Renaissance man

Alea reports a talk that James Simons, founder of Renaissance Technologies, gave at NYU recently. Simons is a highly successful quant investor so his remarks are interesting. The part of the Alea article that really piqued my interest was:

[...] perhaps the most interesting observation came in response to a question posed by the moderator, Nobel Prize-winner Robert Engle: “Why don’t you publish your research, the theory behind your trading methods? If not while you are active in the markets, perhaps later on.”

Simons’ reply – there is nothing to publish. Quantitative investment is not physics. The markets have no fundamental, set-in-stone truths, no immutable laws. Financial “truth” changes constantly, so that a new paper would be needed almost every week.

The implication is that there is no eternal theorem of finance that could serve as an infallible guide through all the ages. Indeed, there can be no Einstein or Newton of finance. Even the math genius raking in $1 billion and consistently generating 30%-plus annual returns wouldn’t qualify. The terrain is just too lawless.

Simon's view seems to me to be obviously true, although I don't quite agree with the Alea spin. It isn't that there is no law, it is that the law changes as the behaviour of market participants change. Yesterday's arb is today's theorem is tomorrow's unrealistic simplification. As I said over a year ago, mostly the market trades based on the current orthodoxy. But big news changes that orthodoxy - as is happening at the moment in the liquidity markets, and so to make a lot of money you need to be willing to keep changing your theory of asset prices.

This neatly brings me to a related topic, the non-equilibrium nature of financial markets. In retrospect, Walras' idea of an auctioneer groping towards equilibrium (word of the week - tâtonnement) is really unhelpful because it suggests that there is enough time for this process to be completed and equilibrium reached before the next piece of news hits the market. I don't think this is true. Rather I conjecture that the process is much more like a game of tetherball, with each new news item changing people's opinions and hence moving the market long before equilibrium is reached from the previous piece. The ball almost never hangs by the pole, so any theory which analyses where it will come to rest isn't much use in determining who is going to win the game.

The last piece of the puzzle is the primary role of transactions. There are no prices without transactions to establish them - lots of transactions. So it is only opinions about asset prices which lead to trading that matter. You can be right for a long period about the fundamentals, but if your assumption about how fundamentals lead to trading is wrong then you will lose money. For example I called the weakness of Japan completely correctly through the 2nd half of the 1990s and first half of 2000s, but I was wrong for extended periods on dollar/yen because I hadn't accounted for the actions of the BoJ and other market participants beliefs about the BoJ. To make a lot of money you need to predict what most other market participants trading-related beliefs will be and get your position on before they do. Predicting fundamentals is only useful if they will influence future trading: on the flip side, predicting wrong beliefs is just as good as predicting right ones if they pertain for long enough for you to make money.