For many of us who have either watched or been more directly involved in the financial crisis that has gripped the markets for over two years, it is easy to find your scapegoats: politicians, bankers, home-owners buying out of their bracket, mortgage brokers, regulators. Certainly there is blame that falls on all of them. However, a new book The Quants reveals the effects of the hedge funds and proprietary trading desks at investment banks managed based on complex quantitative models that failed in the darkest days. (The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, by Scott Patterson. Published by Crown Business, February 2010.)The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It
Patterson draws the history of quantitative investing from the 1960's to the late 2000's, showing that again and again there are correlations which act in predictable manners (thereby making them useful for quantitative modeling) but that these correlations can go awry in ways that are not statistically possible. But the real story of the book isn't the modeling. In fact, the actual models themselves are only barely described. The real stories of the book are the stories of the people behind the models as they were growing in clout and the humbling of these same people as the markets crushed their much-loved models.
The history of quantitative investing is based on the premise that the markets are efficient with some modest inefficiencies. By modeling the markets, one can see where there are pricing "mistakes" and then the traders can then profit on knowing those mis-priced securities. If something looks cheap according to the market, you buy a lot of it and when it comes back to where it should be you take a nice profit.
The problem that Patterson points out is that while this idea of fundamentally efficient markets is the basis for quantitative modeling, during the 2007 to 2009 window the correlations that were modeled into the programs were no longer true causing hundreds of billions of losses.
The Quants is a fascinating and compelling book, and we recommend it strongly. Again, this is not a textbook on quantitative theory. Instead, it is a journey of the people involved in quantitative investing as they rode high and fell hard, and created billions of dollars of wealth only to see much of it evaporate.
Disclosure: I received this book as a review book at no cost from the publisher. However, if I didn't like it I wouldn't be recommending it.