The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Sunday, December 24, 2006

The Genius of Finance -- Book Review of Fischer Black and the Revolutionary Idea of Finance

In Fischer Black and the Revolutionary Idea of Finance, a biography of the legendary pioneer of quantitative finance by Perry Merhling, John C. Cox (finance professor at MIT) is quoted as saying that Fischer Black was "the only real genius I've ever met in finance." After reading this biography of the enigmatic and paradoxical life of Fischer Black, I wholeheartedly agree with Prof. Cox: Fischer Black was the genius of finance.

Fischer Black is best remembered for being the "Black" of the option pricing model -- an intellectual achievement that, along with Modern Portfolio Theory and the (CAPM), heralded the birth of quantitative finance. But, as Perry Merhling masterfully reveals to the readers of his book, Fischer Black considered the Black-Scholes formula -- which earned Myron Scholes and Robert Merton Nobel Prizes (which would have been awarded to Fischer Black had he not died of cancer in 1995) -- to be a relatively minor component in his overall views of both the financial world and the world at large.

Unlike the vast majority of academics and practitioners, he was not slavishly loyal -- with the quasi-exception of his quixotic CAPM and equilibrium based philosophy, which cannot easily be pigeonhold into any stereotypical category -- to any particular school of thought or to any particular model, even ones' named after him. Instead, the framework with which he analyzed, and by which he even lived his all too brief life, was not any particular school of thought in finance but to finance itself. Fischer Black approached finance, not only as a science, but also as an art -- a way to express oneself and be creative.

To Fischer Black, finance was a port or a lighthouse in the storm; finance was a way to negotiate through the swirling currents and buffeting winds of risk and return. To Fischer (perhaps under the influence of one of his teachers, Harvard philosopher/logician ), finance was a language -- in fact, one of his proudest achievements was to create, for his students at MIT, a dictionary of finance (the definitions reflecting his unique views on finance) to provide a semantic schema for this language -- a way to formulate ideas and express them in a world full of uncertain gains and losses.

The book also reveals Fischer Black to have been a man of paradoxes and unconventionality. In his personal life, his daily routines were so invariant and downright boring that it would have been easy to predict what he had for lunch on a particular day (plain broiled fish and a baked potato with no butter), yet there were significant aspects of his life that were bohemian and extremely unconventional. He was capable of great generosity and humility, yet his lack of social graces could be off-putting even to those most closest to him. He was an academic that wound up as a partner at Goldman Sachs; he was a practitioner that did substantial research in finance on his own time and dime with no discernible intention to gain professional currency or glory.

The most ironic paradox was the fact that, although Fischer Black obtained a PhD in Applied Mathematics from Harvard, he could not solve the Black-Scholes stochastic differential equation using conventional methods from math and physics (he arrived at a solution through a kind of 'back-solving' method where Black and Scholes applied CAPM logic assuming a zero-beta security; Robert Merton later supplied a more straight-forward proof). This might be a sign to some that Fischer Black wasn't good at math (despite the PhD). I draw the opposite conclusion: If one views 'math' as being mostly about calculation or applying textbook methods in textbook ways, then Black wasn't a good mathematician. But, if one views mathematics as being, at heart, about applying logic and abstract thinking to creatively solve problems and prove propositions, then what Black did was brilliant mathematics -- arriving at an imaginative solution, using accessible and relatively simple tools at hand, to what was then a difficult conundrum that had stumped other brilliant thinkers.

Fischer Black's unconventional approach to life can best be summed up by his political preference during the 1980 presidential election. Rather than supporting Reagan, who his Chicago colleagues likely favored, or Carter, who his MIT colleagues would have been warm towards, Fischer supported the third party candidate, John Anderson!

His path to finance was, not surprisingly, an unconventional one. Fischer Black started his intellectual and professional career, not as an economist, but as a computer scientist and a technology consultant. His early career saw stints as a consultant at BBN, a firm that played a crucial role in the development of the Internet, and at Arthur D. Little.

His early career as a computer scientist (this was before there really was such a job description) had a lasting impact -- both in how he lived his life and in his approach to the the practice of finance when he latter joined Goldman Sachs -- on Fischer. Fischer's research in computer science was focused on artificial intelligence, but, whereas most AI researchers explicitly or implicitly centered their research on how machine intelligence could substitute for human intelligence, Fischer focused on the interaction between man and machine -- specifically, how machines could be used to enhance human intelligence. Fischer held onto to the idea that machines could enhance and supplement human intelligence and was skeptical that machines could truly replace man.

This led to another interesting paradox that was on display when Fischer joined the ranks of Goldman Sachs : On one hand, Fischer did not use the latest in computer technology for his personal work; his computer had a monochrome screen when color screens were widely available and probably did not have the latest in graphical user interfaces. In fact, he was (in)famous for relying on a paper-based filing system (whose only technological connection was that Fischer used a very simple organizational software called ThinkTank to catalogue the cards and notes) to memorialize his musings. Yet -- as Emanuel Derman, in his autobiography My Life as a Quant: Reflections on Physics and Finance, noted -- Fischer went to great lengths to insist on a user friendly interface for computerized valuation tools and trading systems for Goldman Sachs traders. Furthermore, Fischer had the foresight to predict automated trading systems and exchanges decades before they came into wide-spread use and acceptance.

It was at Arthur D. Little that he came into contact with CAPM and the pioneering work on quantitative finance done by Robert Samuelson, Harry Markowitz, William Sharpe, and, most significantly for Fischer, Jack Treynor. It was CAPM, and the closely related idea that prices tend toward equilibrium, that served as Fischer Black's map and compass on his many adventures in finance and economics as a professor of finance at the University of Chicago and at MIT as well as at Goldman Sachs.

In the field of finance, Fischer's contributions and musings are too numerous to recount here, but he made important contributions (or could have if some of his thoughts had been more widely circulated) to almost every field of finance, including financial and managerial accounting, tax accounting and law, corporate finance, international finance, and investment management. In direct opposition to the 'efficient market hypothesis' school of thought, Fischer was one of the first to recognize the influence of noise traders on financial markets. He went so far as to argue that the Black-Scholes model -- which initially would have provided 'signals' (valuable information) in the marketplace -- had contributed to some of the increasing noise in the financial markets. He further demonstrated an ability to sacrifice ego for the sake of advancing knowledge and practice when, at Goldman Sachs, he encouraged the use of discrete, tree-based option pricing models by John Cox, Stephen Ross, and Mark Rubenstein (with some inspiration by William Sharpe) over the Black-Scholes-Merton model because the tree model was more flexible.

Whereas his contributions to finance, including his challenge to conventional wisdom, was, at the very least, met with general acceptance by the financial community, Fischer's forays into other parts of economics -- especially macroeconomics -- were met with a great deal of skepticism if not downright hostility. His views of the business cycle and monetary theory were considered to be almost blasphemous by some -- his 'monetary theory' basically did away with money altogether! (At least, the convention notions of money.) Fischer's theories of macroeconomics were based on his quixotic views of CAPM and equilibrium and did not fit in either with the Keynesian (or neo-Keynesian) or Monetarist camps; Fischer's views could best be called the 'finance theory of macroeconomic business cycles.' In fact, he had been a professor at the 'holy cities' of both camps (Chicago for Monetarists and MIT for neo-Keynesians) and made little headway with either group in converting them to his ideas. As Perry Mehrling correctly points out, time seems to be on Fischer's side, and, as recent trends in the awarding of Nobel prizes to macroeconomists with views similar to Fischer's seem to suggest, Fischer's views may step out of the intellectual wilderness and become mainstream views in the near future.

In both his forays into finance and economics, as well as in aspects of his personal life, the idea of equilibrium, which Fischer saw as being at the core of his CAPM-based philosophy of life, was of critical importance to Fischer Black both intellectually and as a man. But his approach to economic, financial, and other types of equilibrium was, as in other aspects of his life, paradoxical. On one hand, his devotion and laser-like focus on general equilibrium would have put even the most ardent Chicago-school economist to shame. Yet, Fischer's idea of equilibrium was not the static or smooth one that is typical of economists of any school; Fischer inherently viewed equilibrium as being dynamic and jumpy.

To Fischer Black, equilibrium was a goal of life and not necessarily a fixed state of being. Rather than staying in place or being completely aimless, Prices will move from equilibrium towards a new equilibrium. In other words, equilibria serve as attractors to prices but they were by no means the unchanging and unerring entities as they were in the minds of many economists. Moreover, the idea of equilibrium, e.g., finding the right balance between risk and return, was more of a guiding philosophy and an analytical framework to Fischer rather than some unbending rule that one simple-mindedly tied oneself to.

Fischer's more flexible attitude toward equilibrium allowed him take the right kinds and amounts of risks. Fischer took a great deal of intellectual risks with his research because he, rightly, saw that the returns to him were well worth the risk. Fischer, however, refused to take less-than-wise financial risks. For example, although he had been offered a position with a great deal of financial benefits to take part in the mis-adventure of LTCM -- an offer that both of his option pricing colleagues, Myron Scholes and Robert Merton, took to their regret -- Fischer rejected their offers. In Fischer's mind, LTCM was "loading up on risk." It turned out, after his death, that he was absolutely correct.

Fischer's willingness to challenge conventional wisdom (and foolishness) was perhaps best displayed in his famous "Fifty Questions" in finance courses at Chicago and MIT. There he was in his element; like a master painter working at a canvas or a poet tapping away at a typewriter, Fischer Black used his classes -- with the aid of his "Fischer Black's Glossary for Finance" -- to explore the language of finance. The questions were usually the same from class to class, but the answers were often radically different. Such is the price of genius.

Thursday, December 14, 2006

Swarm Marketing: More Tyranny of the Power Law?

A while ago I read a couple of articles on , theory, and marketing. One of the articles was in The Economist, Swarming the shelves (Nov. 9, 2006), and the other was a Harvard Business Review piece co-written by Columbia mathematical sociologist Duncan J. Watts and McKinsey consultant Steve Hasker, Marketing in an Unpredictable World (Sep. 2006). I wanted to very briefly analyze these two articles because I think they: (a) are interesting bits of research on their own, and (b) they become even more fascinating in light of the and a previous blog piece I wrote, Tyranny of the Power Law (and Why We Should Become Eclectic).

The Economist piece discusses a marketing strategy developed by two Florida Institute of Technology computer scientists for use in supermarkets and other retailers. Taking advantage of radio frequency identification tags that are increasingly getting embedded into consumer products, the researchers propose to use that technology, along with wi-fi screen/scanner included with every shopping cart, to inform customers about how many other consumers choose that particular product.

This scheme is basically a take off on an old marketing trick, 'bandwagon effect,' updated with the latest in social network analysis and mobile technology. The idea is that consumers will tend to 'herd' toward particular products because it was popular with other consumers; with up-to-date technology, consumers can now be more rapidly informed of what choices other consumers made. Think of the 'cool kids' in high school becoming more popular because everyone was informed they were popular.

The Economist piece also makes a passing reference to the research done at Columbia University that is written up in a popular format in the Harvard Business Review article. The research, published in Science as Experimental Study of Inequality and Unpredictability in an Artificial Cultural Market (311:854-856, Feb. 10, 2006), by Salganik, Dodds, and Watts involved a web-based experiment where the researchers created a market for downloadable music. They used this experimental market to see the influence of social influence on consumer choices and the predictability of a product's success. They found that "increasing the strength of social influence increased both inequality and unpredictability of success." In other words, increasing the influence that people have on each other -- e.g., by informing consumers of what products are popular -- will tend to make popular products more popular and widen the gap between them and less popular products as well as make it harder to predict beforehand which products will turn out to become popular.

All of this should sound familiar to those of us familiar with things like , the business/pop-science book The Wisdom of Crowds, and the ; the crowd tends to know better so we should go along with the crowd. This stands in contrast to the ideas put forward in the book The Long Tail and in my blog post Tyranny of the Power Law (and Why We Should Become Eclectic). In fact, Watts and Hasker directly challenge and contradict the long tail theory -- that technological innovations should lead to a wider and eclectic assortment of choices for consumers -- in their HBR piece.

As I made it known in the "Tyranny of the Power Law" blog post, I have serious misgivings about the type of world that Messrs Watts, Hasker, et al. envision. Yes, it's nice and helpful to know what other people are buying. As I made clear in my previous blog post, I don't disagree with the idea that crowds are sometimes wise. But are they always wise? And, as I tried to philosophically dissect, even if people tend to go along with the crowd and make popular things or people more popular, does that mean that such a mentality is an unalloyed good or is something we should encourage as a normative policy prescription?

Lemmings also follow the herd ... down ravines and to their doom. Crowds can be daft and mad and following them has often led to some of the most foolish and catastrophic incidents in history. As the Science piece points out, the network effects of social influence -- which can be fitted with a power law distribution -- can cause a serious disconnect between quality and ultimate success.

In that experiment, the 'best' (a quality which was determined by comparing the social influence conditions to the placebo/independent condition) songs, while doing well on average, did not always succeed as one might have expected and, in terms of market share, had the most unpredictable outcomes. In other words, at least for the music download market experiment, there was at least some substantive detachment between quality and success.

In real life, as opposed to artificial experiments, we can -- and have seen -- even greater disassociation between quality and success. The best products and people don't always get the success they deserve. That is, at least in part, due to the 'tyranny of the power law': Some products, services, people, and organizations get a leg up (sometimes, unfairly) and their pre-ordained success gets reinforced by social structures that are rigged to keep it that way ... meritocracy be damned. It's like high school, the cool kids weren't always the smartest or the most talented kids. The cool kids were cool because ... well, they were cool to begin with. That might be okay for teenagers, but is that any way we want to run a country, encourage culture, promote an educated populace, and run a business?

Friday, December 08, 2006

Pop Culture & Hedge Funds

The New York Times has an article today on how hedge funds are getting 'name checked' in various outlets of pop culture: Culturally, Hedge Funds Go Public (Dec 8, 2006). From soap operas to a "for Dummies" book, and even a shoe (by Kenneth Cole) named after it, hedge funds are going mainstream.

IMHO, all of that probably means that there will be a major crash and/or scandal in the hedge fund industry (beyond what we have already had) very soon ;)

Sunday, December 03, 2006

Goldman Sachs' Hedge Fund Clone

Goldman Sachs, one of the most prestigious investment banks in the financial industry, is setting up a hedge fund replication tool (or hedge fund 'cloning' tool) -- which it calls the Absolute Return Tracker index (ART) -- that may usher in a new era of even greater competition in the hedge fund industry. You can read about it in today's Financial Times.

This announcement is closely tied to a previous blog posting I did -- The Econophysics Blog: Hedge Funds & Minding One's Pennies -- about how finance academics at MIT and other schools are attempting to create an intellectual foundation for replicating the performance characteristics of hedge funds at lower costs and using more accessible financial instruments.