Book review: Lessons of quant failure have not been learnt

Book review: Lessons of quant failure have not been learnt

The Money Formula: Dodgy Finance, Pseudo Science and How Mathematicians Took Over the Markets by Paul Wilmott and David Orrell

Review by Nick Train

Among my all-time favourite pieces of investment advice is this dogmatic assertion from Fidelity’s great Peter Lynch: “No one can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts.” 

My own investment performance improved almost immediately when I began following that advice. Now Messrs Wilmott and Orrell have provided another Mr Lynch humdinger: “Efficient markets? That’s a bunch of junk. Crazy stuff.”

I have got to believe Mr Lynch is right to pooh-pooh market efficiency, I really have – otherwise I am forced to question what I have been doing for my entire career. But Mr Wilmott and Mr Orrell demonstrate that much more is at stake. 

If the hypothesis is wrong – and they believe it is – then the whole edifice of quantitative finance is undermined. In particular the risk controls and the hedging practices of investment banks are likely to be ineffectual. 

And, cruelly, quant-based risk controls are most likely to fail exactly at the juncture they are most required. Their book is both a history of how quant failed over the 2008 debacle, but also a warning that lessons have not been learned and the financial system and the living standards of almost all of us remain vulnerable to the inevitable next dislocation.

The authors provide the best summary of the thesis thus: “A simpler explanation is that the system is driven by complex dynamics that resist numerical prediction.” 

For most practitioners, including me, the inscrutability they describe rings true. As a result I have always preferred bringing narrative analysis to bear on prices, rather than maths. What is the story behind this price series? But that may be down to my history degree and that, to all intents and purposes, I am innumerate.

The Money Formula is instructive and engagingly written – the authors are smart and funny guys. 

I do wonder, though, about the didactic value and even purpose of the book. By this I mean I am sceptical whether the policy proscriptions they propose to tame market and banker excesses could ever be effective and I even question whether it is in homo sapiens’ best interest for the excesses to be tamed. Looking back over the sweep of economic history it is clear that excess and panic are intrinsic to the workings of markets. 

There were “panick terrours” – to use Dr Johnson’s wonderful description of the liquidity freeze of 1772 – well before the invention of collateralised debt obligations and quantum finance. The authors state: “The purpose of markets is to enable companies to raise money to grow and benefit society.” We are all agreed. However, a pessimistic, but to date realistic, conclusion is that boom, bust, greed and fear are all necessary components for markets to do their work. That the advances and improvements in global living standards brought by market-tested innovation are worth the volatility and occasional crashes. That it is better to let those who make bad bets go bust than to hamstring the engine of prosperity.