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Transcription of interview with James Owen Weatherall on June 3, 2013.

Douglas Goldstein, CFP�, Financial Planner & Investment Advisor

James Owen Weatherall is an Assistant Professor of Logic and Philosophy of Science at the

University of California in Irvine. He recently came out with a new book called the Physics

of Wall Street.

Douglas Goldstein, financial planner & investment advisor, interviewed Weatherall on Arutz Sheva

Radio.

Douglas Goldstein: How you got started on writing this book?

James Owen Weatherall: I was a graduate student in physics and now I teach philosophy and

the foundations of physics but I got my start in physics. I was a graduate student in physics

just as the world financial crisis hit in 2007 and 2008. I was pretty fascinated by

the media coverage of the crisis. It seemed to put a lot of focus on people who quite

surprising to me who had no background in finance, people whose backgrounds were like

mine, people who had background in fields like math and physics want to understand how

it was these so-called quants had gotten into Wall Street and what kind of effects they�ve

had.

Douglas Goldstein: Do you find any parallel to anything that they were doing that made

sense in both the physics and the finance world?

James Owen Weatherall: I found quite a bit. One of the questions that I was most interested

in answering was just how it was that physicists and mathematicians had gotten into Wall Street

in the first place. It seemed like through the fact that they had and I wanted to know

how they had gotten there, what they were doing, and what sorts of ideas they had brought

along.

Douglas Goldstein: In your research, what were some of the similarities that you began

to discover?

James Owen Weatherall: Some of the most influential ideas in particularly mathematical finance

over the last 50 or 100 years actually originated with people who had backgrounds in physics

and in some cases in mathematics. It wasn�t simply that there were parallels between the

theories that one such you opened a finance book and the theories that you saw if you

open the physics book. In fact there has actually been a movement of ideas that physicist had

gotten interested in finance and had brought ideas with them.

Douglas Goldstein: Is this just because paychecks are higher on Wall Street?

James Owen Weatherall: Strikingly no. First of all, some of the first people who did this,

some of the people who really laid the foundation never went to work on Wall Street and never

seemed to have made much money. In fact, the first two physicists who I talked about in

the Physics of Wall Street were both people who in some sense concluded that there was

no way to make a profit using these sorts of ideas. They had thought that they had proved

mathematically that the market was a random and that things like stock picking, anything

but index fund investment was just going to be useful to you. They never made a profit

or went to work for bank stocking later.

Douglas Goldstein: Can you give us an example and maybe keep it on the level of a personal

finance show of something in physics that you�ve seen paralleled in investing?

James Owen Weatherall: One idea is the options pricing model. This is actually a great example

because the options pricing models themselves aren�t really ideas from physics but they

are based on ideas about randomness and an idea particularly called a �random walk�

so how do you think about a particle moving randomly for instance a fluid. You can use

the same sort of math described how a stock price moved randomly over time and come out

with a theory for how the probability is will change over time and once you�ve had that

theory, it turned out that there were physicists who did this as well, apply that theory and

figure out how the price of an option should vary with the price of underlying stock.

Douglas Goldstein: This does not necessarily make a trading algorithm that you could say

as right more than 50% at a time?

James Owen Weatherall: That by itself doesn�t. In fact, that�s why some of these earliest

physicists came to believe that they had not come up with ideas that could make profits

but of course that change, there wouldn�t be physicist on Wall Street if everyone still

believe that. One of the people who I talk about in the book who really made a connection

was a guy named Ed Thorp. Ed Thorp was trained as a physicist and a mathematician at UCLA.

He has a PhD in mathematics. He was very interested in gambling. He had worked with the first

person to prove mathematically that you could have an advantage in black jack if you counted

cards. Along the way, he discovered something called the Kelly Betting Criterion which is

a mathematical formula that comes out of electrical engineering information theory about how information

should affect trading strategies or betting strategies. That idea which was essentially

an idea from electrical engineering to turn the sorts of options pricing models that people

were thinking about into strategies that could make money more than half a time. These are

the first, by any reasons, standard first quantity hedge fund.

Douglas Goldstein: Is that parallel to people having problems looking at certain elements

because by simply looking at them, the protons hitting them change the nature of them?

James Owen Weatherall: There is an analogy to that in finance. One of the big challenges

that face people who try to use mathematics to understand market is that the kinds of

models that we end up using can change how markets behave. If everyone starts using the

same sort of model, that will change how prices vary and we in fact saw it in the 1980s. A

particular options pricing model know as a Black-Scholes model became very popular and

it used to be that prices did not agree that well with that model and then during the 1980s,

they gradually shifted so that they agreed perfectly with the model and that best explanation

for this was that everyone was using the model. This means that there�s now a challenge.

This is one of the theses of the book, models aren�t perfect. There are assumptions that

go into them and models can fail. The trick is to understand how these assumptions to

work and when they might fail, but if everyone is using the same model, it can mask the ways

in which the assumptions are beginning to fail causing problems so the challenge to

market modelers to figure out how to stand half of markets that are changing in response

to what they do.

Douglas Goldstein: One of the things you described in your book is how a geophysicist uses a

model designed for earthquakes to predict a massive stock market crash. How does that

work? Is there something we can learn from that as well?

James Owen Weatherall: His name is Didier Sorneth who is a professor at ETH Zurich in

Switzerland. He got a start actually working on when pressure tanks on European space craft

would explode. He developed a way of predicting this apparently random explosions and then

he took the mathematics he developed there and applies them to earthquakes and try to

identify situations where catastrophic earthquake would occur and then realized that a similar

sort of idea maybe could be use to predict stock market crashes. In fact, he has successfully

predicted a number of crashes over the last roughly 15 years starting in 1997.

The thing that he is doing isn�t so different from what a lot of sort of ordinary investors

would think as probably right. His idea is that markets crash in part because of external

influences, the economy going south but also in part because it�s something to do with

market conditions, how investors were actually behaving. That�s something to do with for

instance an idea of groupthink or crowd behavior, the ideas that before crashes often you can

have a kind of market hysteria. So if you think something about the dot.com crash, there�s

an idea that lots of people got pulled into this new industry and with the idea that it

was going to be extraordinarily successful, put a lot of money in it, stocks rose very

quickly and then couldn�t sustain those gains. His idea is simply to look for situations

where the market might have that kind of math hysteria going on, the ideas there are statistical

patterns you might expect to be associated with situations where everyone is trading

for instance on the same sorts of information.

Douglas Goldstein: Isn�t just kind of a crowd mentality which is what we then refer

to as a bubble?

James Owen Weatherall: The idea is that actually bubbles should have certain statistical patterns

associated with them. If you want to predict the crash, don�t predict the bit of news

that�s going to make everyone sell. Identify the situations where there is a bubble where

a bit of outside news could make a big difference.

Douglas Goldstein: One of the things that also frequently attract people�s attention

is what a great trader Warren Buffet is. In fact, I know that you�ve been critical of

the Black Swan Theory which tries to discourage people from looking at these huge aberrations.

The black swan theory is there�s going to be someone who is the best and then we always

think that there�s something really magical about that investor. You didn�t seem to

see it the same way as the economist Nassim Taleb?

James Owen Weatherall: There are few things that I�m critical about with Taleb. He has

the idea that because of black swan, because of extreme events that are far outside of

expectations, the tools and methods that we use in mathematical finance, basically mathematics

period, can�t help us understand market. I think that�s pretty short-sided and in

fact, many of the ideas that he has developed are based on the work of a mathematician and

physicist named Benoit Mandelbrot how introduced the tools that one would need in order to

think about these sorts of extreme situations.

Douglas Goldstein: Is this model constantly changing? Is it worthwhile to bring more physicists

into the fray to try and study the events of Wall Street?

James Owen Weatherall: It seems to me that the answer is yes. One thing that we should

never do is make the mistake that models that are working pretty well right now are somehow

the absolute truth. Models are certain kinds of approximate representations. They are useful

to us in all sorts of ways. They can make predictions about how markets are going to

change. They can tell us what kinds of relationships we should expect between derivative prices

and other prices. As I said before, they are based on assumptions that are usually at best

approximate and sometimes quite radically false.

Douglas Goldstein: When someone comes up with a theory or a model, it will work for a certain

period of time perhaps but then it loses its magic touch?

James Owen Weatherall: That can happen or alternatively, it could work under some general

condition. A good example was a model that failed in 2007 and 2008 because housing markets

began to decline. You can have a model that works whenever housing pricing are going up

and doesn�t work when housing prices are going down because there�s a kind of implicit

assumption on how the model is built. So it�s not that it�s going to lose its magic touch

forever, it�s just that you�re misapplying it and if you apply it under circumstances

when housing prices are declining.

I think one of the things that people with backgrounds in fields like physics and math

can continue to do is develop new models and also question the assumptions underlying current

models. It�s not clear that people who are using models in markets, practitioners and

investors, have the time or the background or the skills to figure out whether or not

the model they are using is the perfect one for right now. Someone needs to be doing that.

In some sense, this is where I agree with Taleb that if you don�t do things like that

and if you are too complaisant about the models that you use about the mathematics that you

use, you�re creating enormous risks.

Douglas Goldstein: How can people follow your work or research?

James Owen Weatherall: The book is called the Physics of Wall Street and it�s available

online. It is published by Houghton Mifflin Harcourt. My website is www.jamesowenweatherall.com.

Douglas Goldstein, CFP�, is the director of Profile Investment Services and the host

of the Goldstein on Gelt radio show (Monday nights at 7:00 PM on www.israelnationalradio.com.

He is a licensed financial professional both in the U.S. and Israel. Securities offered

through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried

by National Financial Services LLC. Member NYSE/SIPC, a Fidelity Investments company.

His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered

at: www.profile-financial.com (02) 624-2788 or (03) 524-0942.

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