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My Two Cents

Models Don’t Work All the Time

Chris Farrell Aug 21, 2007

The Washington Post has a story on how textbook brilliant Wall Street rocket scientists lacking street smarts blew it. Here’s what I take is the main theme of For Wall Street’s Math Brains, Miscalculations Complex Formulas Used by ‘Quant’ Funds Didn’t Add Up in Market Downturn.

As elegant as the models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs, overly reliant on their tools.

“Most are idiot savants brought to industrial proportion,” Nassim Nicholas Taleb, former quant-jock and bestselling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, “The Black Swan.”

“They are very smart in front of a textbook but not smart enough to understand very elementary things in reality,” he said.

I don’t buy it. No model works at all times in all markets. Even young quant jocks would be well acquainted with the history and mistakes from the 1998 blow-up of the famous hedge fund, Long-Term Capital Management. (A good book on the LTCM debacle is When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.) Basically, more and more of these market neutral quant funds made huge sums of money following the same strategy, such as shorting growth and playing the carry trade. In the story, hedge fund maven Cliff Asness gets it right:

“I occasionally hear broad statements like, ‘This just shows computer models don’t always work,’ ” Clifford S. Asness, founding principal of the quant-fund firm AQR Capital Management, wrote to his clients after the sell-off. “That’s true, of course, they don’t, nothing always works. However, this isn’t about models, this is about a strategy getting too crowded, as other successful strategies both quantitative and non-quantitative have gotten many times in the past, and then suffering when too many try to get out the same door.”

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