The Physics of Wall Street – Review

Despite an unfortunate title that sounds like a textbook for a course that most people would not voluntarily take, The Physics of Wall Street is an engaging history (sans equations) of the contributions of scientists and mathematicians to financial modeling.

In the volatile aftermath of the recent economic meltdown, for which they are partially blamed, the cultural icon of the Wall Street “quant” is one of the most feared and reviled figures in finance, perhaps more so than the “fat cat banker.”  As author James Owen Weatherall quotes in the introduction, even uber-rational Warren Buffett, the beloved Papa Smurf of investors, has said, “Beware of geeks bearing formulas.”  This book seeks to back off from the fear and loathing and examine the interactions between science and finance, with a view towards improvement for the future.

Weatherall has a true gift for explaining, in simple terms, difficult concepts of physics, math, and finance, while preserving the sense of breakthough “eureka” excitement the discoveries engendered.  The story begins with a concept familiar to anyone who has ever taken a class that was graded on a curve, the standard distribution or bell curve.  The application of the normal distribution and probability theory, first to gambling, then to stock markets, was a revolutionary concept in the late 1800s.

From there, as science and math have progressed and decidedly “non-standard” curve behavior has been observed, the financial models have been improved and updated, even including some of the concepts of the recently developed chaos theory.  In most cases, the advances have involved controversial, often marginalized, scholars who operated at the fringes of multiple disciplines to carry ideas from one field to another.  Indeed, the moral of the story is a plea for an increase in these collaborations and a warning that they cannot be managed like a handoff of a baton in a relay race.  Ideally, the interaction should be ongoing and iterative, with the dangers arising when these complex models are simply passed along and their shortcomings and assumptions forgotten.

Weatherall refutes one final negative argument in the epilogue, that recent discoveries of behavioral finance and the irrationality of human psychology preclude the success of financial models.  He argues with examples, that a successful, well-developed model can account for the vagaries of people.  This view is backed up by researches in the behavioral field, such as Dan Ariely, whose bestseller Predictably Irrational explains why the two terms are not mutually exclusive.

Also, anyone who is familiar with the writings of Jared Diamond has seen the evidence that human behavior is typically driven by biology. Biology is, at its core, chemistry, which in turn obeys the laws of physics, and we are circled right back to the concept of using physics for development of financial models.  Perhaps the best approach going forward would be to moderate the sweeping, overly dramatic attitude of Nassim Taleb’s The Black Swan of “it’s impossible and can’t be done,” with the more tempered and modest, “it’s difficult and we’re not sure how to do it right now.” [subscribe2]