll of the dice in a game where the accumulated savings of people and enterprises are predated by traders whose sole art is in predicting where prices might move, and trying to get there before their competitors. Financial markets are an ecology in which long-term investors are the herbivores, and short-term speculators are the carnivores.
This book notes how Nobel Prize-winning economists have lost millions in the stock markets, while several of the most successful fund managers have never studied economics but had backgrounds in physics or higher mathematics. With no interest in social or economic causes and effects, they have developed sophisticated methods to analyze price movements as a means of predicting opportunities for profit.
To listen to most financial commentators, one might believe that market prices move according to the assessment of buyers and sellers on the business prospects of the underlying asset – the shares, bonds or derivatives attached to some property or other in the real economy. However, the speculators who dominate financial market trading don’t give a hoot for the long-term performance of an underlying asset. Their only concern is to predict the direction, scale and timing of price movements. The most spectacular profits described in this book are made from predicting financial crashes, rather than predicting market successes. “Short selling” and “put options” are two legal ways to bet on falling markets, allowing some to profit while most suffer loss.
The earliest attempts to create mathematical models to predict financial markets were in 19th Century France, where a mathematician at the Paris Bourse, Louis Bachelier, developed a pricing model for options – contracts setting a price to buy or sell an asset at a future date. He identifieded the key factor as randomness, not the relevant information that economists theorise to be the basis of efficient markets.
Bachelier’s idea was that since there were so many unpredictable factors that could affect a future price, the only fair way to price an option was to assume the price change would be random, and the probability of a certain price at a certain time could be calculated as one would calculate the odds of a roulette wheel producing a certain outcome after a certain number of spins. His formula proved impractical. Besides, nobody was really motivated by the prospect of a fair price, since the whole point of speculation is to maximize your own profit at the expense of the other party.
There have always been gamblers convinced they can beat the odds, and a good number of high-powered mathematical physicists have been involved in schemes to take down American casinos. Claude Shannon is a revered mathematical genius credited as the founder of Information Science that underlies modern computing. While a professor at the prestigious Massachusetts Institute of Technology in the early 1960s, he mentored a team of bright sparks who tried computer-assisted means to beat the odds in Las Vegas and Reno casinos, at both roulette and with baccarat. Some of these maths and physics students went on to become successful hedge fund managers, applying the same skills and obsessions with probabilities, though mostly with less risk of physical violence.
It’s not unusual for physicists to see the world differently to other people. Many of those who invented ways to beat the markets, by forecasting trends from what most would see as a chaos of information and price signals, had been eccentric outsiders since childhood. Doyne Farmer famously wore a teeshirt emblazoned “Eat the Rich” to a meeting setting up The Prediction Company that was destined to make him very rich and still operates. He had previously been working at the Los Alamos national nuclear laboratories.
The most successful of all crash predictors is another Frenchman, Didier Sornette, a brilliant physicist and expert in chaos theory in complex systems, whose greatest breakthrough came when he supervised, and married, a young geophysicist, Anne Sauron, who specialized in prediction of earthquakes. Together, they developed methods to analyse early symptoms of tremors in financial markets that could point, with extraordinary accuracy, to the timing of a future market crash.
Despite the brilliance of some of these individuals, and their ability to make money from prediction, none of that brilliance did anything to prevent the latest series of market crashes, US economic decline, and a global loss of faith in free markets as arbiters of economic value. The author notes this with puzzlement and concern, but does not make the connection that the entire science of financial speculation is justified on a fallacy.
We are told that hedge funds and derivatives trading serve a positive function by distributing risk – similar to insurance. While this is true, the Wall Street crash of 2008 showed clearly that derivatives also can multiply the amount of risk circulating in financial markets, to the point where all connection to real asset backing has been lost in a bubble of pure speculation. The net result may be that a few of the cleverest speculators extract vast wealth from the market, while most productive industries and individuals lose the savings they had accumulated through real economic activity.
I can appreciate this story as a kind of Wall Street Revenge of the Nerds, but admiration for their innovation and skill must be tempered by awareness that tens of millions of less favoured Americans lost most of their superannuation savings if not their houses, not to mention the legacy of continuing instability in the global economy.
Richard Thwaites is a helpless dependant on the chaos of financial markets.