It's crazy how fast time is going... we're almost getting to that point where we have to start working on our final products! I've decided that, in the interest of time, my final product will be a haiku about econophysics. Here's a sample of my rough draft:
Econophysics
Oh, how you explain it all
More people should know.
Okay, just kidding. My final product will not be a haiku, even though that would make my life significantly easier. Instead, I'll be writing a paper that analyzes the claims of econophysics in the context of various investment strategies, trying to decide if it's worth its salt as a theory. I'm super excited about it, but I definitely have a bit of an overflow of information, so my challenge will be organizing it in a way that creates an effective argument.
This week, I'll be talking about another allegation that is leveled at econophysics, claiming it is ineffectual or even harmful to the economy when applied improperly. I don't think these allegations have a lot of substance, as I'll explain in a minute.
As I've mentioned before, the idea that tools from physics can be applied in the economy is not somehow novel. Wall Street has been hiring physicists for decades, given their unique abilities in math, computer science, and problem solving. They joined hedge funds and together with PhDs in finance, armed themselves with formulas and computer programs telling them exactly how options and stocks should be priced. These scientists were referred to as "quants", short for quantitative finance.
However, in August 2007, hedge fund portfolios, run by quants, tanked. Positions that were supposed to go up went down. Positions that were supposed to go up even if everything else went down also went down. As presitigious firms like Morgan Stanley and Goldman Sachs lost anywhere from 500 million to 1.5 billion dollars, every stock they had bet against actually rallied-- the DOW Jones overall went up 150 points.
Even as the crisis of the summer of 2007 (known as the "quant crisis") stabilized, the 2008 housing meltdown followed. Again, models showing how subprime mortgages could be treated as bonds collapsed, leaving the entire housing market vulnerable. (And we're arguably still recovering from the afteraffects.)
Many policymakers and regulators, seeing the disastrous results that the quants wreaked on the economy, are inclined to distrust any such models. As Warren Buffett famously said, "Beware of geeks bearing formulas." It seemed that using science on Wall Street was nothing more than a dream.
I disagree, however, and I certainly don't advocate the cessation of doing science on Wall Street, for several reasons.
1) Speculative bubbles are not a new thing. While the housing craze and subsequent crash of 2008 may have been a result of the meddling of quants, such bubbles go much farther back to well before the dawn of computers. (Remember the Dutch tulip frenzy from European history? A single bulb could sell for the worth of a house, at least until the bubble popped.) It's unfair to entirely blame quants for a crisis that could just as easily have been the Dot-Com crisis of the early 2000s.
2) The quants were doing "bad science." Criticism of quants as scientists only works if you believe they were acting as scientists would. The problem wasn't that the quants were using the scientifically-derived models to price options; rather, the problem was that they were relying too heavily on the models. Any good scientist will recognize that there may be inherent holes in their model, and as such, will not treat it as infallible, but rather continue to look for the holes and be wary of its failings. The quants of 2007, though, were not checking their models properly.
3) Not every hedge fund was hit by the crisis. The Renaissance fund, run by Jim Simons (a well-known theoretical physicist), is staffed entirely by physicists, mathematicians, and statisticians. None of them have gotten their start at traditional investment banks. In 2008, when every other hedge fund was losing millions of dollars, Renaissance's Medallion Fund actually gained an 80% return. This suggests that whatever models that Renaissance created were somehow "better" than those of their competitors; perhaps because they were created based on pure mathematical and scientific principles, that is, the principles that econophysics purports to advocate.
Therefore, we should not be skeptical of using mathematical and physical tools in the economy; people have proven that it is possible to do so successfully. Rather, we should ensure that we are doing so in a manner that follows the scientific method, and continue to check ourselves for our mistakes.
I really enjoyed seeing many of you at the senior meeting! For those of you who are out of town, I look forward to talking to you when you get back. I hope this week brought good news to all waiting to hear from colleges. :)
Have a great week, and comment below if you have any questions/concerns.
Since I don't have any project-related pictures for you this week, here is a shot of an adorable baby animal!
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