The Physics of Wall Street and its Failures

Warren Buffett famously warned, “beware of geeks bearing formulas.” After the Great Panic of 2008, many pundits placed the blame on derivatives and other “complex financial instruments.” That would lead one to believe that the blame lies with the physicists and mathematicians who dreamed them up. James Owen Weatherall decided to look behind that blame and explore the history of how physicists came to Wall Street. The result is The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

The book is an engaging exploration of the men who took turns trying to create mathematical formulas to explain stock price movement, with the hope of predicting that movement.

The early models always failed. Weatherall pins the crashes in 1987, 1997, and 2008 on the failure of the models. Although he shifts the blame from the physicists to the heads of the Wall Street firms. Their failure came about because they failed to think like physicists. Models, whether in science or finance, have limitations. They break down at the edges and under certain conditions. In each of those financial crises these sophisticated models fell into the hands of people who didn’t understand their limitations.

Don’t think the book is focused on financial models and mathematical derivatives. It’s focused on the individuals, their stories, the steps they took before creating their models, how their models ere adopted (or not), and, ultimately, how their models failed.

One item I found fascinating was that most of the physicists starring in the book took their first steps towards wealth creation in gambling, and not finance. You can make your own joke about that. Each took an attempt to better define probabilities so they could make better wagers. Early on, it was dice games. Blackjack was popular. One gentleman even tried to devise a computer to predict roulette. Ultimately, they each discovered that there was more money to be made on Wall Street.

Each model got better and better. But each ultimately failed. Some of that can be traced back to success causing a failure. As more firms adopted the model, their behavior changed and therefore the model became based on outdated behavior.  Ultimately, the book seems to lend credence to Taleb’s Black Swan theory.  The improbable will happen and all the financial models fail to account for the improbable financial calamities happening more often than the models predict.

I have to admit that I thought the book might be a dry slog on finance and probability. But, it was surprisingly enjoyable to read. If you have any interest in the quant side of Wall Street or probability theories, this book provides a great historical background.

The publisher was nice enough to send me preview in hopes that I would write about the book. It goes on sale January 2, 2013.