Flying to New York for my son's engagement party a week ago last Thursday, I finished Scott Patterson's new book, "The Quants - How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." Stepping off the plane, I learned that they had just done it again. Those "quants." They need a stake through the heart.
There are two kinds of quants. The first is someone who uses what we may remember from high school calculus as the third derivative. A line depicting the performance of some investment can be changing direction and the change represents the second derivative. The rate of change is the third derivative and studying this metric can offer an indication of what will be happening next. Having that information will prompt a buy or a sell on the part of the quant.
The second type of quant is someone who keeps track of how far an investment has deviated from the norm. They are calculating the point at which a "reversion to the norm" will be inevitable, and that determines what their bet will be.
About 30 years ago, quant pioneers started by "card counting" while playing blackjack in casinos. They read Ed Thorp's book "Beat the Dealer" and it worked. Then they applied the concepts to investment products like options. Now, instead of having to use their heads, they are able to use computers. These computer-driven investment models have consumed increasing amounts of the volume of trading across the country. Today, it represents more than 60 percent of all trades nationwide.
There are now more than 50 different "stock markets" operating in this world of electronic trading. The discipline brought by the old-line major stock exchanges - New York, American, Nasdaq, etc. is gone. Therefore, the damage Quants can do is immense. We saw this in October of 1987 and again in August of 2007. May 6th of this month was even more ridiculous - Accenture dropping from $40 to one cent? Please.
Quants have been known to generate 20 percent to 40 percent returns - year after year. Unfortunately for them, a growing number of home-brewed quants have filled their garages with Macs and have duplicated what their forebears had introduced. The software is available for less than $1,000. This growing army has made it harder and harder for the pros to maintain an edge.
It is crazy to allow people to invest borrowed money in stocks beyond some reasonable limit. We "Little People" have a "margin requirement" of 50 percent - the limit of how much borrowed money we can invest. Hedge funds have no such limit, because they and their clientele are considered to be "sophisticated investors." What a joke. How many more blow-ups threatening the entire financial system does it take to convince us that we are all in this together? The same rules need to apply to all.
Next, we "Little People" who try to day-trade or even re-balance periodically get chewed up by trading costs. Not so for the quants. They actually get paid to trade by those 50 some-odd exchanges, because they supposedly provide "liquidity." Consider the supreme irony of the fact that we "Little People" (voters, remember) are the ones effectively paying to support the rapid-fire trading that goes on all day for free - trading that has been routinely crashing a system upon which the rest of us increasingly rely.
Ending the problem is this simple: Limit all investment borrowing in publicly-traded stocks and bonds to 50 percent and make everyone pay the same trading cost.