“I can calculate the motion of heavenly bodies, but not the madness of people.”- Sir Isaac Newton
These were the words of one of the most revered physicist of all time after the South Sea Company bubble. Indeed, Newton described the intricacies in modeling the psychology of people. As compared to the sciences such as physics, chemistry or mathematics, finance is fundamentally different, for several reasons.
Firstly, in sciences, objects do not react as humans do towards information. Neither the three laws of motion governing our macro world nor the speed of light will change due to our investigation into those areas. Hence, the laws in the sciences that are established through experiments and theoretical argument truly describe the very nature of the phenomenon. For that very reason, these laws can stand the test of time.
On the contrary, for finance, people are extremely reactive to information. If a piece of research work shows that are opportunities to exploit the market in a certain way, you can be sure that such exploitations will not work soon enough as such opportunities will vanish under the laws of supply and demand. This is also the core basic of finance, the principle of “No Free Lunch” or formally, the No Arbitrage principle which indeed holds in the markets. Therefore, financial modelling is relatively challenging and there is more dynamics in the process.
Secondly, in finance, the so-called “laws” are fundamentally weak as they may not hold for every instant. Despite that we are trying to quantify finance and economics and provide a more mathematical treatment on those subjects, we fail to observe that some of the laws in those fields are meaningless. Not matter how technical or bombastic mathematics we use, some of theorems and laws we arrive at will not hold for long. In fact, I would suggest an extreme and not to call those findings as theorem but rather an observation. Holding on to those laws when they are not relevant may result in adverse impact on your portfolio or understanding of the markets. Instead, I propose that we adopt a more dynamic view in describing the phenomenon in the markets by constantly adjusting our interpretations and methodologies. Not only are we able to adopt the ever dynamic market environment, we will be able to devise new ways to solve the related problems in finance and economics.
Although the above two arguments hold true in my perspective, they do not mean that application of scientific methods to finance and economics are valueless. In fact, that is probably the best we can do given the tools that are at our disposal. For instance, opponents of quantitative finance would argue that stock prices are not normally distributed. However, here a challenge I would throw to them, find a tool that is as convenient as Brownian motion with all the established known mathematical laws to model stock price evolution. I doubt they will able to achieve anything in facing such a challenge. Mandelbrot suggested using chaos theory to build financial models, however, the mathematics in that area are not developed to be applied conveniently to financial data. To that end, we see that financial modelers and economists are already putting the best of tools they have to explain the crazy world of economics and finance.
In spite of that, we as modelers in finance and economics, should take into account that the models and the tools we have are not perfect. There are always information in the data that we are unable to capture with our current knowledge and tools. Rather than defending the models we developed, I propose that we have an open mind and understand what are the shortcomings and deficiencies of the models and theories we developed. To a certain extent, the field of quantitative finance are full of so called “players” and people who are not willing to work with data. Foregoing the information of the data and focusing too much on the mathematics of the models, in my opinion, are completely a waste of time as the models developed cannot be applied! This is probably what the finance academics and economists will have to address.
While we compare science and finance, we observe that their paths crossed at the tools that are used in modeling and understanding the phenomenon in each respective fields. However, we also see that finance are not like the sciences as the mathematical laws in finance may not hold true to eternity.
In light of the 78 cents increase in fuel price, I predict there will be 3 immediate effects:
1. Abdullah Badawi will not be the PM for long. People will feel the pinch immediately and more dissatisfied with the federal government.
2. Inflation will hit record high and if not managed properly, the Malaysian economy will suffer.
3. Protests from parties that do not understand the issue at hand and try to politicize it.
I do agree that the government is making the right move to abolish the oil subsidy. However, I do not think they are managing it quite as well. Given that we are facing food crisis and grain prices increased substantially since early this year, increasing the fuel price by 40% overnight will send shocks to the economy and people.
Instead, there should be a plan since years ago to slowly restructure the oil subsidy. This is to shield adverse market correction that may trigger the economy to go into recession. The government needs to show its ability to control the inflation. However, Inflation is a wild beast that’s hard to tame.
Here’s a great article on Ben Bernanke and the subprime crisis.
Bernanke Grapples With Greenspan as Volcker Scorns Fed Bailouts by Steve Matthews
Here’s a famous story:
In mid-1983 famous commodities trader Richard Dennis was having an ongoing dispute with his long-time friend Bill Eckhardt about whether great traders were born or made. Dennis believed that he could teach people to become great traders. Eckhardt thought genetics were the determining factor.
In order to settle the matter, Dennis suggested that they recruit and train some traders and give them actual accounts to trade to see which one of them was correct.
They took out a large ad advertising positions for trading apprentices in Barron’s, the Wall Street Journal and the New York Times. The ad stated that after a brief training session, the trainees would be supplied with an account to trade.
This group was invited to Chicago and trained for two weeks at the end of December, 1983. They began trading small accounts at the beginning of January. After they proved themselves, Dennis funded most of the trainees with $1 million in February.
“The students were called the ‘Turtles.’ (Mr. Dennis, who says he had just returned from Asia when he started the program, explains that he described it to someone by saying, ‘We are going to grow traders just like they grow turtles in Singapore.’)” – Stanley W. Angrist, Wall Street Journal 09/05/1989
The Turtles became the most famous experiment in trading history because over the next four years, they earned an aggregate sum of over $100 million dollars.
Richard Dennis proved that with a simple set of rules, he could take people with little or no trading experience and make them excellent traders.
This story was taken from ORIGINAL TURTLES.
For more information of turtle trading, visit HERE
For the original turtle trading rules, please check out the pdf file here.
In recent months, we have seen hedge fund failures due to the subprime mortgage crisis. In the past, most of the time, we heard of amazing hedge funds like LTCM that earn excessive profits that went bust thereafter.
Here’s an couple of amazing stories regarding the humble origins of Citadel, a hedge fund that has enjoyed tremendous success and also its founder, Kenneth C. Grffin.
CNNMoney’s Article: A hedge fund superstar
New York Times’ Articles: Will a Hedge Fund Become the Next Goldman Sachs?
Here are a couple of stories on how Goldman Sachs made stellar profits while other banks and financial institutions struggle with the subprime mortgage crisis. It is interesting to note in the first article that the traders who helped Goldman Sachs to achieve the profits received only a simple thank you, indicating the extremely strong team culture within the firm. 
http://blogs.wsj.com/deals/2007/12/14/there-is-no-i-in-goldman-sachs/
http://www.independent.co.uk/news/business/news/credit-crunch-the-4bn-killing-765261.html
ClicK HERE for full story from Wall Street Journal columnist
Picture paints a thousand words.
Click HERE for the excel file.
This article vividly describes the last days of Bear Stearns before its collapse. It is rather interesting to have a read. Click HERE.
As I update this post, it’s close to 10 months to the collapse of Bear Stearns. While the demise of Bear Stearns at its time was unthinkable, we have already seen how far the credit crisis can go with nationalization of Fannie Mae and Freddie Mac, collapse of Lehman Brothers and bailout of AIG.
While 2009 is a new year and the market rallied for the first 9 days of the new year, the mood remained to be somber as the impact of the credit crisis hits the real economy hard. The November figure for unemployment rate was at a staggering 6.7%. Though this is short of the 26% seen in the Great Depression, still, it is rather worrisome. Also, the house prices for November as tabulated by the Case-Shiller Index was down 18% compared to a year earlier. There are no signs of recovery and no indication how long and deep this recession will be.
In retrospect, the bailing out of Bear Stearns was the mark of the beginning of the end of Wall St. The business models of the pure investment banks were broken with Lehman’s collapse and acquisition of Merrill by Bank of America. Goldman Sachs and Morgan Stanley have convert to be commercial bank with holding deposits as well. There will be more to come and to see in the upcoming 6 months, and without a doubt, things will be grim for some time.
p/s: For an excellent article on the fall of Lehman, please read this
