My Life as a Quant (3 page)

Risk management is also in mode, and for good reason. A decade ago, in 1994, a sudden unexpected rise in global interest rates caused severe losses on many proprietary bond trading desks whose bets turned sour. This led banks to enlarge their previously rudimentary risk management efforts, and caused regulators of the securities industry to focus on risk limitation. Many quants now work within each investment bank's centralized-risk group, whose job it is to aggregate all the firm's positions and so estimate quantitatively the current risk and probable future losses. But probabilities are necessarily extracted from past events; they provide notoriously poor estimates of the likelihood of future catastrophes. Market crashes are not randomly occurring lightning bolts; they are the consequence of the madness of crowds who are busy avoiding the last mania as they participate in what will turn out to be the current one. Despite the losses of 1994, many firms again lost vast sums on their speculations during the worldwide withdrawal of credit following Russia's 1998 bond default. More and more, therefore, the market for quants is in risk monitoring and management.

I didn't fully realize that the word
quant
had negative overtones until I leafed through a dictionary of finance terms several years ago and saw the entry “quant—often pejorative.” Often is right. When I first came to work at Goldman, Sachs and Co. in 1985, I instantly noticed the shame involved in being numerate. Sometimes, talking in a crowded elevator to another quant, you might start to say something about the “duration” or “convexity” of a bond. These are relatively low-tech bond-math terms that describe the sensitivity of a bond's price to changes in interest rates. If the colleague you were talking to had been at the firm a little longer than you, then he—most quants are male—would shift uncomfortably and try to change the subject. “Futures dropped more than a handle today!” he might say, imitating the confident vernacular of a genuine bond trader. Soon, you began to realize, it was bad taste for two consenting adults to talk math or UNIX or C in the company of traders, salespeople, and bankers. People around you averted their gaze. There was something terminally awful about being outed.

Even in the mid-1990s geeks were fair game. One afternoon a colleague and I were standing on either side of one of the narrow aisles between the banks of trading desks on the floor when one of the chief traders walked between us, his head momentarily between ours. At that instant he winced, clutched his head with both hands as though in excruciating pain, and exclaimed, “Aaarrggh-hhh! The force field! It's too intense! Let me out of the way!” In the same vein, I lost count of the number of times some junior traders heading for lunch entered the elevator to see a group of quants standing there and then reflexively uttered some variant of “Uh-oh! Isn't there some rule against all of you getting in the elevator at once?”

Traders and quants are genuinely different species. Traders pride themselves on being tough and forthright while quants are more circumspect and reticent. These differences in personality are reflections of deeper cultural preferences. Traders are paid to act. All day long they watch screens, assimilate economic information, page frantically through spreadsheets, run programs written by quants, enter trades, talk to salespeople and brokers, and punch keys. It's hard to have an extended conversation with a trader during the business day; it takes an hour of standing around to have five minutes of punctuated repartee. Part of what traders do has a video game quality. In consequence, they learn to be opinionated, visceral, fast-thinking, and decisive, though not always right. They thrive on interruption.

Quants do not. Like academics trained in research, they prefer to do one thing from beginning to end, deeply and well. This is a luxury that is difficult to enjoy in the multitasking world of business, where you have to do many things simultaneously. When I moved to Wall Street, the hardest attitude adjustment for me was to learn to carry out multiple assignments in parallel, to interrupt one urgent and still incomplete task with another more pressing one, to complete that, and then pop the stack.

Traders and quants think differently, too. Good traders must be perpetually aware of the threat of change and what it will do to the value of their positions. Stock options in particular, because of their intrinsic asymmetry, magnify stock price changes and therefore suffer or benefit dramatically from even small moves. Quants think less about future change and more about current value. According to financial theory, at any instant the so-called fair value of a security is an average over the range of all its possible future values. Fair value and change are therefore two sides of the same coin; the more ways in which a security can lose value from a future market move, the less it should rationally be worth today, and hence the mantra: more risk, more return. This difference between the quant's view of value as an average versus the trader's need to worry about any change makes this kind of professional cross-communication difficult.

Tour de France cyclists don't need to know how to solve Newton's Laws in order to bank around a curve. Indeed, thinking too much about physics while cycling may prove a hindrance. Similarly, options traders need not be expert quants; they can leave the details of the recipe for manufacturing options to others as long as they have the patience to thoroughly understand how to use it and when to trust it, for no model is perfect. One trader I know used to say, “You can't give a person a Black-Scholes calculator and turn him into a trader,” and this is true; it takes study, understanding, intuition, and a grasp of the limits of the model in order to trade wisely. You cannot just follow formulas, no matter how precise they appear to be.

A good quant must be a mixture, too—part trader, part salesperson, part programmer, and part mathematician. Many quants would like to cross over to become traders, but they face the formidable obstacles of scholarly backgrounds, introspective personalities, and hybrid skills.

One of the theories about what makes an animal nonkosher is that it transcends categories. In the book of Genesis, the creation categorizes animals by both their species and location, referring to “birds of the sky” and “fish of the sea.” Occupying both categories is what makes some animals nonkosher. Shrimp, for example, live in the sea but aren't fish and don't swim. Ostriches are birds, but do not fly in the sky. Both are nonkosher. Similarly, cloth made from a mixture of linen (a plant) and wool (an animal product) is also proscribed. Those who were brought up keeping kosher can feel nauseated at the thought of eating category-violating food.

Quants are the nonkosher category violators of Wall Street, half-breed players who make pure traders or undiluted information technology managers uncomfortable. Quants are amateurs with no clear professional role model. While traders and programmers in investment banks have distinct ladders to climb and clearly marked rungs to ascend, the quant professional ladder is short and often ends in midair.

Nevertheless, in the twenty-first century, as universities have initiated financial engineering programs and financial institutions have embraced risk management, being a quant has slowly become a more legitimate profession. The overheated tech-stock market of the late 1990s cast a warm, reflected glow on geeks of all types, as did the droves of hedge funds trying to use mathematical models to squeeze dollars out of subtleties. The guts to lose a lot of money carries its own aura. D.E. Shaw & Co., a New York trading house that was rumored to be making substantial profits doing “black box” computerized statistical arbitrage before their billion-dollar losses in 1998, and Long Term Capital Management, the quant-driven Connecticut hedge fund that ultimately needed a multibillion-dollar bailout, have both contributed to this more glamorous view of quantization. And indeed, many of the Long Term Capital protagonists are back in business again at new firms. The capacity to wreak destruction with your models provides the ultimate respectability.

There is an almost religious quality to the pursuit of physics that stems from its transcendent qualities. How
does
a planet know that it must obey Newton's Laws, or an electron perceive that it must move according to the principles of quantum electrodynamics? Do tiny internal homunculi program internal nanocomputers to spit out the electron's next position? It's hard not to have a sense of wonder when you see that principles, imagination, and a little mathematics—in a word, the mind—can divine the behavior of the universe. Short of genuine enlightenment, nothing but art comes closer to God.

When I was a graduate student at Columbia in the 1970s, physics was the great attractor for the aspiring scientists of the world. Bearing witness to this was the large box of documents kept near the entrance to the physics department library. We referred to it as the “crank file.”The box contained the unsolicited typewritten letters, manuscripts, and appeals that poured steadily into the mailbox of the department's chairman. Eccentric though the documents were, they made fascinating reading. There were eager speculations on the nature of space and time, elaborately detailed papers refuting relativity and quantum mechanics, grandiose claims to have unified them, and farfetched meditations that combined physics with more metaphysical topics. I remember one note that tried to deduce the existence of God from the approximate equality of the solid angles subtended by the sun and the moon when observed from the earth, a remarkable circumstance without which there would be no solar eclipses.

None of these papers had much chance of getting past a journal referee. Few of the writers had much hope of even getting into graduate school. They may not have wanted to. The letters were mostly a
cri de cæur
from isolated and solitary physicist manqués all over the world.

Most of my classmates laughed at the naiveté of the letter writers, but as I skimmed through the crank file I found it hard to feel superior. Instead, peering into the box of manuscripts, I always saw my pale reflection. Out there, beyond academia and industry, were people like us, similarly in thrall to the same sense of mystery and power that lay behind the attempt to understand and master the universe with only imagination and symbols. They were cranks, those letter writers, but they were also genuine amateurs, lovers of the field interested in wisdom and magic rather than money.

There are amateurs in the financial modeling world, too, but they often come in more mercenary flavors, and why not? Because I used to run a group called Quantitative Strategies at Goldman Sachs for many years, after a while almost any letter from the outside world addressed to the “Quantitative Something-or-Other” at Goldman found its way to me. Once every few months I received a note from someone isolated and far away who thought he or she had made some great breakthrough in financial theory. Often, they would explain, it was a breakthrough whose exact details they were unwilling to divulge without being given a contract promising them a share of the future profits they were certain its use would guarantee. I sympathized with them. They, too, believed in the power of imagination.

Theoretical physicists are accustomed to the success of mathematics in formulating the laws of the universe and elaborating their consequences. The universe does indeed seem to run like some splendid Swiss clockwork: We can predict the orbits of planets and the frequency of light emitted by atoms to eight or ten decimal places. But when a physicist first pages through a graduate economics or finance textbook, he or she begins to feel aghast. The mathematics of economics is so much more formal than the mathematics of physics textbooks—much of it reads like Euclid or set theory, replete with axioms, theorems, and lemmas. You would think that all this formality would produce precision. And yet, compared with physics, economics has so little explanatory or predictive power. Everything looks suspect; questions abound.

When physicists pursue the laws of the universe, it seems selfless. But watching quants pursue sacred laws for the profane production of profit, I sometimes find myself thinking disturbingly of worshippers at a black mass. What does it signify to use the methods of physics and the language of mathematics to model the economic world? Is it justifiable to treat the economy and its markets as a complex machine? How can traders put their faith in this stuff? Isn't value determined by people? And how can people be described by equations and predetermined rules? Isn't this endeavor the misguided consequence of some sort of physics envy, an inappropriate attempt to model messy human systems with the wrong paradigm? Is social science, as the economic historian Robert Skidelsky once observed, merely a compendium of flawed thinking disguised as scientific understanding? If mathematics is the Queen of Sciences, is quantitative finance a science at all? And finally, are quants scientists or cranks?

This book is an account of my experiences as a scientist, quant, and, on occasion, a fellow traveler of cranks.

The attractions of science

The glory days of particle physics

Driven by ambitious dreams to Columbia

Legendary physicists and budding
wunderkinder

Talent versus character, plans versus luck

I expected New York to glitter. Instead, when I arrived on that hot August afternoon in 1966, the city was grimy and littered, disappointingly unmodern. I was jet-lagged and weary, and the sweaty cab ride from Kennedy airport to upper Manhattan tilted me towards depression. The cramped Formica-filled rooms in International House, a graduate student dormitory established by the Rockefeller Foundation on the far reaches of New York's Upper West Side, bore little resemblance to the spacious-looking illustrations in the brochure they had sent to me in South Africa. The sickly green-and-white walls in the corridors and the guards at the back entrance added to the prison sensibility. It took several months before habit obscured all of this ugliness. “I. House,” as we all called it, was actually a very good place for foreigners.