Some Thoughts on Predicting the Future

I am just finishing up the book “My Life as a Quant”  by Emanuel Derman, a theoretical physicist turned Wall Street “Quant” – or Quantitative Analyst. What does he have to say about predicting market moves, modeling bond futures and general modern day economics?

I have been meaning to read “My Life as a Quant” for a long time, while unpacking boxes (I have just finished closing on a house and moving in – explaining the lack of posts here recently!) I came across it and started reading.

I was attracted to the book because I too am a physicist, though not PhD such as Mr. Derman, who is also fascinated with the financial markets. After graduating, I applied to many “science” jobs as well as Wall Street type finance jobs, science bit first…so here I am blogging about the markets while having a day job as a “scientist”.

 

Physics in a sense is about predicting the future by modeling the universe around us. If you throw a ball in the air we can calculate the force of gravity exerted on the ball, the acceleration the ball has toward the earth, the ball’s trajectory, etc. So its no surprise that Wall Street wants some of this predicting power for itself.

 

What does Mr. Derman have to say about the role of Quants, the use of financial models and the environment of Wall Street in general? Here are some quotes towards the end of his book that I had highlighted during reading:

 

“The techniques of physics hardly ever produce more than the most approximate truth in finance. Because “true” financial value is itself a suspect notion. In physics, a model is right when it correctly predicts the future trajectories of planets or the existence and properties of new particles, such as Gell-Mann’s Omega Minus. In finance you can not easily prove a model right by such observations….As a result physicists turned quants don’t expect too much from their theories, though many economists naively do. Perhaps this is because physicists, raised on theories capable of superb divination, know the difference between fundamental theory and a phenomenological toy, useful though the latter may be.”

 

“In physics, your playing against God, and He doesn’t change his laws very often. When you’ve checkmated Him, He’ll concede. In finance, you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions. They don’t know when they’ve lost, so they keep trying.”

 

“So why is it that the methods of physics work less well in finance? As a physicist, when you propose a model of Nature, you’re pretending you can guess the structure created by God….But as a quant, when you propose a new model of value, you’re pretending you can guess the structure created by other people. When you try out a new yield curve model, you’re implicitly saying something like “Let’s pretend people in the markets care only about the level of future short-term interest rates, and that they expect them to be distributed normally”…if you’re honest, your heart sinks…you know immediately there is no chance at all that you are truly right. When you take on other people, you’re pretending you can comprehend other pretenders, a much more difficult task.”

 

And lastly,

 

“Nevertheless, it’s the unpredictable I’s – people like you and me – who determine financial value. Fisher Black once wrote of financial theories that:

‘In the end, a theory is accepted not because it is confirmed by conventional empirical tests, but because researchers persuade one another that the theory is correct and relevant.”

 

One can see why Wall Street was so quick to pick up some of the smartest minds on the planet. Tremendous wealth would await you if you could predict the future. But the market is not something that can be simply modeled or predicted.

 

Think you can predict the future? You can bet (note the word bet – no investing in this scenario) your life savings on stock ABC going up because it is the third Tuesday of the month and it is 61% below its 200 day moving average (Or whatever reason you choose)….or you can invest based on the facts and understanding of the risks, that will reasonably prepare you for a wide variety of outcomes in the future and give you much more certainty that your money will be there in the future when you need it.

 

Investing has a very different feel to it when you are able to simply admit that you have no idea what the markets are going to do tomorrow. I don’t pretend to know what will happen tomorrow, but I do think you can set your self up to be able to reap the benefits of the markets without knowing everything that lies ahead. For 99% of investors this is done by diversification, reining in costs and limiting risks.

I am willing to eliminate the chance that I will have the best returns on Wall Street for a life that does not hinge on the performance of the stock market on a single day.

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