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The Physics of Wall Street: A Brief History of Predicting the Unpredictable Hardcover – January 2, 2013

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Editorial Reviews Review

Q&A with James Owen Weatherall

James Owen Weatherall

Q. What is The Physics of Wall Street all about?

A. Over the past few years, we've heard a lot about a new kind of Wall Street elite known as "quants." These are often physicists and mathematicians who have moved to finance and brought radically new ideas along with them. This book is an attempt to understand these quants and the mathematical models they use to predict market behavior. It's two parts history and one part argument: I tell the surprisingly fun story of how physicists and their ideas made it to Wall Street in the first place, and along the way I argue that this history reveals something important about how we should think about the models and practices they have introduced--especially in light of the 2007-2008 financial crisis.

Q. You say the history is surprisingly fun. Can you give an example?

A. The physicists and mathematicians I write about in the book are (or were) very smart, creative people who put their scientific training to use in surprising new ways. Their stories are fascinating. For instance, Edward Thorp, who invented the modern quantitative hedge fund, was also the first person to prove that card counting could be used to reliably get an edge in blackjack. He spent a good amount of time working the card tables in Las Vegas. And Norman Packard and Doyne Farmer, who started a pioneering financial services firm in the early 1990s, spent their graduate school years at UC Santa Cruz inventing the new science of chaos theory while trying to build a computer to beat the odds in roulette--the profits from which were intended to start a yippie commune in the Pacific Northwest.

Q. What surprised you most about the history you uncovered?

A. One thing that surprised me was that derivatives contracts such as options, futures, and swaps, which are often discussed as though they were a troubling new innovation, have actually been around for thousands of years. For example, scientists have found cuneiform tablets containing records of futures traded by ancient Sumerians. Even the idea of using mathematical methods to price options is quite old. I pick up the story in 1900, with the visionary work of a French physicist named Louis Bachelier, but some strands go back further, to the mid-nineteenth century. Plus, there are some striking historical connections in the book. For instance, I explain the relationship between the invention of nylon and the development of the atomic bomb--and how both influenced at least one physicist's to switch to a financial career. And I tell the story of how the space race and the Vietnam War were partly responsible for many physicists moving to Wall Street banks in the 1980s.

Q. What can this history teach us about models used in finance?

A. If you look at how the physicists and mathematicians who came up with the earliest financial models thought about what they were doing, the role of simplifying assumptions and idealizations becomes very clear. The goal was to get a toehold on some very hard problems, and not to come up with a final, overarching theory of financial markets. Making simplified assumptions can lead to the solution of a problem that you otherwise couldn’t solve--but that solution is only going to be a reliable guide to how the world works when the assumptions you’ve made are approximately true. The important question, and the one that physicists are always trained to ask, is when do your assumptions fail and what happens when they do? I don’t think the importance of this question has been recognized as widely as it should be among the traders who rely on these models.

Q. At the end of the book, you describe an "Economic Manhattan Project." What would that be like?

A. The Economic Manhattan Project was proposed in 2008 by the mathematical physicist and hedge fund manager Eric Weinstein. The idea is that economic and financial security--that is, regulating the economy to avoid future calamities--should be at the very top of our agenda. Yet the resources we devote to physical security, to military technology and defense, far outstrip what we spend on developing better economic theories. In the past, America has set goals--for the original Manhattan Project, the race to the moon, and others--when we have funneled resources into serious innovation. And whenever we have done so, we have succeeded in accomplishing great things. I think it is time to make a similar kind of commitment to developing the next generation of economic models, with the goal of finding radical new ideas to make the economy safer and more robust.

Q. You're a philosophy professor. Why did you write a book about finance?

A. The short answer is simply that I find the history and the ideas fascinating. I have a Ph.D. in physics and I like thinking about how physics can be applied to novel problems. The longer answer is that the issues in this book aren't so far removed from philosophy. Philosophers spend a lot of time thinking about what we can know about the world and how to deal with fundamental uncertainty. Philosophy has a reputation for being abstract and distant from everyday concerns. And sometimes it is. But when it comes to mathematical models, philosophical issues really matter for how we make important economic and financial decisions--decisions that have significant real-world ramifications. And for me, at least, the most interesting and important philosophical questions are those that we face as practicing scientists and policymakers--and even as investors.

From Booklist

Wall Street has long attracted talented business-school graduates; only in recent years has it also drawn analysts with doctorates in physics, mathematics, and statistics. That change is the focus of this fascinating history by a young University of California, Irvine, professor. Weatherall’s narrative mixes familiar names (Blaise Pascal, Pierre de Fermat, Paul Samuelson, Fischer Black, Myron Scholes) with more obscure figures like Gerolamo Cardano, Louis Bachelier, and Didier Sornette. Many key concepts will be familiar from the financial press: e.g., random walk theory, delta hedging, dynamic hedging, and black box models. Happily, the author has a gift for making complex concepts clear to lay readers. Weatherall understands the temptation to blame the quants for the 2008 market crash but urges that the danger comes when we use ideas from physics, but we stop thinking like physicists. Thinking like physicists means recognizing that every model is based on simplifying assumptions and that model building requires a constant iterative process of testing and improvement. Using that process, Weatherall argues, quants can offer useful insights and tools for both economic policymakers and financial speculators. --Mary Carroll
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Product Details

  • Hardcover: 304 pages
  • Publisher: Houghton Mifflin Harcourt; First Edition edition (January 2, 2013)
  • Language: English
  • ISBN-10: 0547317271
  • ISBN-13: 978-0547317274
  • Product Dimensions: 1 x 6.5 x 9.2 inches
  • Shipping Weight: 1 pounds (View shipping rates and policies)
  • Average Customer Review: 3.9 out of 5 stars  See all reviews (97 customer reviews)
  • Amazon Best Sellers Rank: #97,191 in Books (See Top 100 in Books)

More About the Author

James Owen Weatherall is a physicist, philosopher, and mathematician, currently working as Assistant Professor of Logic and Philosophy of Science at the University of California, Irvine, where he is also a member of the Institute for Mathematical Behavioral Science. He lives in Irvine, CA with his wife and two daughters.

Customer Reviews

Next, Thorp makes a fortune by applying the Kelly criterion to financial markets.
Gaetan Lion
The author also introduces a lot of the personalities behind all of this work and provides lots of great anecdotes and personal stories.
Ilya Grigorik
My problem with the book is that it may be confusing to many who are not versed in the subject of economics and math.
Beau Sabreur

Most Helpful Customer Reviews

113 of 116 people found the following review helpful By physics lover VINE VOICE on January 12, 2013
Format: Hardcover Vine Customer Review of Free Product ( What's this? )
It is not easy to come up with star ratings for this book. I will split the difference between two and four stars. Here is why...

On one hand, I consider it to be a chronology of scientific efforts to predict markets beginning as early as the 18th Century, all the way up to 2012. As such, it is very interesting in terms of some the best known historical names dabbling in it. The storytelling in the book is not very good, but despite that it kept my interest through many chapters.

On the other hand, I consider this book to be an attempt to explain (to the layman) how science can be used to predict markets. To that end, the examples of Simons and Sornette (and their spectacular success on Wall Street) are presented without going into details. One cannot justify everything by the brilliance of these men alone. If they indeed were successful based on their knowledge of physics, how they managed to do that should have been analyzed in the book. Instead, the author takes a very long-winded tour of random statistical distributions starting with Gaussians, then he moves on to Cauchy distributions and other fat-tailed distributions, and how they may be relevant to markets. If that was all there is for the scientific methodology of market prediction, you would not need physicists like Simons and Sornette. Anybody with some basic math and statistics will do fine. The physicists do far more than that, and none of that was discussed in the book. They come up with models of dynamic market balance, they convert these models to differential equations to be solved, and they (approximately) solve them (on fast super-computers.) It would have been fascinating if the author had any details available on that subject.
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86 of 97 people found the following review helpful By Gaetan Lion on November 28, 2012
Format: Hardcover Vine Customer Review of Free Product ( What's this? )
Weatherall tells that contrary to what we know, Warren Buffet is not the US best investor. The best one is Jim Simons, a brilliant physicist expert in String Theory who founded the investment firm Renaissance Technologies and its Medallion Fund. Simons returns have far outpaced Buffet's. During the recent financial crisis in 2008 when Buffet incurred a 50% loss, Simons Medallion Fund returned 80%. Other outstanding investors include Ed Thorp, James Doyne Farmer and Norman Packard. What those better-than-Buffet investors have in common is that they are all scientists instead of financial types. They use complex mathematical models to implement profitable short-term trades instead of holding stocks over the long term based on fundamentals like Buffet.

Weatherall develops a philosophy of the scientific method that permeates the whole book. Contrary to Taleb who dogmatically states you can't model anything; so, throw the entire body of modern finance out and just buy insurance (Put options); Weatherall, observes that "The model-building process involves constantly updating your best models and theories in light of new evidence."

Weatherall starts the history of modern finance with the French mathematician Louis Bachelier and his revolutionary paper "Theorie de la Speculation" published in 1900. Weatherall states: "In a just world, Bachelier would be to finance what Newton is to physics." Indeed, Bachelier was the first to figure that stock prices captured all information and moved randomly. He explained the related random walk of stock prices. He was a pioneer in applying probability theory to financial markets. He specified the Efficient Market Hypothesis without naming it. The latter will be articulated by Eugene Fama in 1965.
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19 of 20 people found the following review helpful By Scott C. Locklin VINE VOICE on January 13, 2013
Format: Hardcover Vine Customer Review of Free Product ( What's this? )
I come at this review as an occasional worker in the financial world, a former physicist and a larval futures trader.

The good: the author has some excellent historical material on Bachelier, MFM Osborne and Ed Thorp, who are (mostly) unrecognized giants in the field. I learned a few things, and think the author had some real insights into the contributions made by these men. Frankly, I'd have bought the book for the Thorp and Osborne anecdotes. Someone really needs to do an authorized biography of Thorp, and one of Osborne would be pretty neat as well. Some of the material on Mandelbrot and the prediction company guys was also amusing, though I have always considered these folks overrated. This book is extremely well written, and despite the problems I had with it, I found myself enjoying the reading.

The bad: The subjects of this book are not all people a working practitioner of finance would have chosen. Most of subjects of the book are *known.* Many practitioners of finance (and physics) are only famous because they like publicity and talking to journalists, or because there is somehow a popular book associated with them. I mentioned Mandelbrot and the prediction company guys above: these are accomplished, interesting and talented men. Do they belong in the same league as Ed Thorp or MFM Osborne? I think they'd agree the answer to this question is "no." I've read most of the popular books the author used as raw source material, so most of this book wasn't new. He did reach out to some of the protagonists, and managed to dig up a few things I wasn't familiar with, but the meat of this book exists in several other books out there. Not that there is anything wrong with that; it summarizes about a dozen other books, and does so with considerable style.
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