The Quants By Scott Patterson - Part 1

With the crash still fresh, and the financial archeology processing, I thought it was be interesting to read someone else's take on what happened. To that end, I've just picked up a copy of Scott Patterson's new book, The Quants, subtitled “How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It”.

I guess the title is there to draw you in, but so far it's been worth it.

The book starts by introducing the main players. This was very helpful when reading the rest of the book. Unless you were in the industry it's unlikely you'd have heard of many of the people involved. They include Peter Muller, the manager of Morgan Stanley's hedge fund PDT; Ken Griffin, manager of Citadel Investment Group; Cliff Asness, the founder of AQR Capital Management and Jim Simons, the manager of Renaissance Technologies. Each had their part to play in what happened.

A reoccurring theme through all the books about Wall Street, the players and the fallout, is the love of card games, specifically poker. There seems to be an overwhelming sense that if you can beat win at poker, you can win the market. Indeed, one of the most influential figures in finance, Ed Thorpe wrote both 'Beat the Dealer' about blackjack, and 'Beat the Market'.

To this end, the book starts with a high-stakes poker game amongst the main players. In early 2006, Muller, Simons, Griffin and a collection of other players from the financial market met at their 'Wall Street Poker Night Tournament'. Patterson starts to show some of the connections between the players, the mesh of interconnected lives becoming clear.

This is Ed Thorp's chapter. Patterson does a great job of showing how Thorp came through academia, the near obsession with beating the casino at blackjack, and how that translated into the his need to beat the stock market. The passages on Thorpe's background shows a man clearly unaffected by what other's thought of him. Indeed, his very nature was that of needing the impossible challenge to overcome. Patterson describes clearly the lengths Thorp was willing to go to, in order to prove that his systems worked, and that the odds could be shifted in his favour.

The connection between Thorp and Claude Shannon (the 'father' of information theory) are particularly enlightening, and the bond that the two men made, aiming towards a common goal, is well covered.

This chapter continues Thorp's journey into the stock market. I found one of the key aspects of this capture to be the idea of 'building on the shoulders of giants'. It's clearly shown that Thorp himself found inspiration in earlier works, specifically 'The Random Character of Stock Market Prices', a collection of essays published in 1964. This is a reoccurring theme throughout the book, and enforces that great leaps tend to come from evolution rather than revolution.

This chapter also introduces the concept of Brownian Motion, the idea that seemingly random movements may actually have a hidden order. Thorp made the connection between these theroies and the movement of pricing for Bonds and Warrants. It was the link between volatility, and the pricing of Warrants against Bonds that Thorp realised he could make money on.

Together with Sheen Kassouf, Thorp published Beat the MArket : A Scientific Stock Market System. It was controversial, as it flew in the face of research that showed it was impossible to beat the overall market, promoted by Eugene Fama, called efficent-market theory (EMT). Both the book, and EMT are critical in providing the foundation for those who are covered later in the book.

It was after the book was published, that Thorp and Kassouf launched their own business, modelled on an under-used corporate entiy known as a Hedge Fund. The connection at this stage between them and Warren Buffet is also fascinating. This was the creation of Princeton/Newport Partners.

This chapter also introduced Gerry Bamberger and his trading strategy known as Statistical Arbitrage, or stat arb. Patterson covers the history of Bamberger and his stat arb method nicely, without distracting on the continuing story of Thorp.

I hope you've enjoyed this first part. In the next part, I'll cover the 'Volatilty Smile', and introduce some more of the players.

~~BOOKMARKME:bottom~~.