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February 15, 2013 8:14 pm
The Physics of Finance, by James Owen Weatherall, Short Books, RRP£12.99, 288 pages
Since the global financial crisis, there have been two contrasting views of the role played by mathematics and physics in the markets. One school blames out-of-control scientists for creating insanely complex financial derivatives and for driving computerised trading with algorithms too impenetrable for anyone to understand. As investor Warren Buffett famously put it: “Beware of geeks bearing formulas.”
The counter-argument, advanced in The Physics of Finance, is that the markets have been driven by scientifically illiterate financiers who could be rescued from their folly by a good dose of cutting-edge maths. “The crisis was partly a failure of mathematical modelling,” James Owen Weatherall concedes. “But even more it was a failure of some very sophisticated financial institutions to think like physicists.”
Weatherall, an assistant professor of logic and philosophy of science at the University of California, Irvine, has written an entertaining but selective account of the contributions made by scientists to the theory and practice of finance. In fact, his book is mainly about maths, though he writes as much as possible about “physics” and “physicists” – presumably because he thinks they sound more glamorous.
The story starts in fin-de-siècle Paris with Louis Bachelier (1870-1946), who laid the foundations of mathematical finance, drawing up the first scientific model of the way market prices change with time. His “random walk” model, as it has become known, is far from reality but at least it was a start.
According to Weatherall, Bachelier’s research only made an impact after his death, when it was picked up by the great American economist Paul Samuelson. The title of the book’s US edition is The Physics of Wall Street and its whole approach is indeed very US-centric. After Bachelier, the only Europeans who feature are those who have done a lot of work in America, such as Benoit Mandelbrot and Didier Sornette.
Even so, the exploits of his all-American heroes are well worth reading, though some will give succour to the view that stock markets are giant casinos. Several leading figures in financial maths (including Edward Thorp, James Doyne Farmer and Norman Packard) honed their theories playing roulette and blackjack in Las Vegas – and made money in the process.
They went on to make more serious money in the financial markets. The Prediction Company founded by Farmer and Packard in 1991 was one of the first successful ventures to use an opaque “black box” system, running many different mathematical models at the same time. Unfortunately for Weatherall, the “wildly successful” Prediction Company remains secretive about its methods and returns.
Even more successful and secretive is Renaissance Technologies, set up in 1982 by Jim Simons after a formidable academic career in mathematical physics. The fund employs 200 people – one-third with PhDs in maths and physics – at its headquarters in Long Island and has achieved astonishing results, even in bad years such as 2008, when it returned 80 per cent.
“The secret to Simons’ success has been steering clear of financial experts,” Weatherall claims. “Renaissance shows that mathematical sophistication is the remedy, not the disease.”
Well, possibly – though outsiders cannot judge because Renaissance discloses next to nothing about its methods. Nor can we be confident that mathematical sophistication that brings success to a fund will be good for financial markets as a whole.
I sympathise with the attitude that hard science is more part of the solution than the cause of financial instability. But I wish The Physics of Finance, enjoyable though it is, had provided more hard evidence to support that view.
Clive Cookson is the FT’s science editor
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