Books and Arts

Nature 456, 173-174 (13 November 2008) | doi:10.1038/456173a; Published online 12 November 2008

The two cultures of Wall Street

J. Doyne Farmer1

BOOK REVIEWEDPhysicists on Wall Street and Other Essays on Science and Society

by Jeremy Bernstein

Springer: 2008. 195 pp. £19.99

The two cultures of Wall Street

S. BAKER/GETTY IMAGES

Released in the middle of the greatest financial crisis in the United States for 70 years, the timing of this book could hardly be better. Physicists on Wall Street and Other Essays on Science and Society presents a diverse collection of writings by essayist Jeremy Bernstein, starting with the world of finance.

Physicists are famous for building black boxes that can trade on financial markets with little or no human intervention, and for developing the arcane formulas that set the prices of strange financial instruments such as mortgage-backed securities derivatives. The title essay follows the story of Emanuel Derman, a particle physicist who moved from academia to become a quantitative analyst, or 'quant', on New York's Wall Street, and who wrote an excellent memoir called My Life as a Quant (Wiley, 2004). Derman is a good subject because he is articulate and his experience is typical of that of many physicists who moved to Wall Street during the 1980s and 1990s. This curious migration came about as a result of the coincidence of a bad job market in physics, the proliferation of quantitative mathematical methods in finance, and the contrast between salaries on Wall Street and those in academia. This is interesting from an anthropological viewpoint because the two cultures are completely different. Moving from a physics department to an investment bank is like moving from a suburb in California to a tribe in the Amazon. Except that this particular tribe is enormously rich and controls the financial well-being of the world.

The two cultures of Wall Street

Although he is a regular contributor to The New Yorker, Bernstein's writing can be hard to follow. He strives for a conversational style, but often comes across like someone speaking quickly into a tape recorder. Abrupt segues and free associations are the norm. For example, part way through the title essay he suddenly switches from Derman's story to a discussion of Long Term Capital Management (LTCM), the infamous US hedge fund that nearly brought down the global financial system in 1998.

Although LTCM also employed quantitative analysts, the hedge fund was run by economists rather than physicists, including two winners of the Nobel Prize in Economics. Bernstein skims over this point, perhaps because he does not want to draw attention to it. This confusion affected the publisher too, with the book's dust jacket describing "how some physicists who developed interesting economic models based on derivatives and hedge funds almost led the country into bankruptcy".

As a physicist who spent eight years running a quantitative hedge fund, I must protest. Economists, not physicists, were responsible for the financial near-meltdown that was triggered by the irresponsible practices of LTCM. Quantitative hedge funds tend to divide into those run by economists and those run by scientists from other disciplines, such as physics, maths or computer science. For example, perhaps the most successful hedge fund, the New York-based firm Renaissance, has some 70 researchers, none of whom is an economist. By contrast, LTCM's only connection to physics is that Derman once applied for a job there and did not get it.

This distinction is not just a matter of professional pride and disciplinary boundaries. Bernstein misses an important point: economists and physicists traditionally approach the problem of risk control in different ways. Risk control is the art of determining the likelihood of large and unexpected price changes happening in the future. It is well known that extremely large changes, and financial crashes in particular, are more frequent than would be expected from a 'normal' statistical distribution. Physicists tend to favour a 'power law' mathematical description to model the heavy tails of these distributions, giving a pessimistic view of the likelihood of large price movements. By contrast, the economists who led LTCM spoke about price movements in terms of standard deviations, a terminology that is only relevant for normal distributions. This demonstrates that they were not thinking about the problem in the right way.

As a result, LTCM dramatically underestimated the likelihood of large adverse price moves. They took on enormous levels of borrowed capital, known as leverage — for every $1 they had under management, they reputedly owned $40 of bonds. When things were good this resulted in enormous profits, but when things went bad they lost all of the money under management. LTCM controlled a lot of assets, and their mistake might have brought down the global bond markets if Alan Greenspan, then the Chairman of the US Federal Reserve, had not forced a consortium of large banks who were their clients to bail them out.

Unfortunately, dramatic underestimates of risk are still prevalent on Wall Street. The recent subprime mortgage crisis is a good example. Without a proper understanding of extreme risks, people follow cycles in which leverage slowly creeps up during good times, until a big loss happens and leverage requirements drop to levels that are too low, exacerbating or even causing a financial crash. Excessively low levels of leverage, such as those we are experiencing now, make recovery even harder. Far-thinking economists, such as John Geanakoplos of Yale University in New Haven, Connecticut, are beginning to understand this process and suggest possible solutions. An answer in the meantime would be to simply impose sensible risk requirements. Wall Street should follow the conservative approach to risk control that arises from properly modelling risks as power laws.

'Physicists on Wall Street' is one of many essays in this volume, which spans a wide range of topics. These include the German atomic-bomb project, attempts to use nuclear weapons to power space craft, the Warsaw ghetto, deciphering early Etruscan writing, interpretations of quantum physics in the novels of Michel Houellebecq, a proof of an important conjecture in algebraic topology, and scientists gambling in Las Vegas. Each essay focuses on one individual or on a few people, often involving Bernstein's own ample and varied personal experience — in these cases, the essays work well. Unfortunately, in many cases, he is not involved and has not done enough background research. His definition of leverage in the first essay is wrong and his diatribe about the dangers of hedge funds is naive. Many of the essays are essentially reports about books that the reader could digest on his or her own.

Bernstein's book contains a lot of interesting science, and many entertaining stories about the people responsible. It is a pity that, at times, the barrier to understanding the science within the essays is larger than it should be.

  1. J. Doyne Farmer is a professor at the Santa Fe Institute, Santa Fe, New Mexico 87501, USA.
    Email: jdf@santafe.edu