Saturday, January 31, 2009

Physicsworld on quants

I came across these articles from Physicsworld again recently. They're quite old (1999), but made some interesting points.

Physicsworld: ...the strongest demand will be for "people who have had a rigorous training in applied sciences (physics, engineering, etc), where the emphasis is on problem solving" rather than people who have specifically trained in financial mathematics. The report has even better news for physicists, especially those with skills in probability theory, stochastic calculus and partial differential equations: "Even though mathematical skills are sought, we found a strong preference for physicists over mathematicians. As one bank explained it: 'Physicists want to find the answers to problems. Mathematicians have all the answers and want problems to solve.' "

Compare to this quote about Crick and Watson from biologist Erwin Chagraff:

It was clear to me that I was faced with a novelty: enormous ambition and aggressiveness... I could not help being baffled. I am sure that, had I had more contact with, for instance, theoretical physicists, my astonishment would have been less great. In any event, there they were, speculating, pondering, angling for information. ...

The comment in bold below is quite interesting and, I think, quite correct: physicists are often very sloppy, but they have a good nose for where the action is. I also think we just went through a phase transition in investor attitudes towards risk and the future.

Physicsworld: ...The international financial markets generate lots of data about the high-frequency variations in price of many different assets (stocks, currencies, bonds and so on), and these data are available to physicists for analysis. Physicists have their own way of analysing data, which is very different from the way econometricians (as economists who specialize in this area are called) look at data. For example, physicists are not interested in proving that a statistical model is right, but rather in extracting useful intuitions based on observation and developing computational methods to develop this intuition. As physicists we are sure that analysis of financial data will undoubtedly benefit from ideas and methods invented for statistical physics, such as critical phenomena, turbulence and various non-equilibrium phenomena.

...A topic of much research is the possible connection between financial crashes and "critical points" in statistical mechanics, where the response of a physical system to a small external perturbation becomes infinite because all the subparts of the system respond co-operatively. Classic examples include the liquid-gas critical point in water and the Curie point in magnetism (i.e. the temperature above which ferromagnetic materials become paramagnetic). Similarly, during crashes, a large proportion of the players in a market decide simultaneously to sell their stocks.

...Similarly, although it may in principle be possible to model the behaviour of each individual operator or "agent" in a financial market, this is obviously a daunting task. The fact that one of them needs to sell his stock because he wants to buy a car, or that another one wants to buy some stocks because a friend advised him to do so, might be more conveniently described, on a coarser scale, by a Langevin noise.

However, many economists - who believe that agents are rational and try to optimize their "utility function" (essentially a trade-off between profit and risk) - are reluctant to accept such a theoretical shortcut. Indeed, some economists even claim that it is "an insult to the intelligence of the market" to invoke the presence of a noise term!

Interestingly, the same debate happened recently between engineers and physicists in the context of traffic modelling, where the analogue of the rational-agent hypothesis is that each driver wants to maximize his or her speed. Without any "noise" to account for unexpected braking events (caused, for example, by the driver sneezing), the rational-driver model predicts a steady flow of cars all moving rapidly along the road. As soon as a small amount of noise is introduced, however, traffic jams appear and disrupt the steady flow - and make the model more realistic. In other words, the addition of an arbitrarily small amount of noise allows one to reproduce an everyday phenomenon that would be absent in a perfectly rational world. Similarly, one can expect that small irrational effects might completely change the picture emerging from a completely rational economic model.

...One of the primary assets that physicists bring to finance and economics is their intermediate level of mathematical sophistication - half way between the empirical knowledge of traders and the highly formal approach taken by economists, which is sometimes remote from reality. The use of intuition based on decades of research into the highly complex systems found in statistical physics - including finely honed approximation schemes and problem-solving techniques - offers a new dimension not found in economics textbooks.

8 comments:

gs said...

Similar sentiments are expressed here. The piece has much to agree with, but I am uneasy with wording like this: So if it is the physicists who are to blame, how do we explain the fact that large and not-so-large crashes have been appearing with frequencies that are approximately time-independent? Just because no single component of a system is exclusively responsible for a systemic failure does not mean that every component is blameless.

(OT: Among everone who brought the current mess to pass, Alan Greenspan was just about the only major culprit with the intellectual integrity to admit he was mistaken. I wish he would resume speaking out. His thoughts have value and the derision they would attract would be appropriate penance.)

STS said...

GS:

Greenspan's admission is all the more striking for the almost comical absurdity of his mistake. Like, you never heard of the agent-principal problem? I guess that's sort of hush-hush over at Jackson Hole ...

The article you linked to mentions "... film by Fumiko Yonezawa of her simulations below the critical point of Ising models ...". I'm afraid I haven't seen it, nor could I find it quickly via google. I wonder if it has even been uploaded anywhere.

Born Again Democrat said...

Physicists are no better than mathematicians if they believe there is some underlying order in the world of human behavior in markets like that found among elementary particles, atoms, molecules, statistical mechanics, etc..

Anonymous said...

Although it is possible to make a kiling in high frequency, it should not be considered an application. High-frequency has as much utility as bank robbery.

Andrew Foland said...

BAD--

actually, the whole point of the noise discussion (with the traffic as an example) is precisely to address your concern. It's the physicists who insisted on accounting for human imperfection and unruliness, and who found that the high-level outcomes depended critically on recognizing those imperfections.

CW said...

To complement what Andrew said, I would observe that the rationality that exists in markets, or on our highways, is a limited kind of enforced rationality. It is sustained by an awareness of the participants of what a godawful mess can ensue if disregard of the "rules of the road" becomes widespread. Some tendency to shortcut or ignore the rules, or simply to do irrational things, is always present.

Analyzing this dynamic tension arguably represents the heart of these subjects. The possibility and necessity of doing so stems precisely from the fact that human behavior is central; humans follow rules, but only approximately and selectively.

smekhovo said...

It's notorious that physicists actually have a much higher level of mathematical sophistication than economists, but economists are peacock-proud of the little that they have.

STS said...

CW:

I like your point about the tension between rule following behavior and non-compliance.

One key take away from Stuart Kauffman's various attempts to characterize spontaneous order is: order arises at the boundary between rigidity and chaos. The land of phase transitions, in other words.

Disobedience is anti-social, except when its ... well ... justified. One man's treason is another man's civil disobedience. It isn't good to be TOO tame. Of course the financial industry has just provided us with a spectacular example of what happens when nobody plays by any rules.

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