Tuesday, August 21, 2007

Black Swan Beats Genius Quants!

Fifty years ago on Wall Street, guys boasted they could beat the market because they had a "system."

Five years ago on Wall Street, managers of quant hedge funds boasted they could not only beat the market but produce positive investment returns no matter what. They had "algorithms."

The systems worked, but only sometimes. Pretty much the same deal for the algorithms, as The Washington Post reports in this page one story:
Instead of veteran, market-savvy traders waving fistfuls of sell slips, the elite quant funds employ Nobel nerds with math PhDs, often divorced from the real world. It's not for nothing that they are called "black-box" funds -- opaque to outsiders, the boxes contain investment magic understood by only the wizards who conjured it up.

But the 387-point drop in the Dow Jones industrial average Aug. 9 and the continuing turmoil in the markets, in part attributed to massive sell-offs by the quant funds, have tarnished some of the quants' glimmering intellectual credentials and shown that, when push comes to shove, they can rush toward the exits as fast as a novice investor.

* * *

As elegant as the [qaunts'] models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs, overly reliant on their tools.

"Most are idiot savants brought to industrial proportion," Nassim Nicholas Taleb, former quant-jock and bestselling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, "The Black Swan."

"They are very smart in front of a textbook but not smart enough to understand very elementary things in reality," he said.

The investment world is full of bell curves, charts showing us what usually happens and allowing us to calculate the odds on unusual happenings. All too easily, the improbable becomes reclassified as impossible.

Talab calls this error the black swan theory. Throughout most of human history, everyone but a few aborigines down under "knew" all swans were white. There could be no such bird as a black swan.

Not until the 1600's did Europeans discover black swans in Australia. Whoops!

Bird call update. The heading for this post originally referred to "Black Honkers." Bad guess. Geese honk, not swans. Some swans trumpet; others are mute. The black swan has a musical trumpeting call.


Jim Gust said...

Writing in the Wall Street Journal, James Stewart thought it was the strangest week for investments he had ever seen, because "high-quality stocks got hammered, while risky, low-quality, heavily shorted stocks gained." That circumstance was never incorporated into the quants' models.

The article is at http://online.wsj.com/article/SB118713082065997781.html

JLM said...

The professors never expected it because it never would have happened except for the quant fund managers and other hedgies who loaded up on bonds backed by subprime mortgages.

As a number of postmortems have noted, hedgies had to come up with cash for investors scared by the mortgage mess. But the hedgies couldn't sell their bonds to anybody at any price. So they had to sell their quality stocks and close out their short positions in the low-quality stuff.