By Noah Smith
It takes more than theory to make money, as a trail of infamous financial collapses by lauded economists shows
In 1996, Jay Ritter, a finance professor at the University of Florida’s Warrington College of Business, published a rueful essay in the journal Financial Management, recounting a story of how he lost money in the markets. It started with a victory: Thinking he had detected a pattern in the futures market, he and some other professors bet some money on it and won. Encouraged, they doubled down, only to find that the pattern had disappeared. Eventually, Ritter learned that the legendary Fischer Black of Goldman Sachs had figured out what he and others like him were doing and had traded against him, thus taking his money.
Ritter is far from alone. His funny little joke on finance professors has found echoes in much bigger arenas, for much bigger stakes. Myron Scholes — who won a Nobel Prize in 1997 — helped found the hedge fund Long-Term Capital Management, which famously blew up in 1998. After that fiasco, Scholes served as chairman of another hedge fund, Platinum Grove Asset Management. Platinum Grove suffered devastating losses in the financial crisis of 2008, and Scholes retired as chairman in 2011.
Other top academics have fared little better in market ventures. Robert Merton, who shared the Nobel with Scholes and was one of the most mathematically gifted financial economists of his generation, was also on the Long-Term Capital Management team. Andrew Lo, a legendary financial economist and head of MIT’s Laboratory for Financial Engineering, founded a money management company called Alpha Simplex Group, but its performance was underwhelming.
This phenomenon is not new. Irving Fisher, a macroeconomist whose theories about monetary policy and inflation are still hugely influential, made a killing when he invented the rolodex. But he lost his fortune in the stock market crash of 1929, after making the famous, tragic statement that stock prices had reached a “permanently high plateau”.
These are some of the top finance and economics professors in history. Their deep and penetrating research has revolutionised the world of academic finance. To call them brilliant would be an understatement. So why have they stumbled in the private sector? And why do relatively few of their academic colleagues launch their own funds?
One possibility is that the kind of thinking that works for research is not suited to the business world. The private sector is fast-paced; academic research is slow and deep. Businesses rely heavily on teamwork; academia is often solitary.
Isaac Newton would seem to confirm this theory. After losing his money in the South Sea Bubble of 1720, Newton reportedly declared, “I can calculate the movement of stars, but not the madness of men”.
This explanation overlooks the fact that many academics do make a killing in the financial markets. The most famous example is James Simons, founder of the hedge fund management firm Renaissance Technologies. A legendary geometry professor, Simons was equally successful in the market, and is now a billionaire (and a major contributor to my university, Stony Brook, where he once worked). Another example is computer scientist and biologist David Shaw, who founded the hedge fund D.E. Shaw & Co. and also became a billionaire. Both of these firms, and many others, hire scholars to design and carry out their strategies.
Perhaps those who most successfully make the transition from academia to finance come from fields like math, applied math, and computer science, rather than from economics and finance.
Economics is a theory-centric field. Until the last decade or so, theory dominated the literature and empirics took a back seat. In the world of engineering and practical application, that is a recipe for trouble. Theories that have not been rigorously tested against data may get papers published and may win Nobel prizes, but they will not necessarily work when you try to apply them.
That is doubly true in the financial markets, where there are few permanent principles. Asset prices move not according to the fixed laws of nature, but according to the actions of human beings — market participants, investors, and traders. Human actions may sometimes obey laws, but often they will not, and that is when economic theories will fail.
In other words, the heavy theoretical focus of economics may have hurt Scholes, Merton and the rest. That is, of course, just a theory on my part. But if it’s true, it means that hedge funds should look for academic talent in the fields of applied math and computer science instead of in economics departments and business schools.