# Renaissance Technologies

Via Steve Hsu, the news from the Wall Street Journal is that Renaissance Technologies is about to launch a new hedge fund that could end up managing $100 billion, 10% of the total managed by all hedge funds today. Renaissance Technologies is run by mathematician Jim Simons, perhaps the most successful hedge fund manager ever. His current Medallion hedge fund manages$5 billion, and his personal net worth is estimated to be about $2.5 billion. Renaissance employs many Ph.D. mathematicians and other scientists, but is quite secretive about their investment strategies. If you ask people who are working there about what they are doing, you get answers like “I could tell you, but then I’d have to kill you.” Simons was an undergraduate at MIT, got his Ph.D. from Berkeley in 1961, then was a junior faculty member at MIT and Harvard. He worked for a while at the Institute for Defense Analyses in Princeton, but was fired over criticism of the Vietnam War. He then went to SUNY Stony Brook, where as chair he built up a great math department, one especially strong in geometry. His work with Chern in the early seventies led to an extension of Chern-Weil theory involving “Chern-Simons forms”, which have been of great importance in physics. During the seventies he started trading currencies and commodities with his own money, leaving Stony Brook in 1978 to form his own investment fund. Over the years he has been generous to the mathematics community, supporting MSRI, the IAS, the Stony Brook and MIT math departments, and many conferences and workshops. I have no idea what his long term plans are for his current billions or the additional ones his new hedge fund may generate, but if even a fraction of them end up financing pure math research, this could have a very dramatic effect. This entry was posted in Uncategorized. Bookmark the permalink. ### 55 Responses to Renaissance Technologies 1. M says: Hi Anonymous, Thanks for your well thought out comment regarding free markets and central planning. Before commenting on some of your specific points, some clarification is appropriate. In my initial comment about free markets vs. central planning, in an effort to try to avoid the kind of misunderstanding that seems to have occurred, I mentioned early on that First, I agree that overall, free markets are much preferable to centrally planned economies, and probably for similar reasons to yours. Given that, you will hopefully agree that I will give an emphatic “No” to answer your question, So, just to make sure that I got you right: states, i.e. the entities which use theft and slavery to start and run wars, are inherently good; companies, which offer goods on a free market for voluntary exchange, are inherently bad. Did I get that quite right? I think my agreement with you on various other points in the past should support my disagreement of your assessment of my overall view. You may have gotten your impression from examples I gave to support the idea that there are times when “central planning” can have overall positive results (sometimes unintentionally!). Generally I try to avoid holding more extreme views since they are usually the product of ideological thinking rather than well thought-out arguments, and to cast free markets vs. central planning is “always good” vs. “always bad” seems somewhat extreme… Overall, I think there can be a role for regulation or outside intervention in at least three general conditions: 1. Abusive practices create an unfair advantage for an individual or company. Examples are laws against bribery or racketeering, some regulation of insider trading, and regulations against some kinds of monopolistic practices (e.g., blatantly predatory pricing). 2. Laws and regulations to prevent indentured servitude or abusive working conditions. 3. Seeding or nurturing of basic science research, or even new basic technologies that are speculative or have very start up costs without any positive return on investment in an agreeable time frame. This is probably the most controversial area, and I will try to defend it below. In a truly free market, government would not take action in any of the above areas. Hopefully we can both agree that government intervention in at least the first two areas above is justified by significant actual abuses that have occurred in the past, even if we disagree on how much government action is appropriate. Now, on to some specific points you made. This is essentially Marx’ old argument for how free market capitalism would abolish itself. It has a couple of big holes in it. I wasn’t thinking about Marx at all when I made the comment, and I don’t think that his agreement or disagreement with it has anything to do with whether the argument is correct. Marx probably thought periodic bathing was a good idea too; I doubt anyone will stop bathing because Marx thought that. 🙂 One boils down to the difficulty of precisely defining “the market in X”. This isn’t something I had thought about, but I agree with your argument here. I would probably call much of it “market segmentation” rather than “different markets,” but I don’t know if this is purely a matter of semantics or not. The kind of monopolies I am concerned about are the ones relating to basic needs, where a monopoly has a lock on a very important market and there are no available alternatives, whether it is a scarce resource, a distribution channel, or a manufactured product. On the other hand, many markets are probably not prone to monopoly; for example, trees grow in a lot of places, one company could probably never own a sizable fraction of all the farm land, and you can always drive a basic car if you don’t want to pay for a high end sports car. As new technologies emerge, old ones are abandoned, and even if a monopolist had managed to establish itself in the context of the old technology, it is very rarely able to retain its position – or even just to survive – when the technology changes… Xerox and IBM are two examples which I particularly like… Here I will both agree and disagree, but in different ways. I disagree because this only works in many cases if the market is sufficiently free. A new competitor must be able to establish itself enough to become a serious competitor, and new technology won’t necessarily allow that if the established monopolist can use predatory pricing to prevent the new competitor from making a profit, or if the monopolist closes distribution channels to the hopeful competitor by using its market power. Probably most importantly, there is nothing to prevent a monopolist from seeing the need to adapt to the technological change by adopting the new technology itself and then proceeding to use anticompetitive practices to put the new competitor out of business before raising prices again. The reason this works is that adoption of new technology is rarely immediate, so the monopolist can use its power to buy time while adapting to the change. The way I see it, your argument about technological change is primarily valid if (1) the monopolist is incompetent and refuses to adapt to maintain dominance; or (2) another company with a lot of resources and clout decides to enter the monopolist’s market. I admit to grossly oversimplifying things by completely ignoring international trade, and that probably throws into question a lot of what I am arguing since a monopolist can’t exert much control in a country where it has little presence. But the international market is even less free than the US market, so I think it is hard to fully take that into account. And wage disparity won’t be permanent in the presence of a free market. If monopolists are effective in using the above anti-competitive practices, it seems safe to say that there will be less and less interest by investors in funding a new company that will compete primarily on the basis of new technology. I think Microsoft is an excellent example — venture capitalists tend to steer clear of funding companies that will compete with Microsoft, one reason being that Microsoft has been very good at incorporating new ideas and thus depriving the new competitor of a market. Finally, I think the examples you gave of how new technologies can end monopolies don’t really support your argument too well. They are great examples of how companies can lose dominance or markets can dramatically change due to new technology, but they all happened in a relatively free market. If IBM hadn’t been restrained by the US government in the 1960s to 1980s, I think there would be a lot more mainframe usage today. (As far as Xerox goes, their inability to make money from great new technologies they invented outside their core market is legendary; that says more about their incompetence than anything else). Finally, a lot of the new technologies and markets are offshoots of earlier ones, and they probably wouldn’t exist if the earlier ones hadn’t established themselves. I don’t think you can come up with good supporting arguments for your position that apply to a truly free market, because as far as I know there is no history of that kind of free market existing, at least in “modern” times. It is just “belief” on your part… No, a government monopolist will squeeze much harder, in the absence of *any* counterforce. I was thinking of the Soviet Union when commenting that a government monopolist will probably not be as inclined to try to extract the maximum possible price for goods. Basic goods were often cheap; it’s just that their supply was limited or nonexistent (a different problem). I was not trying to use that as an argument in favor of central planning… I think this has gotten long enough. I want to respond to some of your other points, especially where you tried to argue that among my examples of government involvement, none actually had an overall positive economic benefit. (At least that seemed to be what you were claiming.) Some of my examples were better than others (the farming one is probably questionable), but I think you are extremely optimistic to think that the aircraft, electronics or communications industries, for example, would be anything close to what they are now if the government hadn’t supported their development and acted as a large, reliable customer while the technologies established themselves and costs declined. But I admit that is speculation. Anyway, thanks for taking the time to reply to my past comments. I am definitely learning from it, and it is getting me to think more about these issues. 2. Alejandro Rivero says: But seriously, your definition, and the subsequent extinction of “planned economy” species only proofs, from the point of view of evolution theory, that planned economies had a disadvantage in the niche of “XXth century countries”. Darwin’s theory does not have a concept of progress, just extinction. 3. Alejandro says: I am imagining the sexual intercourse of two countries… well, mitosis seems a more frequent process. 4. Anonymous says: A.R. wrote: Evolution theory is about species and niches, not about individuals. It is a shame that divulgated evolution theory fails to stress this. So what prevents me from defining the species of free market economies and watching it outcompete the species of planned economies, with countries in the role of individuals? 5. Anonymous says: M wrote: as Maynard mentioned a little while back, “friction” could be introduced into the system to decrease that attractiveness of quick, low profit trades, for example a tax on certain kinds of transactions Such friction is already in place: it’s known as the spread, i.e. the difference between bid and ask prices which ultimately lands in the pockets of brokers and exchanges as payment for services rendered. No need for a tax. 🙂 6. Alejandro Rivero says: what does in fact, prevent a country from being considered a biological organism? You need species. Evolution theory is about species and niches, not about individuals. It is a shame that divulgated evolution theory fails to stress this. 7. M says: Hi Anonymous, Thank you for your well reasoned reply to my comments about the Ren Tech stragegy. I really appreciate your informed comments — I am learning from them, and trying to learn something and test/modify my views is my motivation for putting some energy into this topic. At this point it seems like our views are not really in conflict, at least in matters that are well understood. Just a couple of comments about what you wrote: What actually seems to happen is that the competing technical systems quickly start pre-empting and therefore neutralizing each other, as noted above. Even if this weren’t the case, it’s hard to see how regulation could help. I think JC mentioned something about this neutralization early on. It certainly makes sense; one could probably predict this would happen. If this is indeed how things play out, then there probabably wouldn’t be important, negative long term consequences, meaning that this kind of trading didn’t offer significant new efficiencies (i.e., that it was a short term tactical move borne of opportunity). If, on the other hand, the trading strategy has meaningful negative consequences then I believe regulators will try to step in and “fix” it. Note that I am not arguing that they should step in, nor that such an attempt would be successful (as you noted). On the other hand, I am not an absolutist; I think some kinds of regulation do more good than harm, so I don’t have an opinion at this point. But whatever I (or you) may think, if there is enough disruption and it is perceived as negative, then I am confident that regulators will try to clamp down. I agree that the kinds of regulation that you mentioned, such as limits on trades, computer based trading and limits on trading volume would be either ineffective or counterproductive. However, as Maynard mentioned a little while back, “friction” could be introduced into the system to decrease that attractiveness of quick, low profit trades, for example a tax on certain kinds of transactions (at a minimum this would eliminate the benefit of using multiple brokers). Please note that I am not advocating taxation of this sort, but mention it only as an example of the many different tools a creative regulator could use. We’ll see how it all plays out… 8. Anonymous says: A.R. wrote: Please let me apologise No need to apologise. A.R. wrote: pricing mechanisms depend on availability, and that any market system, willing to have exchange prices, must restrict availability by using ownership. The same applies, intriguingly, in Estate regulated economies, except that ownership is not exercised by individuals. I agree, prices depend on availability; if you don’t want to run into scarcity and oversupply problems, there’s no way around that. The problem when trying to dictate prices, rather than letting the market find them on its own, is that you are trying to perform and enormously complicated optimization task. You don’t have all the relevant data to do it; if you did have all the data it would overwhelm you; and if it somehow didn’t overwhelm you, you would just end up finding the same optimal price point set by the market. So what was the point of all that work, then? A.R. wrote: I fail to see how Spanish America was a *internal* colonisation. Before they became independent countries, the Spanish, Portuguese (and Dutch, and French, and British) colonies in the Americas were run as territories of the respective coloniser, remember? And for a long time, they pretty much plodded along according to the usual European model of the time, with kings, aristocrats and priests running the show. The US got rolling only after it threw tea, taxes and Britons back into the Atlantic and decided to start doing things its own way. And not a minute too soon, I say! A.R. wrote: As for “evolution=confrontation”, I am pretty sure this is not a theory of evolution as applied by the biologists Watch countries, economies and social systems evolve, interact with their environment and compete with each other over historical timescales (centuries, millennia). How does this process differ from that of biological organisms evolving, interacting with their environment and competing with each other? (Now that you got me started, what does in fact, prevent a country from being considered a biological organism in its own right?) 9. Anonymous says: M wrote: I am not aware of any truly free market in any developed, industrialized country I must unfortunately agree. Such is the state of our world that we must choose among the lesser among evils. 🙁 M wrote: a truly free market, i.e. a completely unregulated one, is in a kind of unstable equilibrium. Left alone, some competitors will emerge as the strongest, and monopolies form because there is nothing to prevent the most powerful from becoming powerful enough to completely dominate their market. This is essentially Marx’ old argument for how free market capitalism would abolish itself. It has a couple of big holes in it. One boils down to the difficulty of precisely defining “the market in X”. A silly example: is there just one market in cars, or do Ferraris and SEATs really trade on separate markets? Methinks they are really separate, and guess what – the people who make the world’s best sport and luxury vehicles turn out to be really bad at competing in the low end mass market, where they get handily beaten not only by Seat but by a whole bunch of Japanese (and other) manufacturers (behind the various corporate logos, it’s all FIAT, sometimes spelled out as Failed Italian Attempt at Transportation… which is just plain wrong, at least if your name happens to be Schumacher). Markets stratify and specialize, and competition tends to reward those who concentrate on one segment. Even then, it’s rarely the case that a single company completely dominates its segment for long. The second big hole has to do with the last two words in the previous paragraph: “for long”. Schumpeter coined the phrase “creative destruction” to describe the effects of technological development on companies. As new technologies emerge, old ones are abandoned, and even if a monopolist had managed to establish itself in the context of the old technology, it is very rarely able to retain its position – or even just to survive – when the technology changes. When you get a little bit older you start realising that the average time period involved – the duration of a dominating position – is really quite short. You start thinking about it, and you can rattle off one company after the other which totally dominated its market when you were a child or a teenager, and now it’s gone – along with the market! Are you old enough to remember mechanical watches from world-renowned Swiss manufacturers (what were they even called?), mechanical calculators (Facit), typewriters (Olivetti), Polaroid instant cameras, Xerox copiers, IBM mainframes? Xerox and IBM are two examples which I particularly like, because of all their irony: the Palo Alto Research Center run by Xerox developed the mouse & GUI computer interface which we all take for granted these days. Apple “borrowed” it, using it first in a clumsy contraption called “Lisa” (after Job’s daughter, I think – or was it Wozniak’s?) which bombed in the market, but which was followed by the (need i say it?) wildly successful Mac line. All the while Xerox kept churning out paper copiers, eventually waking up in reconstruction as the market for paper copiers was largely killed by digital documents stored, processed and viewed on (and occasionally printed from) computers with mouse & GUI interfaces – their own technology! Meanwhile, IBM – king of corporate computing – outsourced the task of developing an operating system for its newfangled personal office computer to a two-bit startup calling itself Microsloth or something… and in so doing created the largest computer market in history, only to be pushed out of the hardware business by Dell and other low cost manufacturers (do you even remember the time when those were called “clone makers”?), while MS took over the software business (but for how much longer?). Did you ever notice when IBM recently sold off the last remnants of its PC business to a Chinese outfit? Probably less so than Apple’s announcement that they are finally dropping IBM’s processors in favour of Intel’s. What IBM does these days? Mainly “services”, which to a large extent seems to be about keeping those old mainframes running at the premises of die-hard corporate customers. It’s not easy being a dominatic actor these days… not to mention a monopolist, which strictly speaking is something else, a company which isn’t allowed to have competitors (typically by political mandate, as in the common cases of tobacco, alcohol and telecommunications), rather than one which is just very good at beating them in the market (which must mean it’s doing something right in the eyes of the consumers, or they would indeed favour the competition). Now, I’ll give you this much: it’s conceivable that technologically mature markets, where little further development is possible, may fall in the hands of a dominating company, that such a company may abuse its dominating position in various ways, and that the lack of creative destruction due to the lack of technological competition will cement this dominating position for a long time. I agree that such extraordinary circumstances may call for extraordinary measures, presumably the breaking up of the company in smaller independent units, as was done in the US with Standard Oil and with Bell. But such cases are truly few and far between, and even the two big, historical ones which I just mentioned are often taken as examples of the questionable wisdom of such imposed breakups. Were they really necessary, or would technology have done its job soon enough? Were they really not politically motivated, a la Lukoil? Were ties between baby oils and baby bells really severed, behind the scenes? And what was the net impact on the national economy? There’s plenty of material for debate there. M continued: Society suffers as these monopolies extract the maximum price their markets will bear without collapsing. Innovation suffers because as long as the monopolist has a captive market there is little external economic pressure to improve efficiency. I most definitely disagree. The first sentence in the above quote describes a situation of extreme economic duress for the customers, who will therefore be extremely motivated to innovate their way out of their dependence on the monopolist. M. hoped that: A government monopolist is probably not going to squeeze the consumer as hard either. No, a government monopolist will squeeze much harder, in the absence of *any* counterforce. When the same people who run the businesses are the ones who run the schools, the media, the courts and the government, exactly where are you going to turn? And if there’s nowhere to turn, why would they not squeeze you as hard as they can? Out of the goodness of their hearts? M asked: Was their inefficiency and ineffectiveness at meeting consumer needs due to the fact that the businesses were monopolies (and hence had little motivation to improve), or was it primarily attributable just to their central planning? How can there be competition without a free market? How can there be central planning with a free market? You can have one or the other, but not both. M opined: China seems to maintain a significant amount of central economic planning while gradually freeing its markets by moving away from government monopolies and toward privately owned businesses. No. China maintains a political dictatorship, i.e. one party rule, state control over the media, censorship, jailing and execution of dissidents, but has been dismantling state run businesses and letting private ones run pretty much undisturbed as long as they make money and nothing else (i.e. trouble, as in free media). It’s not the first time the world sees this kind of mix between steel-fisted political dictatorship and pretty free market economics; another releatively recent example which comes to mind is Chile under Pinochet. As far as the economy is concerned, it’s not more centrally planned than the US. M then really made my day by reminding us all that: The aircraft and electronics industries were extensively funded and nurtured to maturity due to their usefulness for war. Yes. States with lots of resources – ultimately always derived from taxation, known as theft when any other entity engages in it – always do that, plow those resources down into military expenditures of one kind or another. After relieving their citizenry of the means needed to develop and build the weapons, they draft – a practice known as slavery when any other entity engages in it – their sons (and occasionally daughters) and send them out to kill other expendable young people like themselves using said weapons. I guess that’s why you assumed, a little while ago, that those who run state monopolies are inherently good and won’t squeeze as hard as private “monopolists”, correct? So, just to make sure that I got you right: states, i.e. the entities which use theft and slavery to start and run wars, are inherently good; companies, which offer goods on a free market for voluntary exchange, are inherently bad. Did I get that quite right? M claimed: The Internet was originally a military project. You are persumably thinking of ARPA-net, just one of the many – mostly academic – networks which grew independently and then fused into the Internet as we know it today. What made it into a mass phenomenon, hence relevant, was (1) the WWW, which as we all know was originally dreamed up at CERN (on European tax money, I’ll hand you that much) and (2) the mass availability of PCs, for which we can thank Xerox, Apple, IBM, MS, Dell et.al., in various degrees (see above). M claimed: The space industry would probably not exist yet without government funding. My guess, which is at least as good as yours, is that communication, earth resource and weather satellites – all most commercially viable – would be orbiting the earth now even if not one dime of tax money had ever gone into politically motivated moonwalks and other such nonsense, which historically absorbed most of the funds thrown into the “space” bin. I agree we would most probably not have those amazing videos of astronauts playing golf on the moon. The loss! M claimed: The railroad industry was given a significant push due to government grants in the 19th century. The thought which never seems to enter the mind of those talking about “government grants” is that the money in question came from somewhere – and no, it wan’t from the government, it was from something known as taxes. So, let’s see; first the government relieves workers and companies of their money, then (after taking its “own” ample cut) it hands some of that money back in various ways. That makes the government the giver of all good things? Let’s imagine the unimaginable, that companies and workers had been allowed to keep their money to do things like – oh, I don’t know, invest in railways, perhaps? Do you seriously believe that profitable activities wouldn’t be undertaken without the “aid” (actually, it should be properly called interference) of the government? M continued: Government funding of the intrastate and interstate highway systems involved huge outlays of funds Same illogic as for railroads. M reached new highs with this: Central planning has been important in maintaining the health of the farming industry, for example in price supports to prevent boom and bust cycles. Surely even you are aware that the farming “industry” in both the US and the EU is an unmitigated scandal, living off subsidies and protected by trade barriers against third world countries, all amounting to far more money being poured on fat Western farmers than what goes in “aid” to starving ones in the third world, the whole revolting state-run business resulting in Western consumers (yes, the same ones who finance the farm subsidies with their tax money) paying far more than they would in a free market for products which could be imported cheaply from people who are literally dying for a chance to sell their crops? The “health” of the US, EU (and to some extent Japanese) farming industry is nothing but. Farming is – or rather, should be – a business like all others. If it can’t be run profitably, it shouldn’t be run at all. Those “healthy” farms which you are looking at zombies. The sooner they are put to rest for good, the less further damage they will do. M continued: The Federal Reserve Board uses its power over the credit markets to try to keep things stable The artificially low interest rates dictated by the Federal Reserve Board (which, needless to say, should not be allowed to dictate any interest rates at all – there is no reason why the optimal price for borrowing money shouldn’t be set freely by the market, no matter what the duration of the loan) have created a whole series of bubbles, too long to even start rattling it off here. If you really believe the current situation is stable, I suggest that, as a first step, you peek at a chart over total US debt. M then surprised me with: and many would say that currently its policy of maintaining artifically low interest rates continues to encourage unnaturally rapid price increases in many housing markets. Yes, that’s the most well-advertised of the current Fed-induced bubbles. I thought you were talking about stability? M correctly summed up thusly: All in all, I think one could make a good argument that even the US has significant elements of central planning I must unfortunately agree. M then again lost me with: and that overall it has been to the good of the economy and society The US is great because it’s less regulated and central planned, i.e. more free, than most other countries. The US could be far greater still if it really lived up to the spirit of what got it started in the first place: that little tax revolt known as the Boston Tea Party. 10. Anonymous says: M wrote: there is something about the use of blind, automated trading, based only on recent activity without regard to any kind of fundamentals, that bothers me There, now you put your foot right in the ever-raging debate between fundamental and technical traders. 🙂 Most technicians would probably tell you that all available information is already priced into to market, so studying fundamentals is just a laborious and error-prone way of finding out what you can learn immediately from the price and volume charts. The fundamentalists would counter this by asking: ah, but what information can there be in a chart if every trader just looks at market action and nobody bothers to analyze the fundamentals any longer? My (obvious) answer is that, sooner or later, such behaviour will result in a bubble, with financial markets detaching themselves from the realities of the underlying real economy and taking on a brief but spectacular life all of their own. But, and here we come full circle, if you study the past behaviour of markets – as you must, if you want to be a technical trader – you can’t avoid learning about the existence of bubbles. In fact, you’ll get to know all kinds of interesting historical examples (tulip mania, South Sea Bubble, DJI ~1929, NDX ~2000…). If you are hard core enough, you will even find technical bubble signatures like the log-periodic oscillations of Sornette et.al.; but what you’ll defintely learn is the necessity of always keeping a watchful eye at least on a few fundamental indicators like price over earnings growth. Not to trade on from day to day – that’s futile – but at the very least as rough cuts to keep you out of the worst trouble, and more generally to give you a sense of overall direction over the longer term. Now, I don’t know what RenTech is doing – I guess nobody outside the company does, or is allowed to tell, at least – but if they are half as successful as claimed, I find it extremely hard to believe that they are not throwing fundamentals into the longer term part of their statistical analysis. M continued: This, in a sense, is indeed an efficiency improvement, although it is only of benefit to Ren. Tech’s clients rather than the investment community as a whole. It’s so tempting to quip “what’s good for RenTech is good for the markets”, but as long as they don’t pay me to do that, I’ll try to take a broader view. So, let’s remember who’s at the other side of trades entered by speculators. Another speculator? That’s one possibility. In that case, each individual trade may be a zero-sum game between speculators, but the sum of all those trades provides much of the previously mentioned liquidity and price discovery. Consider for instance the passage of Dennis through the Mexican Gulf. Last Friday, nobody could tell for sure whether the oil rigs and ports in the region would be hit, and if so how badly, and what the consequences would be for oil production and availability. Companies which depend on a steady flow of oil were looking at a risk. Now, the first thing which you want to do when dealing with a risk is quantify it. That means answering the question: how bad can it get? The activities of speculators in the oil futures markets provided an educated answer to that question, based on weather reports and publically available information about the daily volume of oil produced and off-loaded in the Gulf, the positions and repair status of oil rigs and ports, the safety measures (like taking personnel off platforms and suspending port operations) of companies in the region and so on. This amounted to a pretty sophisticated analysis, performed in real time in a distributed fashion by a large number of independent agents, all acting in – and sharply motivated by – their own self-interest. The consensus emerging from this operation, weighted by degree of conviction (a good measure of analysis effort spent) and speculative resources (a good measure of analysis resources) could be looked up as it evolved, tick by tick, by anyone with nternet access. That’s a pretty good societal service. But returning to the question of who’s at the other side of the trade: the other major possibility, if it isn’t a speculator, is that it’s a commercial trying to insure against a risk, a.k.a. a hedger. That’s the second thing you want to do when dealing with a risk: after you’ve quantified it, if you determine that circumstances call for it, you buy insurance against it. Last Friday, if you were a commercial depending on the price of oil for your operations, you could have bought insurance against supply disruptions in the form of oil futures or call options. The counterpart would have been a speculator, willing to take on the risk in exchange for the prospect of a profit. And here we find the answer to your question: if this speculator is successful, it’s because it has good risk management and analysis. From your point of view as a commercial seeking insurance, good risk management means that your counterpart won’t go bust and prove unable to pay you when it’s time to close the trade; good analysis means that it can take on larger volumes and offer you a better price than other speculators, who are less confident about the future direction of oil prices. Remember, when a commercial goes to the futures or options market to buy insurance, the speculators have to bid for the commercial’s business. M correctly observed: it seems the game now starts to change. Trading activity is now influenced by the same trading considerations as before, but an additional influence also starts to become important: the behavior of the automated trading systems themselves True. It’s often observed by technical traders that once an indicator becomes widely known and used, its efficiency declines rapidly, as everybody starts pre-empting its signals. To the extent that trading is a zero-sum game between speculators, this inevitably kills the profitability of the indicator, since all traders can’t possibly make money from it at the same time. The same reasoning applies when you employ statistical analysis to find patterns in past market action. You may not know the explicit form of the indicator(s) being used by your speculating counterparts, but if you can deduce how they’ll respond to future moves, that’s close enough. You’ll still have neutralized their advantage. So off they go to the drawing board (or, more likely, to the computer) to cook up something new. And so do you. I believe biology has plenty of behaviours and physical characteristics evolved in such a manner, with predators and preys, or even males and females of the same species successively adapting to each other’s adaptations in previous rounds. M continued: Over time, if blind, automated trading systems become the norm (as they would in an unregulated environment if they are more efficient than older systems), then I would expect an important shift in the rationality of affected kinds of speculative activity. What actually seems to happen is that the competing technical systems quickly start pre-empting and therefore neutralizing each other, as noted above. Even if this weren’t the case, it’s hard to see how regulation could help. Are we going to prohibit thinking up new trading strategies? How would such regulation be enforced? Prohibit computer-based trading? Bye bye NASDAQ – and just about every modern exchange in the world (even the last few strongholds of open outcry run electronic trading networks and will probably be fully screen based in a a few more years). Impose a limit on the number or speed of trades? Just sign up with more brokers, trade through more exchanges or make larger block trades (the latter really bad news for anyone wishing to see smooth, liquid, continuous market action). Impose a limit on daily volatility? Done already, after the crash of 1987 – automated trading systems were conveniently blamed, so automatic circuit breakers were put in place which would prevent a repeat performance (and proved pretty useless in 2000 and 2001; all they did was protact the agony rather than have it all go down in one full swoop). Ultimately, I just don’t see with what *right* a third party could come in and impose such regulations on the participants in a free market. Those who want to trade a market do, those who don’t want to don’t; those who want to start up a new market with their own rules can do so, too (and do, like the bunch of ECNs for stock trading which started up in the late 90s; the flavor of the day seems to be emission rights trading). 11. Alejandro Rivero says: Dear anonymous, Please let me apologise by the translation problem in the word “value”, and blame myself with Machado: “Solo un necio confunde valor con precio”. It seems to me, and this was my whole point, that pricing mechanisms depend on availability, and that any market system, willing to have exchange prices, must restrict availability by using ownership. The same applies, intriguingly, in Estate regulated economies, except that ownership is not exercised by individuals. I fail to see how Spanish America was a *internal* colonisation. As for Siberian, as you say, there is a component lacking: the willingness to go there and to stay there. Of course I do not like the old Spanish (et al) system of imposed values. Your suggestion surprised me, and it shows that I did not got to make myself clear in the previous posting. As for “evolution=confrontation”, I am pretty sure this is not a theory of evolution as applied by the biologists. Discussion could be perhaps a bit off from the blog entry topic, economy+physics. 12. M says: Hi Anonymous, You wrote: There is a system of resource allocation which is theoretically understood and empirically known to work very, very well: the free market. There is an alternative system of resource allocation which is theoretically understood and empirically known not to work well at all, leading to all sorts of imbalances (scarcities of needed goods and surpluses of unwanted ones) and typically collapsing after a few decades: central planning. First, I agree that overall, free markets are much preferable to centrally planned economies, and probably for similar reasons to yours. However, I am not aware of any truly free market in any developed, industrialized country, even though the U.S. probably comes as close to that “ideal” as any. I enclosed “ideal” in quotation marks because I think it is hard to argue that a truly free market is desirable for society as a whole, just as a centrally planned economy (the other extreme) is not desirable. From what I understand, a truly free market, i.e. a completely unregulated one, is in a kind of unstable equilibrium. Left alone, some competitors will emerge as the strongest, and monopolies form because there is nothing to prevent the most powerful from becoming powerful enough to completely dominate their market. At the point of monopoly the market is no longer free; the central planners aren’t in government, but they are in the company headquarters. Society suffers as these monopolies extract the maximum price their markets will bear without collapsing. Innovation suffers because as long as the monopolist has a captive market there is little external economic pressure to improve efficiency. And so on. I don’t think any of this is very controversial; it seems to be the way things have gone in times past when there was little regulation. I also imagine that you would favor government regulation to keep it from happening, provided it is kept to the minimum necessary to keep the markets as free as possible. The centrally planned economy you mentioned most prominently, the Soviet Union, is interesting because it also had government ownership of production. Thus, according to my understanding the government was also the monopolist in all key markets, which may be worse than having the different monopolists that emerge in a truly free market, but if so it seems more a matter of degree. (A government monopolist is probably not going to squeeze the consumer as hard either.) So an interesting question arises: Was their inefficiency and ineffectiveness at meeting consumer needs due to the fact that the businesses were monopolies (and hence had little motivation to improve), or was it primarily attributable just to their central planning? Also interestingly, China seems to maintain a significant amount of central economic planning while gradually freeing its markets by moving away from government monopolies and toward privately owned businesses. Since it continues to grow at a strong rate and is emerging as increasingly powerful on the world stage, it seems their example argues more against monopolies than central planning as the primary economic evil. But since giving up their monopolies means the government has less direct control, it may be hard to distinguish between the two. Even in the United States, government involvement has interfered with the natural course of free markets, but at least sometimes it has had very positive economic consequences. For example, consider the aircraft, space, electronics, railroad and automobile industries in the United States, which have been extremely important economically; at different times at least the automobile and electronics industries have been the single largest manufacturing employers in the US. The aircraft and electronics industries were extensively funded and nurtured to maturity due to their usefulness for war. The Internet was originally a military project. The space industry would probably not exist yet without government funding. The railroad industry was given a significant push due to government grants in the 19th century. Government funding of the intrastate and interstate highway systems involved huge outlays of funds and made the automobile more desirable. Central planning has been important in maintaining the health of the farming industry, for example in price supports to prevent boom and bust cycles. The Federal Reserve Board uses its power over the credit markets to try to keep things stable, and many would say that currently its policy of maintaining artifically low interest rates continues to encourage unnaturally rapid price increases in many housing markets. All in all, I think one could make a good argument that even the US has significant elements of central planning and that overall it has been to the good of the economy and society. 13. M says: Hi Anonymous, Well, am finally getting around to responding to you about your last comment in the discussion about computer-based trading of the kind Ren Tech seems to use, and whether it contributes any additional value to society or is just opportunistic. You seemed to take the view that it contributes new value in terms of improved efficiency: Just like technological competition between car manufacturers results in better cars for their customers, techonological competition between speculators results in better risk reduction, liquidity and price discovery for theirs (i.e. the “respectable” market participants). You may be right, but there is something about the use of blind, automated trading, based only on recent activity without regard to any kind of fundamentals, that bothers me. Recall that I agree speculators provide an important service. I also agree with you that efficiency improvements are important; they improve productivity. If an automobile manufacturer introduces significant efficiency improvements, competitors will notice and introduce their own improvements or probably lose market share. Similarly, if a large investment management firm produces superior returns due to rapid, automated trading systems, then its competitors will take notice and either introduce their own similar efficiencies or suffer competitive loss. Where I think the efficiency argument starts to break down is as follows. If the comment by “R” is indicative, i.e., RenTech has a large historical database of stock market price movements. The price movements have a lot of random noise, but also significant signals. The job is to identify the signals… then the trading strategy includes analyzing historical indicators together with current activity and then making trades accordingly. This, in a sense, is indeed an efficiency improvement, although it is only of benefit to Ren. Tech’s clients rather than the investment community as a whole. Assuming they maintain superior returns, others can be expected to employ similar tactics. However, it seems the game now starts to change. Trading activity is now influenced by the same trading considerations as before, but an additional influence also starts to become important: the behavior of the automated trading systems themselves. Historical data and analyses don’t fully reflect the trading patterns of these computer systems; trades by them are done for different reasons than the historical ones. So the trading systems must adapt to this new trading force; automated trading systems must factor in the activity of competing automated trading systems. Over time, if blind, automated trading systems become the norm (as they would in an unregulated environment if they are more efficient than older systems), then I would expect an important shift in the rationality of affected kinds of speculative activity. Trading activity may become less comprehensible to human traders, since blind, automated trading is at least one step removed from the historical forces that drive speculation (e.g., natural disasters, changes in political climate, changes in economic indicators). Left unchecked by regulation, I can imagine several kinds of undesirable consequences. Having rapid, automated trading as a significant force in speculative markets could make these markets less stable. People may be relatively slow, but this slowness can improve stability; significantly reducing this time by automation reduces feedback. Second, if having an automated trading system is the price of entry into some speculative markets, smaller investors except for the very brightest will probably be driven out. It is hard to see how the resulting concentration of power would be a good thing. Finally, if the nature of speculative trading changes significantly enough, it seems it will be less effective in providing its historical value to the economy. I guess I’m saying that I don’t see more than a superficial parallel between traditional efficiency improvements (e.g., in car manufacturing) where economic benefits are fairly clear, and efficiency improvements in speculative trading due to technical data driven automated trading. If the hazards I mentioned become reality then I would expect regulators to step in. If none of those hazards became important then it would probably be because the automated trading systems weren’t all that effective after all. Either way, I still don’t see how the enconomy as a whole will benefit from them; it still seems more like opportunism than additional value to society. 14. Anonymous says: A.R. wrote: proving that a system/theory/whatever is incorrect does not prove that an alternative id./id./id is correct. No, but pitting alternative systems against each other under varying conditions and seeing which one does better is a perfectly valid way to find out which one works best (biologists know the concept well as “evolution”). By now, only somebody incredibly (read willingly) ignorant of history could claim other than this kind of competitive stress test has been done many, many times over, always with the same result: planned economies fail (typically killing millions in the process), free market economies thrive. A.R. also wrote: As for free markets, the problem to me is not freedom, but market. In the sense of valuation, because I feel that the methods to impose value upon objects are defective. This statement shows that your problem is very much freedom. Freedom means that each individual chooses for him- or herself what constitutes value, and acts accordingly. There is no such thing as “methods to impose value” in a free market, only methods to peacefully achieve mutual, voluntary agreement on the correct *price* of X in terms of Y (and vice versa), leading to the optimal availability of *both*. If you value X more than Y, you give som Y in exchange for some X. If you value Y more than X, you give some X in exchange for some Y. Free market economies don’t impose preferences and values. Imposing values, i.e. telling others what they should like and dislike, want and not want, demand and abhor – that’s the business of dictatorships, which centrally planned economies must inevitably be. It’s obvious from your statements that your real reason to dislike free market economies is that they extract the fair price for the things which *you* value – let’s venture a guess, time to think about physics. It would be much nicer to get all that time for free, wouldn’t it? Except there is no such thing as a free lunch. If you don’t pay for it, somebody else has to do so instead. That’s what imposing values ultimately means: forcing others to pay for what you, not they, want. No longer voluntary agreements, a.k.a. trade, but brute force. That’s what you are advocating. A.R. also wrote: internal colonisation -go go west- was really a very special prerrogative of the USA No dear, it wasn’t. The medieval kingdoms of Spain and Portugal, incidentally societies much more in line with your preferences of imposed values, had the same prerogative in Latin America, and see how well that served them. Or if you’d prefer to talk about the Soviet Union, there was plenty of internal colonisation going on there too. Of course, those invaluable Siberian oil fields were not exactly created by voluntary workers, now were they? 15. Alejandro Rivero says: Note that proving that a system/theory/whatever is incorrect does not prove that an alternative id./id./id is correct. I believe this has been already argued in this blog when discussing about Quantum Gravity (or in physicsforums?) and I do not see apropiate to repeat all of it. As for free markets, the problem to me is not freedom, but market. In the sense of valuation, because I feel that the methods to impose value upon objects are defective. Time ago I dreamt of developing a “Physics of Ownership” by studying first valueless, scale invariant, markets as if they were fixed points, and then taking value -either via private or public retention, er, ownership- as a perturbation, analysing relevant and irrelevant parameters etc. (PS: internal colonisation -go go west- was really a very special prerrogative of the USA, and it distorts the whole perspective) 16. Anonymous says: Bah! To this day, even after the loss of the oil-rich, former Soviet republics in the south, Russia remains one of the planet’s largest oil producers and exporters. The Soviet Union of old controlled one sixth of Earth’s surface and was essentially self-sufficient in natural resources – or would have been, had it not been utterly unable to manage its natural wealth due to its dysfunctional central planning system of waste and corruption. So much for oil. As for colonisation, it was certainly neither invented by nor a prerogative of free market economies. Historically, every kingdom and empire which had the capacity to engage in that practice did so, right up to the last one of them, the former Soviet Empire, whose adventures in South East Asia, Africa and Latin America surely aren’t unknown to you. But needless to say, even that couldn’t save its fundamentally flawed system. 17. Alejandro Rivero says: There is a system of resource allocation which is theoretically understood and empirically known to work very, very well: the free market. I deny any scientific meaning to “empirically” above. Such empirical source was not under controlled conditions, and a blank experiment does not exist. Most free markets economies have enjoyed an external resource inflow from external (EU) or internal (US) colonisation process, and this inflow could cause the delusion of efficiency. Additionally, the availability of oil during the XXth century, sometimes becoming almost a free energy source, cast doubts about the equilibrium state. 18. Anonymous says: There is a system of resource allocation which is theoretically understood and empirically known to work very, very well: the free market. There is an alternative system of resource allocation which is theoretically understood and empirically known not to work well at all, leading to all sorts of imbalances (scarcities of needed goods and surpluses of unwanted ones) and typically collapsing after a few decades: central planning. So, you have a plate of good food and a plate of poison. Which mix of the two are you suggesting is optimal? 50% food and 50% poison? 90% food and 10% poison? In a free market, the allocation between “planners” (i.e. investors, speculators, traders and what have you) and producers of other goods is self-regulated by it just like the allocation between producers of any set of goods. Supply goes where there is demand to support it, or it will quickly be starved out and move on to other businesses. In a planned economy, even just a “partially” planned one like European social democracies, allocation decisions are made by politicians and bureocrats, i.e. people who have neither the analytic capabilities nor the information necessary to make sensible decisions, who are not constrained by the feedback mechanisms which make free markets self-correcting and whose own self-interest always calls for one thing only: steal more, spend more. In one word, poison. 19. Maynard Handley says: What good does trading provide? In a certain sense the financial markets are the world’s planning department; they sift through various proposals for how to invest money and choose those that appear to be most likely to generate profit. This is very obvious in the case of venture capitalists, it is somewhat more roundabout in the case of buying stock at the NYSE and thereby “voting” for or against Apple computer. Now one can levy at least two different types of criticism against this activity. * The first is generic “anti-money” sort of criticism, saying things like “the value of a new product is more (eg perhaps some medicine) or less (a newer bigger SUV) than just how much money it will make”. There’s probably validity to this argument, but beyond this overall agreement, people seem unable to make useful progress on either how to measure this beyond-money value, or how to construct a society (based on real human beings subject to all the corruption and evil of real human beings) to put into place these “beyond-money” ideas. So I find this line of criticism rather sterile. * A second line of criticism is to accept the necessity of the current system, but to quibble with details of it. The drugs vs SUVs issue can be tinkered with using taxes and CAFE standards, for example. Specifically, nnow, the issue is, yes these people are doing useful work in planning how the world should invest its money BUT (a) don’t reach a limit in terms of the value of this planning? Having 1% (to pick a number) of the world’s brain power spent on the task may be worthwhile, but perhaps the extra 1% spent taking this to 2% of the world’s brain power is better spent on making the things we’ve already planned to do work better? (b) isn’t most of the energy thrown at the problem actually involved in a zero sum game of attacking other participants in this space, meaning that reducing the amount of effort (brain power and computational power) thrown at the problem even by a factor of 10 would lead to precious little difference in the actual planning outcomes? I personally think both of these are perfectly valid criticisms, and I think society would be better off acting on them. For example small amounts of friction thrown into the system (transaction taxes, higher income taxes etc) would, IMHO, have pretty much zero influence on the actual outcomes for society, but would reduce the value of the exercise for many participants, thereby encouraging them to go off and do something more useful for society. (Naturally, of course, those in power would disagree with this claim. As always, use some common sense and ask yourself “cui bono”?) These ideas are explored at great length in Doug Henwood’s book _Wall Street_, available for download at http://www.wallstreetthebook.com/ 20. r says: Since I have known a few experimental physicists who have gone to RenTech, I thought a few late comments might be in order. But – warning – I have also heard a few math/physics and Wall Street talks, so I might be confusing some of these talks with some of the private RenTech discussions, or with discussions with others who know the RenTech people. RenTech has a large historical database of stock market price movements. The price movements have a lot of random noise, but also significant signals. The job is to identify the signals. It seems the technical people, who come from a variety of backgrounds and thus have different perspectives on how one identifies signals, basically are running an ongoing research project in which they put proposed signals into the model, and then test these against the historical data. I know little about the details of what they do. They do mention signing confidentiality agreements. From either them or others I recall terms like scale invaiance, Wigner random matrix theory, and Markovian statistics. My impression was that they just tend to be a little smarter / faster than other people, rather than being simply contrarian. But a friend’s impression was that they are simply better at hedging their risks, as opposed to really finding signals. So draw your own conclusions from this. 21. Alex R says: M wrote: The contrarian approach can evidently be successful if properly used, but one needs to be intelligent about it. … For example, I observe that nobody is building portable compact disc players with vacuum tube circuitry, but I also predict that if you decide to act contrary to this “majority opinion” and start building vacuum tube-based CD players that you won’t make billions of dollars from it. 🙂 While I, too, have problems with “contrarianism” as an investment philosophy (for example: what happens when *everyone* is trying to be contrarian?), I can’t resist pointing out that even your off-the-cuff “observation” about vacuum-tube based CD-players is incorrect. (OK, strictly speaking, I don’t know how many of these are portable, and I doubt anyone is making billions of dollars in this market, but the market is there.) The point here is not so much that one should be contrary for the sake of being contrary, but that many people make unquestioned assumptions about things based on conventional wisdom or common knowledge, and that it can pay to *discover* what those unquestioned assumptions are (often the hardest part!) and to *question* the conventional wisdom they are based on. 22. Anonymous says: Yeah, right. 23. Arun says: There are too many errors in the previous to correct on a blog devoted to Not Even Wrong physics theories. So I’ll say no more. 24. Anonymous says: Arun wrote: “Profit is the market economy’s measure of the value of the good being provided” is simply wrong. No. It depends on how you interpret “good being provided”. Using your implied interpretation, the statement would be technically correct if it said “added value” instead of just “value”. If you separate out “the good being provided” as what’s added by the provider, and the rest of it (e.g. materials required to produce it) as just being passed along, the “added” is implied and the statement is technically correct as is. Not that any of this silly marking of words is of any relevance to the point made. Arun also wrote: Secondly, there would be lot of profits being made by some traders if the USA had fifty currencies instead of one. The economic benefit of having one currency however outweighs all these profits. Perhaps. So what? Given any set of currencies, it’s better to have speculators trading them freely than not having speculators trading them freely. That’s the point. Arun the illogically added: Similarly, it is not at all obvious that speculators are doing something useful First of all, there is no similarity between the arguments; and secondly, it’s quite obvious that speculators are indeed doing something useful, as previously pointed out. And, I may add, they are doing it of their own free will, with their own money, coercing nobody into trading with them – so what’s your problem, exactly? Arun continued: or whether they are simply living off an inefficiency of the market economy Elementary knowledge of economics would tell you that it’s exactly the process of “living off inefficiencies”, a.k.a. arbitrage, that minimizes those inefficiencies. Wherfeafter Arun surprisingly did admit that: The market economy is simply an optimizing machine. The best one there is. And incidentally the only moral one, since it’s the only one based on participants acting out of free mutual consent for mutual benefit. What more could you possibly ask for? 25. Tony Smith says: M said “… speculative activity is … important in other fields like science or art, notwithstanding the many, inevitable dead ends …”. Is conventional superstring theory analogous to a dead-end speculative bubble ? Tony Smith http://www.valdostamuseum.org/hamsmith/ 26. Arun says: “Profit is the market economy’s measure of the value of the good being provided” is simply wrong. The market economy’s value for a good being provided is the price of the good. The value of a United Airlines flight is the same as the value of an equivalent Southwest Airlines flight – that is why the ticket prices cannot be substantially different. That one company makes a profit while the other is in bankruptcy is a measure of the different costs incurred by the respective airlines, and not a difference in the value of the good to the market economy. Secondly, there would be lot of profits being made by some traders if the USA had fifty currencies instead of one. The economic benefit of having one currency however outweighs all these profits. As a matter of fact, the market economy is ***more efficient*** by having one currency instead of fifty. Similarly, it is not at all obvious that speculators are doing something useful, or whether they are simply living off an inefficiency of the market economy similar to that of having fifty currencies. The market economy will also yield efficiences and profits in the sale of slaves or narcotics just as well as in derivatives. The market economy is simply an optimizing machine. The economic activity, profits, etc., or making hte optimizing machinery work better are not a justification for what we ought to or ought not to trade in, or whether some forms of trading have any social value or not. 27. Anonymous says: The improvement of speculative trading methods (e.g. by automation and more refined statistical analysis) means by definition that the speculator’s business becomes more profitable. Profit is the market economy’s measure of the value of the good being provided. Hence, the improvement of speculative trading methods increases the speculator’s value to the economy. See it like this: a bad (i.e. unsuccessful) speculator doesn’t survive as a speculator for long, and can therefore not keep providing the aforementioned valuable services (risk reduction, liquidity, price discovery) to others. A successful speculator can; a more successful speculator can do it more, and more efficiently. Just like technological competition between car manufacturers results in better cars for their customers, techonological competition between speculators results in better risk reduction, liquidity and price discovery for theirs (i.e. the “respectable” market participants). 28. M says: Hi Dick and Anonymous, Actually, I wasn’t thinking about speculators in general, just the kind of rapid, computer-based trading systems such as what Sean mentioned Renaissance uses. I fully agree with you that speculators play a valuable role in the economy, provided it is not excessive (and speculative activity is likewise important in other fields like science or art, notwithstanding the many, inevitable dead ends). On the other hand, my understanding is that this kind of computer-based speculative trading does not provide a service that didn’t already exist — market makers of various kinds already have established their niches and seem to have efficiently performed their services to the markets for some time now. Thus, it seems that automated, proprietary trading systems that offer superior returns to a single investment company’s customers do not provide a similar benefit to the economy as a whole, unless of course that company is the sole occupant of its niche. Without providing new value, the net effect of this strategy on the overall economy would basically be to redistribute existing wealth rather than create new wealth. This seems more like opportunism, and I don’t see that as something to admire… 29. carl says: As far as physicists being impressed by money, I recall an invited talk by S. Thorpe at a particle physics seminar on the subject of how he made$93 million.

That would have been about 1984 or 85. I read his book on black jack, so after this many years I can’t recall if his talk included that subject, or was entirely on how he was making money based on options pricing.

Carl

30. Andreas says:

Of course, there are societal benefits to expect from speculators if society itself is perceived as a market. While many intelligent and respectable individuals indeed see society as a great market place, such a perception is a bizarre delusion of human reality. Unfortunately, this distorted vision leads global society into crisis.

31. Anonymous says:

There are several well known answers to the question of market speculation’s societal value.

1) Speculators assume financial risks in exchange for future returns (hopefully). Those risks don’t come out of the blue; they come from the balance books of people who do not want or can not afford them. By taking over those risks, speculators perform a service.

2) The presence of speculators in the market makes ir more liquid, improving its ability to accomodate long term investors and commercial operators when they need to perform market operations in the course of their respectable business.

3) Closely related to point 2: speculators improve the market’s ability to function as a price discovery mechanism, i.e. a way to determine the current value of an asset you hold. If you are a commercial company or long term investor, you feel a lot happier knowing not only that there are many buyers and sellers of the stuff on your books, but also knowing at what price they are willing to trade right now, not a week or a month ago.

So yes, unlike string theorists (just to pick a random example) speculators perform very useful services for the economy and therefore for society as a whole.

32. Dick Thompson says:

M, you said

… The Code actually does the buying and selling, much faster than a human ever could. And it doesn’t know, or care, what it is buying or selling; all it knows are the statistics of past performance.

The question that comes to mind is, where the value to society in that? No value is being produced except to those who invested in Rennaisance or work there (at least that I can see), and even there, such a strategy basically seems like a zero sum game.

The value that arbitrageurs, hedgers and such provide to the generality is making a market. Providing opportunities for others to buy and sell where they might not otherwise have had the opportunity. The fact that the code can do this at blinding speed is all to the good.

33. Arun says:

M, I too wonder. If there is, e.g., social value in trading currencies, currency futures, hedging against currency rate fluctuations, then the US could do itself great good by letting each state have its own currency, creating so much more opportunity to play these games. The Euro was then a step backwards and so on.

34. M says:

Regarding my earlier question about differences in viewpoint between physicists/mathematicians and the population as a whole in the respect/awe given to those who have accumulated great wealth:

It seems like most people who gave an opinion don’t see a lot of difference between those who are highly educated in analytical fields like physics and mathematics and the general population when it comes to views about great wealth. There is good food for thought in the responses, at least for me. I especially liked Andreas’ thoughts about the limited correlation between wisdom and intellect/education, and how that might limit significant differences from the general population; it makes sense to me.

I also agree with Walt that having $2.5 billion would eliminate the need to worry about income, potentially freeing up time to do physics or mathematics. But I think this potential is kind of an illusion. If you have that much money and you are like most people, your wealth is going to have a major impact on what you do with your time. If you are conscientious you will try to manage your money carefully, which takes time; even if you let others do the managing, you will still need to pay attention, and it seems like that would interfere with creativity. If you are more carefree, you will spend a lot of that money freely, and that too will be a distraction from intense, creative thought. Either way, it seems like great wealth would be more of a hindrance than a help to doing good physics or math. However, I do agree that financial independence is desirable for doing good work for its own sake. Worries about money kill creativity and lead people to direct their energies to meet practical demands, like career growth or just getting by. As Peter and others have repeatedly pointed out, the need to follow what is popular just to survive is not healthy for science. But… How much money is needed for that independence? Billions? Hardly — it is hard to see how anyone could productively use more than$100 million or so for their own needs. That would buy a very nice house, a yacht, maybe a private island, and leave plenty of money left over to live comfortably. I guess that is part of the reason I would naively hope that highly educated, analytical people might have less envy or awe of billionaires than the general population — they could see that beyond a certain point there is little practical advantage to having more wealth. Beyond that point, it seems like its main benefit is to keep score, to have bragging rights to making the most dough. It seems like there is no place for worrying about being in the really big financial leagues if a person loves science, the attainment of knowledge and understanding, and who strives to make a contribution there. (I am omitting philanthropy as a major issue. It is great when wealthy people spread it around, but I can’t imagine that very many people become wealthy just so they can be philanthropists.)

Something Sean said about a strategy of Rennaisance Technologies disturbs me at another level:

… The Code actually does the buying and selling, much faster than a human ever could. And it doesn’t know, or care, what it is buying or selling; all it knows are the statistics of past performance.

The question that comes to mind is, where the value to society in that? No value is being produced except to those who invested in Rennaisance or work there (at least that I can see), and even there, such a strategy basically seems like a zero sum game. Because there is no new value, wealth is merely being redistributed rather than created. Society as a whole does not benefit; only the names of the winners and losers change. I guess I don’t see what is admirable about playing games like that, and even if the players are rich I feel differently about them than those who become wealthy by making society richer as a whole due to their efforts. (I’m referring to the movers and shakers, not the people who are just trying to make a living at what they do well.) This is in contrast to those who build businesses that create new markets, or long term investors who allow companies to grow and become strong, even if it’s partly at the expense of weaker companies that will probably wither later anyway. Regardless of whether they are doing it to earn bragging rights, at least society gains value in the process. And if they make some serious money in the process, that’s fine with me.

I wonder if I am in a small minority in these views…

35. Chris Oakley says:

Mathematics should be an extension of common sense rather than a replacement. This is something that most people wowed by mathematics PhD’s in finance don’t seem to appreciate.

The LTCM disaster was just maths/physics PhDs doing dumb things, the sort of dumb things that no-one who didn’t have a cocky belief that he was smarter than everyone else would do.

And all Joe Jett was doing was arbitraging the internal accounting system. It was so ridiculously simple that Kidder/Peabody should have been, and probably were ashamed of themselves for allowing it to happen.

36. Andreas says:

M,

to realize that envy for wealth (i.e., economic power) and wealth worship are pointless requires a certain level of personal wisdom. Wisdom, however, is usually uncorrelated with intellect or education, much in the same manner as technology is uncorrelated with culture. Hence, I expect any highly educated individual in the analytic fields be as much susceptible to money as anybody else. For instance, I think of mathematicians like John Nash, De Branges and, surely, Jim Simons.

37. Anonymous says:

In order to be a success at anything or make huge amounts of money you have to love what you do; in fact, love it so much that it’s not actually a job. A lot of physics and math people are like that, myself included. I can relate to the guy who said he worked in a financial institution and hated it. I tried to get into financial math at one point since people I knew were doing it and wanting to go in that direction. I just found it incredibly boring. I am not saying it is boring–some people will get really into it and that’s fine–but for me personally I could’nt do that stuff no matter how much I was being paid. I find it really soulless.

I was also under the impression though that the financial world is more wary of math and physics types due to a number of high-profile disasters in the 90s involving “rocket scientist” types,
like the LTCM meltdown and the Joseph Jett/Kidder Peabody affair.

38. Anonymous says:

Yeah, unless the $2.5 billion and the people you hire to help manage it end up running your life and taking up most of your time. Some people can handle that kind of wealth and remain creative and happy, and some can’t. I’m sure Simons took plenty of time figuring out where he fell in that spectrum. 39. Walt Pohl says: M: I think it’s an ordinary human impulse, not something that requires special explanation. Even if you only care about mathematics or physics, you could do more of either with 2.5 billion dollars than you could without. 40. Anonymous says: “Are people who are highly educated in analytical fields like physics and mathematics similarly susceptible to the wealth envy or wealth worship?” Of course, some are and some aren’t. When I was younger, at the insistence of my supposedly intelligent family and friends, I got a job at a financial institution dealing in the fixed interest derivatives market. I worked with another mathematically trained individual. I started on$40 000 a year. I estimate that he was on about $500 000 a year. He made the company lots of money. I hated every minute of it. I lasted a year and a half – I don’t know how. I left on the dot of 5 o’clock every day, and the only people I was friendly with were the secretary and a woman in accounts. I’m guessing that I was the only technical staff member that was ever expected to actually stay for the one month after I gave notice, because they had no doubts whatsoever that I wasn’t simply moving to another investment firm. Now I’m a little older, and probably no wiser, but I don’t let people boss me around any more. I know many in Maths and Physics like myself. Then again, the guy in the office next to me is currently applying for jobs in banks. It takes all types to make the world…. 41. Quantoken says: Mr. M: Doing something other than what majority of the gang is doing is ONLY a necessary condition for success, NOT a sufficient condition. Clearly if you follow the gang and do identical things the end result could only be failure, not success. Now you ask why not build vacuum tube based CD players, just because no one else does? Well if you look around this world there are too many of this kind of hyperthetical “no body else does” things to enumerate. You could not try all of them. Actually vacuum tubes are still being used today as advanced technology. The largest vacuum tube is 25 miles long and burned underground in Geneva. They are still building it and it’s called LHC. It’s very different from your TV tube, certainly, but it is a vacuum tube nevertheless and it works on the same physics principle with allow particles to travel in the vacuum and electromagnetic fields are used to accelerate them and bend them. You might ask maybe you can build an accelerator without the vacuum tube, just like you can build a CD player without vacuum tube. Quantoken 42. JC says: M, The first “group” in your categorization would perhaps fit into the background of somebody like an Einstein and/or Paul Erdos. Only other people I can think of who could possibly fit into a similar type of categorization (albeit in a different field), would perhaps be people who take a vow of poverty and enter the clergy. 43. M says: This topic has the potential to generate a lot of interesting comments, so I hope Peter will relax his standards a bit for being “on topic” and let well thought out comments remain. It appears that the financial industry is an important employer of physicists and mathematicians, so this seems like a useful topic. I have what is more of a sociological question about perceptions of mathematicians and physicists about wealth and wealth creation, if anyone knows. The basic question: Are people who are highly educated in analytical fields like physics and mathematics similarly susceptible to the “wealth envy” or “wealth worship” that the general population seems to have? For example, Peter’s mention of Jim Simons as managing a$5 billion fund and having \$2.5 billion in personal wealth would undoubtedly evoke awe in a very sizable fraction of the population, regardless of whether he donated any of it for increasing human knowledge. Would physicists and mathematicians have that same awe in similar proportions?

If mathematicians and physicists are similarly awed, a secondary question is, “Why?”

I can speak with more understanding of physicists, but perhaps the comments apply equally well to mathematicians. On the one hand, many of us are attracted to physics for idealistic reasons. We want to make a contribution to human knowledge, and hopefully make society better as a result. We also like the challenge of difficult problems and enjoy the excitement of making discoveries or gaining insight. Perhaps a relatively small subset of this group is driven by a deep need to understand and make sense of the physical world; this goes beyond just doing something that is fun and interesting. Certainly the route to becoming a physicist involves a lot of hard work, and hopefully most realize that in the end there is little likelihood of becoming fabulously wealthy, and hopefully most realize that employment in the field is definitely not guaranteed.

There also seems to be another fraction who see physics and mathematics as very challenging fields that are beyond the ability of most of the population to become active participants. Thus, by entering these fields they can not only do something they are good at but they can (perhaps unconsciously) also impress others by their mental acuity, thus gaining respect (and maybe even some awe) of others.

I guess I would expect the second “group” to be more likely to have great respect for a very wealthy person, simply because these people place some premium on success according to traditional societal standards. But what of the first group?

44. M says:

From Quantoken:

The secret is do the EXACT OPPOSITE thing of what other people would be doing. Make sure you are always the minority. That way, you make money?

The contrarian approach can evidently be successful if properly used, but one needs to be intelligent about it. Just because you’re in the minority doesn’t mean you’ll make money, just as the early bird doesn’t always get the worm (especially if the worm starts roaming around after the bird has hunted for its meal). For example, I observe that nobody is building portable compact disc players with vacuum tube circuitry, but I also predict that if you decide to act contrary to this “majority opinion” and start building vacuum tube-based CD players that you won’t make billions of dollars from it. 🙂

45. Dick Thompson says:

The contrarian strategy is natural for a hedge fund like Renaissance because the idea of a hedge is to invest in something that will pay off if the main investments go sour. I saw the word commodities pop up in these comments. Hedging commodities is a big deal. For example if you are a technology industry with a need for gold in your processes, then you will want to hedge against price swings in gold. You will play around with futures, other metals, things that historically go up when gold goes down and vice versa.

46. JC says:

– Sean,

Sounds like an exercise in “data mining”. The biggest problem is determining whether a correlation in a data set is just spurious (and meaningless) or if there’s a genuine causality with particular “events”. Many spurious correlations seem to come and go in a “fly by night” manner.

– Quantoken,

This is better known as the strategy of being a “contrarian”. Though being a contrarian isn’t always the easiest strategy either, especially if one is into short selling overvalued stocks.

47. Sean says:

I visited Renaissance once to give a colloquium. A fun place, full of smart ex-scientists making boatloads of money. The basic idea is to have a computer program (“The Code”) look at past performance of various commodities, and use that info to guess what will happen next. The Code actually does the buying and selling, much faster than a human ever could. And it doesn’t know, or care, what it is buying or selling; all it knows are the statistics of past performance.

Of course, going from past performance to future behavior is highly nontrivial. That’s what they aren’t able to talk about. Some day almost all trading will be done by dueling algorithms (or is that already true?).

48. Quantoken says:

Oh no, Chris Oakley. “Buy low, sell high” is NOT the secret. It is not followable, most times the market will force you or allure you to do exactly the opposite thing, because market can not be forecasted, without future forecast, you really don’t know what is high and what is low.

OK, here is the real secret. I do not need to kill you. But I bet majority of the audience here would not be able to follow it, except for a few lucky ones. Ready?

The secret is do the EXACT OPPOSITE thing of what other people would be doing. Make sure you are always the minority. That way, you make money?

Why? Because no system could support a model where the majority of people, 99%, becomes billionares, and only a minority, 1%, go bankrupt. The only plausible model that’s sustainable is one where 99% of people lose money and 1% becomes billionaire.

So if you see 99% of people doing the same thing and the other 1% doing the opposite, you can bet that 99% is a losing deal and you should join the 1%.

The slogan is be crazy and be different from an average person.

Quantoken

49. Chris Oakley says:

Actually I know the strategy that Simons is following. I am going to share it with readers of this blog, but if I discover that anyone has leaked it to any outsiders, then I will personally come round and kill them.