What does physics have to do with finance? The science behind understanding complex, seemingly random systems such as atmospheric circulation can also be used to predict the movement of financial markets, says James Owen Weatherall in The Physics of Wall Street: A Brief History of Predicting the Unpredictable.
This is how physicists became some of the most successful money managers on Wall Street. Despite their apparent “wild randomness” and “underlying chaos”, financial markets sometimes behave in a “somewhat orderly” fashion, in much the same way that a bunch of seemingly mindless particles bumping around in the sky sometimes organise themselves into a hurricane.
In this entertaining and wide-ranging book, Weatherall traces physicists’ attempts at modelling financial markets from late 19th-century Paris to mid-20th century Las Vegas and on to late 20th-century Wall Street. Despite some physicists’ early recognition of patterns in the market, they could take the models they developed only so far. Early computers were little more than “souped-up adding machines”, and there was little realisation of the extent to which they could be used to study complicated systems. Even weather forecasting – now a process involving supercomputers crunching millions of pieces of data through complex models – was done on the basis of “gut feelings, rules of thumb and brute luck”.
Physicists Norman Packard and Doyne Farmer began working on “predicting the unpredictable” in the mid-1970s. They started out using computers to solve the differential equations necessary to predict the outcome of the spin of a roulette wheel.
After 15 years working on chaos theory, they “had an unprecedented understanding of how complex systems work and the ability to use computers and mathematics in ways that someone trained in economics … would never have imagined possible”.
Then, believing that “a firm grasp of statistics and a little creative reappropriation of tools from physics were enough to beat the Man”, they set up The Prediction Company and began using their complex models to predict financial markets that everyone agreed were random and unpredictable.
Within a few years, Wall Street bankers were busily recruiting people with physics PhDs to develop, interpret and adapt complex models aimed at understanding and predicting financial markets. The arrival of these “legions of quants”, says Weatherall, changed Wall Street forever.
Weatherall became interested in this topic during the 2008 financial meltdown. The danger, he says, “comes when we use ideas from physics, but we stop thinking like physicists”.
Despite recent market crashes, including what’s become known as the “quant crisis”, there is still a place for sophisticated investors to profit. “You just need to be the most sophisticated investor, the one most carefully attuned to market patterns and the one best-equipped to find ways to turn patterns into profit. And for this task, a few decades of experience in extracting information from chaotic systems plus a room full of supercomputers could be a big help.”
THE PHYSICS OF WALL STREET: A BRIEF HISTORY OF PREDICTING THE UNPREDICTABLE, by James Owen Weatherall (Scribe, $37)
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