“The Formula that Killed Wall Street”

(And destroyed our world in the process.)

Wired magazine is a wonderful source of articles that, at the very least, make you think. This month they published a great article on David X. Li. Li is a math wizard who found a way with a “brilliant spark of mathematical legerdemain, [to make] it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.”

After reading this article I can’t say that I feel any better about how or why we are where we are. But, like so much of this mess, there seems to be a few insights we all should have acted on long ago:

• We need to be much more critical of assumptions;
• We cannot blindly accept, nor believe, that technology is capable of replacing critical human thought;

A sampling from the article:

• As a result of the scarcity of historical data, the errors ... are likely to be much greater
• In 1998, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built ... unpredictable parameters.
• It [was] assumed that correlation was a constant rather than something mercurial.
• Everyone was pinning their hopes on house prices continuing to rise
• The outputs came from "black box" computer models and were hard to subject to a commonsense smell test
• In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent
• They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all. As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

We need to understand the implications of what we do. We need to think so much more than we do. And we need to remember, the widom of hindsight is 20/20." Here's the link to the Wired magazine article.

DS