Monday, December 3, 2007

Surviving and prospering as a quant

I have learned working over the years that the key to surviving and prospering as a quantitative investor is having the combination of quantitative skills with market knowledge and experience. It’s critical to understand the context and limitations of your models. Here is a quick quant quiz:

What is less risky (this not a trick question)?
1 To jump out of an airplane at 30,000 feet without a parachute
2 To stay in the plane while someone else jumps out (yes, there is a pilot flying the plane)

The correct quant answer is 1. Jumping out of the airplane is less risky because the standard deviation of the outcome is zero.

This illustrates the importance of reality checks for models. Mrs. Humble Student of the Markets, who is a pilot, calls it “raising your head up from the instrument panel and looking out the cockpit window once in a while”. Bob Park of FINCAD, a vendor of derivatives software, calls it “domain knowledge”.

Quantitative systems work beautifully most of the time. When they fail they can fail spectacularly, particularly if the failure is due to faulty assumptions. The greatest quantitative failure in the last fifty years was neither the recent sub-prime meltdown nor the Long Term Capital Management collapse.

The greatest quant failure occurred in the 1960s and it was caused by Robert McNamara and the “whiz kids” in their conduct of the Vietnam War. They incorrectly framed the problem and focused on the wrong metrics. The results scarred an entire generation and altered American foreign policy ever since. As an example, you can find an analysis of differing analysis of a battle of the Vietnam war here at Fabius Maximus' blog.

4 comments:

Fabius Maximus said...

Thanks for the link! Any thoughts on my series about the end of "the post-WWII debt supercycle" (as Bank Credit Analyst called it).

Humble Studen of the Markets said...

Fabius -

The "post-WW II debt supercycle story" has been around for a long time and it has taken a long time to unfold. It's hard to gauge the timing of the effects postulated.

This story has been amplified by the gold bugs and the oil peak end-of-the-world advocates (and you seen to know the latter group well).

My job is to try to make money in the markets and it's difficult to know if and when these effects become dominant.

HSOFM

Fabius Maximus said...

Understood, and I agree. After all, the key to the debt supercycle -- the relationship of GDP growth and credit growth -- was first noted by Maria Fiorini Ramirez in the mid-1980's. It'a a long, slow story.

But perhaps it is today. The key signal is the simultaneous action of internal and external debt cycles -- a "Minsky" moment for US Household debt and (perhaps) end of USD as the reserve currency.

That it was a long wait should not blind us to the possibility that it has arrived.

Humble Student of the Markets said...

I agree 100%.

I am sympathetic to this long cycle viewpoint. However, to proclaim this too loudly for too long runs the risk of being lumped in with all the "run for the hills and hoard freeze dried food" gold bugs and survivalists that you run the risk of losing all credibility.