In college I took an elective course called “Recreational Mathematics” in which the professor took an interest in the way that I solved some of the gaming and logic problems that we studied. He handed me a book and suggested that I read it and write a report as extra-credit; the book was from the 1960s and called Beat the Dealer by Ed Thorp, a mathematics professor. I quickly devoured the book, wrote my paper and, like many others, tested the blackjack techniques live in Wendover, Nevada on a drive to California for Christmas. The core idea of the book was mischievously appealing; through my knowledge of math I could and would make untold amounts of money all at the expense of a corrupt entity, the casino.
I did not know what happened to Ed Thorp after he publicized his blackjack strategy until I recently read Scott Patterson’s The Quants: How a New Bread of Math Whizzes Conquered Wall Street and Nearly Destroyed It. In the early 70s, Thorp turned his expertise towards a different casino; Wall Street. He and others like him developed sophisticated programs and strategies aimed at finding exploitable weaknesses in our financial system. Patterson is clearly enamored with Thorp and portrays him as the book’s protagonist (calling him the “Godfather”) whose early writings and funds inspired imitators.
Patterson details how some of the best minds in mathematics, physics and computer programming gravitated to banks, investment firms and private equity funds in order to “beat the market.” Thorp’s first discovery was that the accepted models for pricing a speculative investment called warrants were flawed so he developed a better model and invested in warrants that were under priced; leading to significantly higher returns that the S&P. Soon other “quants” were discovering other loopholes in the financial system and profiting from them. Rather than close the loopholes, large investment houses such as Morgan Stanley and Lehman Brothers invested and profited from these “quants.” Over the next thirty years the financial system would be become a cyclical house of cards with large institutions becoming dependent on mining these statistical loopholes. One of the problems was that nobody truly understood from where the money was generated. Nobody disputes where the money comes from when you win at 21; the casino. But if you discover out and exploit a guaranteed loophole in our financial system (making billions of dollars in the process), who writes the check?
The Quants is a well-written examination into the world of investment and quantitative models. Patterson is generally sympathetic to his subjects and takes care not to vilify anyone. This is both a strength and a weakness of the book. As a writer, Patterson is morally ambiguous towards his topic and his subjects. If anything, he seems sympathetic to the quants and envious of their earning power. His portrayal of Ed Thorp is emblematic of his approach. As a reader, Patterson makes me want to believe in Ed Thorp; a scrappy everyman who uses his mathematical gifts to “beat” large institutions such as casinos and Wall Street. Thorp never seems to make a misstep and is always the one who predicts the market’s problems before the other quants do. He gets out of the market in 2002 well before the current recession. He jumps back in 2008 and delivers a return of 18% (despite massive losses in the Dow that year).
But Patterson tells some stories about Thorp make me wonder if we are getting a saintized version of the man. For example, In 1991 Thorp decides to stop managing an investment fund and works as a consultant for some large pension funds. He is asked to evaluate their holdings including a fund that has been making unbelievable returns for the past 10 years (returns even higher than his own). It took Thorp one day to delve into the fund’s holdings and to conclude that the pension fund should sell its holdings immediately out of Bernard L. Madoff Investment Securities. Thorp had discovered that the fund was a fraud. Patterson uses this story to celebrate how smart Ed Thorp is. For me, this story is wrought with ethical issues. Didn’t Thorp have a responsibility to share this information with more than just the pension fund? The Madoff fund continued to function for the next 15 years? Wasn’t Thorp ever tempted to share his findings with others? How many investors could have been saved by a little charity from Thorp? Thorp did what he was legally and financially obliged to do (just like Joe Paterno). But there is part of me that expects a little more. Patterson’s portrayal of Thorp as a quantitative saint is little hard for me to swallow; maybe it is because I expect more from my saints than just being smart, clever and rich.
The biggest difficulty that Patterson overcomes is taking two extremely difficult subjects (advanced mathematics and Wall Street) and crafting a readable narrative. He does this by 1) never intricately discussing the most difficult math, 2) focusing on the fund managers and 3) using gambling and poker as an organizing motif. While Patterson is able to make his narrative easy to read, I never fully understood the world I was witnessing because the math was never fully explained. To better understand the quants Patterson’s book is a good outline but I am hesitant to make conclusions based on the nature evidence he has provided.
Patterson attempts to make the case that most of the market meltdowns that we’ve witnessed in the past 30 years have been directly linked to the activities of the quants. This includes Black Monday, the tech stock bubble and the current recession. While I agree that the quants contributed to all three events, I believe that Patterson overstates the impact of the quants. Nevertheless, the book’s biggest impact on me is that I will never view Wall Street in the same way as I did before reading his book. 4 stars