
Fisics and Phynance - agarttha
http://www.aps.org/publications/apsnews/201303/backpage.cfm
======
crntaylor
The general thrust is spot on.

Models are approximations. Don't confuse your models with reality.

Know what your assumptions are, and have a plan for what to do when those
assumptions no longer hold.

Know _why_ your models work, so that you know when they are likely to stop
working.

Get deep domain knowledge.

Know that the market can stay irrational longer than you can stay solvent.

Experiment ruthlessly. Apply the scientific method.

Start simple and iterate.

This probably applies to more than just finance.

~~~
scotty79
Basic error is that you think you can predict fully random process. You
develop a model that seems to work excellent until it doesn't.

It doesn't matter whether it's sophisticated algorithm running on big iron or
hunch running on wetware. You will fail because nobody knows the future.
Trying to reliably squeeze money out of the market by better predicting its
behavior is like trying to build perpetum mobile by trying more and more
convoluted designs.

All the smarts of traders ... they do nothing:
[http://finance.fortune.cnn.com/2013/01/24/buffett-hedge-
fund...](http://finance.fortune.cnn.com/2013/01/24/buffett-hedge-fund-bet/)

There is money that can be reliably extracted from investing though. If you
can trade faster than others, you can drain some money from them. That's why
algorithmic trading yields returns. Your strength comes not from predicting
future better, but from acting and reacting faster.

~~~
crntaylor
Certainly you need to protect against over fitting your models, and you need
to consider tail events.

But to say that the entire market is fully random is to claim that the
efficient market hypothesis holds, which it clearly doesn't - not even in weak
form. Anyone who wants to claim that the EMH is true needs to explain the
equity premium puzzle, the success of value investing and the persistent
outperformance of momentum investing - among many other price anomalies that I
could name.

~~~
lutusp
> But to say that the entire market is fully random is to claim that the
> efficient market hypothesis holds, which it clearly doesn't - not even in
> weak form.

Of course it does. All evidence supports the Efficient Market Hypothesis
(EMH), and note my use of the word "evidence". A contradiction would have to
be a series of funds that applied a given, predefined (internally) strategy
and (very important) didn't reveal its picks to the public (to avoid the
announcement effect). Such an experiment hasn't been done, and those cases in
which a specific strategy was applied have been universal failures.

Let's say for the sake of argument that there is a surefire winning strategy
as is so often claimed in worthless investment books. If it were to be
recognized and then applied, it would become the new market norm, everyone
would apply it, and its differential value would evaporate overnight. That
hypothetical experiment merely supports the EMH.

> Anyone who wants to claim that the EMH is true needs to explain the equity
> premium puzzle, the success of value investing and the persistent
> outperformance of momentum investing - among many other price anomalies that
> I could name.

Those result from a combination of the announcement effect and insider
trading. Berkshire-Hathaway is successful because people expect it to be
successful, and who invest in the same stocks when they're announced. It's a
self-fulfilling prophecy.

The only fair, scientific test would be a strategy that is applied in secret,
not in public like Berkshire-Hathaway, and in a way that doesn't tweak the
market itself by way of large purchases that create their own following of
fanboys. In other words, a pure computer model that is defined in advance, not
tweaked enroute, that doesn't actually invest but only models hypothetical
investments, and that shows its value over other systems in perpetuity. There
is no such thing, and the EMH is true.

Remember the Null Hypothesis, the basis of modern scientific thinking. The
Null Hypothesis assumes something without evidence is false. All evidence
supports the EMH.

~~~
crntaylor
It's tough to know where to begin here. To refute the EMH you don't need a
'surefire winning strategy'. You only need a strategy that is profitable in
expectation. And it doesn't need to be laid down in advance - all sources of
expected return have a half life, and strategies need to be retired when they
stop working. That necessitates continuous research.

Also, you seem to defeat your own argument. The strong form EMH says that
excess returns are not possible, even with insider trading - which you admit
can lead to outperformance. The weak form EMH would prohibit excess returns
from the announcement effect, but you admit that leads to return
predictability as well. Which is it - does the EMH hold, or is the
announcement effect real?

Your arguments for why momentum, value and equity investing work also don't
stand up. There's nothing to be "announced" in those strategies - you could
apply them in a vacuum where you didn't know anything except prices and
fundamentals. Similarly no insider knowledge is required. So why do you say
that they are due to the announcement effect and insider trading?

You also misunderstand the scientific method - the failure of an experiment to
refute the null hypothesis does not lend credence to the null hypothesis! At
most it tells you that the null is consistent with the observations. Moreover,
you talk as if the Null Hypothesis is a particular statement, which it is not.
There's a great XKCD comic I'd refer you to if I wasn't on my phone!

If you want such an experiment, I humbly invite you to consider the past and
future returns of the fund I work for, which is 100% model-driven. Although
obviously we trade based on our predictions - because at the end of the day
we're in this to make money, not to write papers or win internet arguments.

~~~
lutusp
> To refute the EMH you don't need a 'surefire winning strategy'. You only
> need a strategy that is profitable in expectation.

Yes, and, in spite of its tremendous theoretical importance, there is no such
thing.

> And it doesn't need to be laid down in advance ...

Is this a scientific conversation? Yes? Then yes, it does. Any number of bogus
studies can prove their claims if one can change the study's claims as the
evidence comes in.

> The strong form EMH says that excess returns are not possible, even with
> insider trading ...

Ah, I see -- redefine the EMH, then prove the falsity of the redefinition. The
EMH says no such thing.

> The weak form EMH would prohibit excess returns from the announcement effect
> ...

Also false. You aren't discussing the EMH, you're making it up as you go
along.

> There's nothing to be "announced" in those strategies - you could apply them
> in a vacuum where you didn't know anything except prices and fundamentals.
> Similarly no insider knowledge is required. So why do you say that they are
> due to the announcement effect and insider trading?

That's easy to answer -- I never said any such thing, anywhere. You're arguing
against a position no one has taken.

I did say that an legitimate test needs to be conducted in private, with no
actual investments -- a computer model defined in advance, that cannot be
changed as the study proceeds, and that by definition cannot influence the
real market being studied. There are no such successful models. The EMH
appears to be true.

> If you want such an experiment, I humbly invite you to consider the past and
> future returns of the fund I work for ...

Ah, so you have a dog in this fight. You're not an impartial participant,
striving for objectivity. That means I'm wasting my time talking to you --
you're not a scientist, you're a salesman.

~~~
swombat
Whatever the merits of your arguments, your ad hominem at the end, as well as
the general tone of your comment, undermine your position almost completely.

~~~
lutusp
> your ad hominem at the end ...

What ad hominem was that? I correctly identified my correspondent as a
salesman, not a scientist. It's a simple statement of fact. He thinks one data
point counts as evidence, which means he isn't a scientist, and he is
objectively in the business of talking people into investing in his fund --
therefore he is a salesman.

Simple straight-up facts. And it really is pointless trying to discuss these
issues with someone whose livelihood depends on the myth that the market can
be tweaked in any way we please.

~~~
swombat
On the off chance...

Perhaps you're like me a decade ago and you don't even realise when you're
insulting someone (I was like that). If so, I urge you to realise that just
because you don't mean to be insulting doesn't mean you aren't.

The last line of your comment was obviously insulting and your comment has
been downvoted by others as a result. That's an evident observation. Take it
on board instead of disputing it, and if you really did not mean any insult,
then think about how you could have phrased that line (and perhaps the rest of
your comment) in a way that would not come across as insulting.

Learning to not involuntarily insult people is pretty useful.

~~~
lutusp
> Perhaps you're like me a decade ago and you don't even realise when you're
> insulting someone ...

You have something against salesmen? I described this person as a salesman,
after he identified himself as a salesman. Which part of this aren't you
getting? He has a vested interest in the position he was putting forth. That
fact, the fact that his livelihood depends on the continued belief in the
predictability and malleability of equities trading, is germane to the
conversation. It prevents objective evaluation of evidence.

> ... in a way that would not come across as insulting.

Not every salesman is Willy Loman, and the insult you saw is solely in your
mind.

He said: "I humbly invite you to consider the past and future returns of the
fund I work for ..."

By referring to "future returns", he went beyond any rational position, and he
directly contradicts the position taken by the SEC on this issue (brokers
should never make claims about future performance).

He is a salesman. Talking to him about this issue is a waste of time. Those
are the facts.

~~~
swombat
No, those are not the facts. That is your interpretation, and it is worded in
your vocabulary. That vocabulary means something to you but may mean something
else to someone else.

The wiser way to behave here is to realise that your interpretation may or may
not be true, since you are working from a highly incomplete data set and
therefore tone down the use of vocabulary that may have multiple meanings and
instead focus on vocabulary that is less likely to be interpreted as an
insult.

For example, you might have said:

> I notice from one of your statements that you seem to be working for a fund
> yourself. Do you think that this impacts your view of this problem?

Instead of:

> Ah, so you have a dog in this fight. _You're not an impartial participant,
> striving for objectivity_. That means _I'm wasting my time talking to you_
> \-- _you're not a scientist, you're a salesman_.

All the bits in italics (yes, that's most of your comment) are potentially
insulting to the person you're replying to. The first one is a mild character
attack, the second one is a direct insult, and the third one is easily
perceived as a direct character attack, especially in the context of the other
two. Overall, this sentence is the comment equivalent of sneering at someone
at a well-to-do party, and loudly dismissing them as a damn fool. If you're
the host of the party or someone notable, you may get away with this sort of
behaviour, but as a guest, you will be the one led to the door.

The restatement above makes the exact same point, casts the exact same
aspersions on the views of the person you're replying to, but does so in a way
that is not perceived as an insult.

~~~
lutusp
> That is your interpretation, and it is worded in your vocabulary. That
> vocabulary means something to you but may mean something else to someone
> else.

This is a scientific discussion, not one about vocabulary or a post-modern
view of reality.

> All the bits in italics (yes, that's most of your comment) are potentially
> insulting to the person you're replying to.

That's the way it is in science. Science is not diplomacy. And the WSJ
Dartboard Contest went on insulting the same people in the same way for years,
but without lifting the veil of ignorance in which these people live, as the
above exchange proves.

[http://online.wsj.com/article/SB1000087239639044402420457804...](http://online.wsj.com/article/SB10000872396390444024204578044390473058954.html)

Quote: "The darts [i.e random stock picks] have historically beaten the
readers [i.e. stockbrokers], with 28 wins out of 47 contests."

~~~
swombat
I'm sure you're a lot of fun at parties.

 _This is a scientific discussion_

No it's not, it's a fucking web argument between a couple of strangers.

 _not one about vocabulary_

All _thought_ is about vocabulary to a large extent. Certainly all
_communication_ is about vocabulary.

Anyway, I'm done wasting my time with this. Someday you'll be ready to get on
with the rest of us humans. We'll be glad to have you then.

------
lutusp
A quote: "And at least some physicists have been phenomenally successful as
fund managers. Indeed, the fund that is widely viewed as the most successful
hedge fund of all time, the Medallion Fund, was run for twenty years by
mathematical physicist James Simons–the same James Simons who lent his name to
Chern-Simons theory, which has been studied extensively by string theorists."

When are financial sector writers going to stop assuming that a chance success
in finance is in any way the result of specific training or background on the
part of a fund manager? One of two things is true -- either the Efficient
Market Hypothesis (EMH) is true, in which case who you are doesn't matter, or
the EMH is false, in which case anyone can make bazillions in the markets by
simply applying the kinds of "sure-fire winning strategies" that are touted in
any number of worthless investment best-sellers.

All the evidence suggests that the EMH is true, that markets are
unpredictable, and all successes are chance successes. The Wall Street Journal
"Dartboard Contest" supports this idea, to the chagrin of any number of
stockbrokers and analysts, who would prefer it if there were any credible
evidence that their services have value.

<http://whyfiles.org/037wall_st/predict.html>

~~~
Tycho
One of the arguments which the author makes is that if the EMH is true, and
returns follow an essentially random walk, somebody still has to _act_ to make
them efficient. A price doesn't reflect all known information about an asset
if the people who have that information don't bid.

Companies like Simon's Renaissance Technologies employ modelling techniques
first developed by physicists studying chaotic systems. They try to squeeze
just enough information about the structure of the market in a given moment to
place a winning short term bet.

The fact that Simon's _Medallion Fund_ is the most successful hedge fund in
history, only employs physicists and mathematicians, and has been successful
over a period of 25 years, suggests rather strongly that it's not just chance
and probably is related to training in other fields...

~~~
lutusp
> The fact that Simon's Medallion Fund is the most successful hedge fund in
> history, only employs physicists and mathematicians, and has been successful
> over a period of 25 years, suggests rather strongly that it's not just
> chance and probably is related to training in other fields...

The market consists of players that lie on a standard distribution, with the
market averages identifying the mean. Now ask yourself -- how many players
will be above the average on a given day? And how many of those "winners" will
be predisposed to acknowledge the role of chance in that outcome?

Because of chance factors, some investors will become multimillionaires by
chance alone. Because of chance factors, some funds will outperform the market
averages for decades running. But without a proper scientific analysis, none
of this means anything apart from randomness.

I cannot tell you how many times I've heard the same claim -- "(name a fund)
consistently outperforms the market norms, therefore ..."

Therefore nothing. Therefore the dice fell in an interesting bur meaningless
way.

Also, a point obviously lost on you, if the fund you describe really has a
winning strategy, why is it not formalized and published? There are two
possible answers: (a) it is not a system, it is a series of lucky guesses, or
(b) it is a system, but they won't publish it and lose its advantage. Neither
answer raises this above the default assumption suggested by Occam's razor --
it's a chance correlation.

Science requires evidence, not anecdotes, and the plural of anecdote is not
evidence.

~~~
Tycho
The excuse you gave for Buffet's long term success was that legions of others
copy his investments and they become self fulfilling prophecies. But
Renaissance Technologies are very secretive - they publish virtually nothing
about what they do. What are the odds of them greatly outperforming the market
(and always having positive returns) for all those consecutive years? What
will you if they do it again this year?

(and I dont think anyone claims they've been playing by a single strategy all
this time)

~~~
lutusp
> But Renaissance Technologies are very secretive - they publish virtually
> nothing about what they do. What are the odds of them greatly outperforming
> the market (and always having positive returns) for all those consecutive
> years?

It is always possible to pick and choose your data to prove any point you care
to make. But the fund you describe is one data point in a large distribution
of investors and funds defined by the market averages. Please try to evaluate
this scientifically, dispassionately.

> ... What are the odds ...

The odds are excellent that, in a field of tens of thousands of funds, a few
of them will do spectacularly well because of chance factors. And this is the
explanation favored by Occam's razor -- the idea that the simplest explanation
is likely to be the correct one.

In a computer analysis described here --

<http://www.arachnoid.com/randomness/#Investment_Genius>

\-- a model is set up with 100,000 investors, each of whom randomly buys and
sells stocks, in a market that creeps up in value over time (like the real
market) along with random fluctuations (like the real market). "What are the
odds" for success because of chance? Very good -- essentially certain. Of the
100,000 investors with managed portfolios, each with an initial $10,000 stake,
224 became millionaires _by chance alone_. The top-earning portfolio returns
$4,638,235.88 _by chance alone_.

But at the same time, the _average_ investor with a managed portfolio (who
wasn't a buy & hold investor) came out behind -- more than 2/3 of the managed
portfolios come out behind the market average. And this model didn't even
assess trading fees -- a more realistic model that charges transaction fees
makes active portfolios look much worse.

Imagine you're a stockbroker and you know these facts, facts that put an
active portfolio in such a bad light. What do you tell your clients? That
having an actively traded portfolio is a losing proposition? Or that a handful
of investors came out ahead, some far ahead?

The bottom line is that a successful fund, especially one that won't reveal
its methods, is the result of chance -- absent scientific evidence that
something other than chance is involved.

Imagine that someone throws a fair coin and eventually produces a series of 16
heads in a row. Doesn't that prove that the thrower has psychokinetic powers?
No, it means he threw the coin 2^16 (65,536) times, a sequence during which
the described outcome has a 50% chance to arise _by chance alone._

Also read this:

<http://www.arachnoid.com/randomness/#Miracle_Man>

In the above strategy, a con man mails you a series of predictions so
remarkable that you're certain he's a genius, but the strategy is so
absolutely predictable (and easily explained) that it can be carried out with
a computer and as printer with no human intervention.

So in answer to your question "what are the odds?", I have to say that all
these outcomes are easily explained as _chance occurrences_ , and that is by
far the most likely explanation.

~~~
Tycho
Chance doesn't explain it. Firstly, in the 90s I doubt there were 65,536 hedge
funds around, so simple chance would not dictate one to return above average
every year. Secondly, we're not talking about just a 50/50
outperform/underperform situation - the Medallion Fund _spectacularly_
outperformed the market in many of those years and never reported losses. In
years when the market crashed they were eg. 90% up. So it's not just the
unlikelihood of consistently outperforming year after year, it's also the
unlikelihood of outperforming at such a magnitude in any given year, that you
need to consider.

~~~
lutusp
> Chance doesn't explain it.

About a program I wrote, that generates random numbers, and that therefore can
only model chance? Yes, chance does explain it -- it is the only possible
explanation for a spectacular performance in a program that simply rolls
random dice.

> Firstly, in the 90s I doubt there were 65,536 hedge funds around ...

I'm waiting to hear your argument. The number of funds doesn't change the
outcome, and the number you chose has no bearing on the problem.

> so simple chance would not dictate one to return above average every year.

Are you aware that we're discussing a computer program that proves that
spectacular returns can be gotten using random numbers? Which part of this
aren't you understanding?

> the Medallion Fund spectacularly outperformed the market in many of those
> years and never reported losses.

False. [http://www.hedgefundletters.com/category/renaissance-
technol...](http://www.hedgefundletters.com/category/renaissance-
technologies/)

Quote: "Between January 1993 and April 2005, RenTech’s flagship Medallion fund
had only 17 losses out of 148 months."

Check your facts, Mr. Scientist.

Also irrelevant. If your position had merit, science would be a matter of
choosing the most extreme, unrepresentative outlier and calling that the
average. But that's not science, that's superstition.

Guess how many funds are above average on a given day? 10%? 20%? Would you
believe 50%? The third answer is the right one -- as you would know if you
understood statistics.

In science, Occam's razor prefers the simple explanation. The simple
explanation is chance. The same chance outcome that means ... wait for it ...
fully 50% of funds are above average.

~~~
Tycho
Medallion never had a down _year_ , which is what I was referring to, although
they have had some _monthly_ losses. The odds on a fund having Medallion's
returns in a strong-EMH environment are astronomical - so either it is a
cosmic fluke or the EMH is incorrect. Occam's Razor suggests the latter.

(also I was never talking about your computer program)

------
scotty79
Blaming people who develop algorithms for purposes of gambling (also called
investing) for decade of market crashes is just silly.

All markets have crashes. Faster markets have crashes more often. Markets are
getting faster due to computer technology not trading algorithms.

Even if algorithms were really simple it would still lead to more frequent
market crashes just because dumbest algorithm can trade faster than humans
previously could.

And blaming physicists for 2007-08 worldwide financial collapse is just silly.
It's not them that hid the risk in convoluted instruments and then sold them
as if they were as solid as cash in the bank.

~~~
lutusp
> Blaming people who develop algorithms for purposes of gambling (also called
> investing) for decade of market crashes is just silly.

Unfairly blaming analysts isn't the problem. The problem is assuming that
anyone can predict the future of equities markets. There's no evidence to
support this idea -- all successes are chance successes, and all failures are
chance failures. This is why market index funds perform on average better than
funds in which a manager tries to choose future winners and charge you for the
privilege of being a member, an "insider".

------
hogu
I think hiring has shifted away from physics to signal processing, and machine
learning people. But I am a signal processing guy so that maybe my bias. Also
because we've moved away from complex derivatives.

------
cjbenedikt
Interesting but flawed....Scotty79: to argue that models cannot be blamed for
market crashes is the same type of argument that says guns don't kill people.
Both statements outside context are correct, yet...btw: another academic
created the option formula already: Vincent Brontin who taught in Triest in
1910...and not the physicists who knew howcto treat formulae appropriately
survived the crashes but street smart traders like Taleb did...experienced
option traders never used Black-Scholes anyway because they knew it was
flawed...an accident waiting to happen...

~~~
barry-cotter
Taleb's fund failed.

~~~
cjbenedikt
actually it didn't ...its successor Spitznagel's Universa made enormous
profits in 2008 to the tune that he now manages $6 billion....also: Taleb made
his money in the '87 crash...and Empirica made a lot in 2000/2001. Taleb
closed it because he suffered from trader fatigue....something quite common
btw

------
tunesmith
Articles like that frustrate me. So much smartness and explanation, and yet it
all is still only devoted to figuring out how to be smarter than the other
masses of investors out there, in order to make a buck off of them.

~~~
Tycho
On the other hand, the stuff they work on could easily be useful in other
fields - modelling, ultra low latency systems, maybe even AI.

------
elliptic
First I've heard anyone referring to James Simons as a physicist.

~~~
balsam
Speaking as a member of APS... what do you expect from an APS magazine :)?
What on earth is a "mathematician"? We have to call Edward Thorp an "American"
because we don't know about his "theories" (c.f. the article)! (And how are
"theories" different from "theorems"?)

EDIT: You beat me to the comment.

