You Didn't Know Quants Make So Much Money in the Stock Market! Story of Two Investing Wizards

Tue, Jan 19, 2021 5:23 AM on Stock Market, Exclusive, Recommended,

- Bivek Neupane

Who Are Quants?

The capital markets were quite different back in the 60s and 70s (US capital market/ Wall Street is taken as a reference here). The prime focus was on the brokerage business and investment banking deals were thriving. The field of quantitative research was growing gradually but the research done at that time was centered around using basic statistics and heavily focused on using fundamental and technical analysis.

However, in the early 80s, as the big banks like J.P Morgan, Morgan Stanley, Goldman Sachs, Citi Group, etc. were rapidly increasing their budgets for their respective trading departments, a certain group was slowly making their mark in the biggest casino of the world. Most often characterized by nerdy outfits, social awkwardness, their fascination with working with computers, and most importantly being very good with numbers. Really really good with numbers.

These people were coming from a very technical field and often from natural sciences. They would have multiple degrees and doctorates in Mathematics, Statistics/ Probability theory, Physics, Computer Science, etc. They did not know the first thing about finance, at least in a traditional sense. They were rather experts in say, using incorporate Stochastic calculus and Brownian motion to develop a derivative pricing model. And, this surely was not understood by literally anybody on Wall Street at that time.

So, how did they survive and thrive in that environment? Well, the 70s and 80s were perhaps the most glorious decade for innovation in finance. Lots of things were happening. Black, Scholes, and Merton published their model for option pricing, Fama and French were promoting their theory of market efficiency, products like portfolio insurance, credit default swaps, asset-backed securities were changing the landscape of Wall Street.

As the demand for these products was growing more and more, the executives in the major banks felt that they had to hire those geeks to help them understand and make money for them. A lot of those quants went on to do many great things and even started their own hedge funds.

Today, I am going to briefly discuss two of the giants in the world of quantitative finance and my personal investing heroes :

1. Ed Thorp

Well, let’s start with the “Godfather of Quants”. Edward Thorp was born in the early 1930s in Chicago, USA. If one had to summarize Thorp in one word, it would definitely be “genius”. This is because he really is a genius. If you have ever played blackjack or roulette or even just seen movies concerning these games that are related to probability, Dr. Thorp is always there. How? That is because he was the first person to ever come up with a mathematical model to actually beat the casinos in their own game.

Oh yeah, and by the way, he has graduate and doctoral degrees in Physics and Mathematics (forgot completely). He, with little added help from Claude Shannon (a.k.a Father of information theory), also developed the first wearable computer which they used in the casinos to figure out where the ball would land (statistically speaking) in the roulette table after a spin. They used Newtonian physics to uncover that mystery. He, later on, wrote a book called “Beat the dealer” which was a best seller. Not surprisingly, all the casinos banned Thorp.

Now that he had already cracked the code of casinos, he was seeking his next challenge. He stumbled upon Financial Markets. More specifically, in the realm of Options (a derivative instrument). He then developed the world’s first option pricing model. Now, if you follow financial history and markets, you must surely know the famous Black-Scholes Option Pricing Model for which the authors won the Nobel prize. What you may not know is that Ed had already developed a pricing model for options almost 7 years before Black-Scholes did.

However, since he was running a hedge fund at that time, he decided not to publish his findings and kept it as a trade secret. Because of that, he made extraordinary returns. His performance track record is out of this world. Not only he averaged more than 20 percent over 30 years, but he also had a positive return for 227 months out of 230 months of trading options. If you subscribe to the concept of the Efficient Market Hypothesis, this would mean that the chance of him being able to do that is nearly impossible.

In fact, the odds are 1 out of 1063, or in other words, one would have 1 in trillion times better chance of randomly selecting an atom on earth than getting similar results. Now you see why I was referring to him as a genius! Soon after his tremendous success in markets, he again decided to pen his works in books like “Beat the market” and “Man for all Markets”. If you are interested in math, probability, and markets, I highly recommend his books.

2. Cliff Asness

Asness is perhaps one of the most scientific thinkers in the world of finance. He grew up as a stereotypical nerd who loved computers, math, and comic books. His college studies involved majoring in computer science and finance. Later on, he went on to do a Ph.D. in Finance from the University of Chicago. His doctoral thesis supervisors were Eugene Fama and Kenneth French, the brains behind the Efficient Market Hypothesis (EMH).

Asness started his career at Goldman Sachs when he was still a student at the University. After working for a few years in Goldman, he and a few of his colleagues decided to launch their Hedge fund called AQR. AQR is filled with really smart people and they almost every month produce fantastic empirical research and publish it on their website. I cannot stress this point more. Hedge funds are notorious for keeping the research and findings within themselves. However, AQR has chosen a different route. They are the leaders in open communication of ideas, concepts, and strategies.

If you have ever heard about factor models used to create portfolios and the anomalies to EMH like value, momentum, size, etc., Asness is the one leading the way in utilizing these tools and developing new strategies and products for investors, both institutional and retail. As a matter of fact, he is also responsible for finding the momentum anomaly while he was writing his Ph.D. paper. If you are interested in empirical finance research and quantitative investment strategies, I highly recommend checking out AQR’s research papers.

Some of the other quants that I follow are Paul Wilmott, Emanuel Derman, Andrew Lo (Best finance Professor hands down), Wes Gray, Rob Arnott, etc.

P.S: I talked about their works only because they impress me the most. But if you are one of those who only follow financially successful people, let me share with you that Cliff is a Billionaire and Thorp’s net worth is about 600 million dollars.

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