Monday, April 13, 2009

Math did not kill your 401K

So I sent this to the LA Times as an editorial, and they wouldn't publish it.
So here it is.

Some financial experts would have us believe that they were lured into ruin by a seductive model, a mathematical model. A recent Wired article blamed our economic crisis on economist David Li and his "fatally flawed function", with "all powerful" parameters, giving rise to an "irresistible" equation. Since when is equality a "dangerously precise concept" that leads financial experts to divorce themselves from reality?
The tendency to blame "quants" (quantitative analysts) is becoming more prevalent as people look for a convenient scapegoat. In a recent letter to his shareholders, Warren Buffet chided his audience for being taken in by “a nerdy-sounding priesthood, using esoteric terms such as beta, gamma, sigma and the like.” I hear from many people that math is Greek to them, but as Mr. Buffet demonstrates with his use of the word "esoteric", we use words with Greek origins every day. On a recent episode of the Bill Maher Show, Representative Maxine Waters (D-California) called for the jailing of "the schemers who have conspired by hiring these mathematicians and others to come up with these exotic products that rip people off and put them in homes that they could not afford ...". But who really put people in homes they could not afford?
A more balanced article from the New York Times, is entitled "They Tried to Outsmart Wall Street", where "they" refers to quants. This article makes the point that quants' warnings concerning the use of a particular model are often ignored if following their advice reduces their company's profits. So perhaps a solution is to create think-tanks of financial mathematicians who produce work that is refereed as it is in academia. Then any flaws would be more quickly exposed, and more freely acknowledged. Companies could subscribe to the think-tank's entire body of work and use it in whatever manner they wanted without having mathematicians on permanent staff. Much like the Material Safety Data Sheets that Chemists produce, this literature would include clear directions for proper use, so that companies who misuse the models produced by mathematicians could be held accountable.
In any case, the demonizing of mathematical models is not productive. Instead, better understanding of the nature of mathematical models is needed. Just as the directions on a cleaning product often read "test on an inconspicuous spot" before using universally, mathematical models should be "spot-tested" on particular situations before they are used more extensively. Of course, all of us have failed to read or ignored the directions on a product before. But we have also begrudgingly accepted that any less-than-stellar consequences are our fault. Models, like any tool, are only as good as their user is skillful. Why is it so much harder to "read the directions" for mathematical tools? When holding a physical tool, the intent of the creator is just easier to see. But the more abstract the tool, the more education is necessary to properly use it, which is why financial managers are usually paid more than quants. So let's not blame the guy who designed the vacuum cleaner when some guy tries to use it to mow the lawn.

Quotes taken from:

Recipe for Disaster: The Formula That Killed Wall Street
Wired Magazine, February 23, 2009
Felix Salmon

In Letter Warren Buffet Concedes a Tough Year
The New York TImes, February 28th, 2009
David Segal

Bill Maher Show
Panel Discussion (with Maxine Waters and others)

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