Wednesday, August 18, 2010

The Quants by Scott Patterson ****

What caused our recent financial difficulties? Greed? Stupidity? Wall Street? The Government? The Quants by Wall Street Journal reporter Scott Patterson places the blame squarely on PhD Mathematicians. PhD Mathematicians!

There have been other theories about the causes of our economics woes, equally convincing, but this is particularly interesting for its emphasis on mathematics and mathematicians.

I found two points surprising. First, how did the financial powers put trillions (12 zeros!) of dollars in the hand of mathematicians? Second, how did the mathematicians make a mistake when the flaw in their models was published almost 50 years ago by none other than Benoit Mandelbroit. Don't be too concerned if you've never heard of Mandelbroit, ALL the mathematicians certainly had.

Do you think you might be able to understand when fooled all these PhD mathematicians? Certainly you can! Consider the distributions of sequences of heads and tails from flipping a coin. Most often the sequence is HTHTHT, but rarely you might see HHHHHH or if you kept flipping for a very long time you might see 100 heads in a row. This is called a Normal Distribution and this is the distribution all these PhD mathematicians used to model the financial system. The important characteristic of this distribution is: if you flip the coin one more time, nothing much can change over all.

Mandelbroit discovered another distribution than looks a lot like the Normal Distribution, except things like 100 heads in a row are more common. This distribution is not like flipping coins, but more like asking people their annual earnings or net worth. Imagine we walk down the street in Seattle and asking people how much money they have. After thousands of people we might find the average to be $200,000. After a thousand more, it might still be close to the same number. As opposed to the coin flipping where one more flip can make little difference, if this case, if the next person we meet is Bill Gates, the average will jump to over $10,000,000. This process is most certainly not a Normal Distribution, and more closely models financial systems.

Certainly a big OOPS.

The story is fascinating for anyone with an interest in numbers and dollars.

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