Kevin T. Ponton

What does it take to shake our unhealthy confidence in mathematical formulae and "scientific hard data"? Ask a securities analyst and an oceanographer and they will give you identical responses: Reality. Hard, numbers-be-damned reality.

In mid-August, one quantitative securities analyst wailed about the previous week's market chaos, "Wednesday is the type of day people will remember in quant-land for a very long time… Events that models only predicted would happen once in 10,000 years happened every day for three days." That analyst was Matthew Rothman, PhD, bemoaning the fate of $40.7 billion invested in hedge funds following market-neutral strategies, a typical quantitative analysis model. (Don't you just love it-as if there were a real place called "quant-land," like Oz or Never-Never Land?)

Of Quants and Oceanographers

But what does quant-land have to do with oceanographers? More than you might suppose: About a year ago, oceanographers recovered evidence of an event that their models had predicted-with 100 percent certainty-could never happen. The event occurred in the Gulf of Mexico, and the evidence indicated it had been happening daily throughout the earth's history.

It was what seafarers call a "rogue wave"-a phenomenon that oceanography "quants" had dismissed as poppycock. A positioning laser beam between two oil rigs in the Gulf caught and recorded a single unbelievably high ocean wave, at once validating the truth of sailors' lore and explanations for the loss of ships such as the Edmund Fitzgerald on Lake Superior, the München in the North Atlantic, and at least one vessel per week going back to the time when ships first sailed the high seas.

It took a laser beam, with its aura of scientific rigor, to convince the quants that the poppycock had been in their own models-not in the sailors' wild-eyed stories.

The Markets' 'Rogue Wave'

There are telling similarities between rogue waves and August's market disaster. Besides being terrifying to imagine, a rogue wave is unannounced (clear, sunny day on a calm ocean), unforeseeable (emerging seemingly from out of nowhere), massively destructive (capsizing and submerging every man-made object it encounters), brief (about 15 seconds), and gone without evidence of its passage (except for that laser beam) beyond the total disappearance of everything in its path.

What hit the markets last summer was also unannounced (one day we went home riding a bull market, and the following morning all hell broke loose), unforeseeable (except in hindsight), massively destructive (we're still doing damage assessment), and brief (funds that were just fine on Friday were gone-simply gone-on Monday). Unlike a rogue wave, however, what hit us last August left lots of wreckage in its wake. And it caused quants like Rothman to lament, "But it was supposed to be impossible!"

OK, so they exist. That leaves us with two questions: Why did we once think they were impossible? And what, if anything, can we do about them?

Why we thought they couldn't exist. Oceanographers'  defense for their assumption that rogue waves couldn't exist sounds weak in retrospect. Pushed to explain why the Edmund Fitzgerald sank, for example, they replied, "We don't know what caused it, but we do know that it wasn't anything we know about. We've tested that silly 'rogue wave' idea, and our mathematical models prove that they just aren't possible."

Ah yes-the mathematical models. Capital markets also love them. Remember "program trading"-applying the "high-tech computers" that computer geeks used to get excited about (picture one enthusing about IBM's Big Blue, "You know, ... the one that beat Boris Spassky!") to "tabulate" all the possible investment alternatives and pick only the "correct" one? Those were the same type of trading programs that forced the NYSE to enforce its "pull the plug" rule to keep them from occasionally bringing down a market for no reason that any human could understand.

All those bright young math-major MBAs that the Wall Street banks have been hiring aren't pulling all-nighters just twiddling their thumbs in some back office across the river in Brooklyn; they're writing code over there. And they've been creating impressive applications for investing in any or all of the following: mortgage-backed securities, asset-backed derivatives, hedge fund investments, even "famous-rockstar's-next-album-sales-receivables-backed" derivatives. The list is endless.

Markets swoon to the power of mathematical formulae and especially mathematical models-as irrational as that may sound (and it is). Perhaps it's rooted in our primal aversion to uncertainty: If we can count it, how uncertain can it be? If we can measure it, how risky can it get?

What We Can Do About Them

Let's take a tip from the oceanographers: What did they do about monstrous waves that come quickly out of nowhere and disappear just as fast? First, they admitted that their models were wrong, that monsters do exist, and that quants are not infallible. Then, they started to design ships to be more resistant (but not immune) to the threat of rogue waves-double hulls and that sort of thing. They also considered how to better detect the freaks, by using technology like the lasers that were on those oil rigs in the Gulf. Finally, they committed to study the very thing they had previously believed was simply ridiculous. None of those precautions had made any sense until reality shook the confidence out of their theoretical models.

The lessons for the capital markets aren't that far removed: We need to admit that our mathematical models are mortal, not divine, and can't protect us from Armageddon. We need to bolster the security behind our investment vehicles. After all, why do we call them financial securities, anyway? Maybe we should also update our vocabulary, like the oceanographers did by adding "rogue wave" to their list of real rather than imaginary phenomena. (Think of it: I'd report my profession on my next W-2 as "Municipal Bond Insecurities Analyst" … Well, maybe not).

But how do we bolster security? It's simple-by adding protections for things that would help us out in the dire situations that are unlikely to occur. Not by removing protections because we think they'll never be used.

In short, we need to admit that our mathematic models, as fancy as they may be, are only models of suggested behaviors. And they are imperfect. They shouldn't absolve us from thinking.

And what else should we do in the wake of such a market catastrophe? We should remind ourselves that it happened before, and it will happen again.


Kevin T. Ponton is senior managing analyst, investment management department, The Dreyfus Corporation, New York (ponton.k@dreyfus.com).


Footnote

a. Whitehouse, K., "One 'Quant' Sees Shakeout for the Ages-'10,000 Years,'" The Wall Street Journal Online, Aug. 11, 2007.

Publication Date: Thursday, November 01, 2007

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