Profiles In Versatility

Quants and the Conquest of The Street Called Wall

By Alaina G. Levine

Editor’s Note: This is the sixth in a series of articles profiling people trained in physics who have gone on to make their mark in a variety of careers. The first article appeared in the April 2007 APS News. The articles are archived online in Profiles.

Emanuel Derman Andrew Davidson Ron Kahn

In the song, Mo Money, Mo Problems, rapper The Notorious B.I.G. postulated that “the more money we come across, the more problems we see.” And though this is certainly a concern for all of us, it is even more so for physicists who work on Wall Street. Except for them, the “problems” they encounter are less sociological and more mathematical in nature, and thus are most certainly welcomed.

The dashing physics-and mathematics-educated pros who work for financial firms are called Quants. Very simply, they seek to solve the fundamental problem that has plagued Man since the dawn of time: how do we get “mo’ money”? Not surprisingly, Quants have the skills and ingenuity to examine complex financial problems and design models to solve them, as well as analyze and reduce risk in securities trading. But what is shocking is how long it took firms on The Street to recognize and appreciate the contribution physicists can make as Quants within their organizations.

In fact, in the late 1970s and early 1980s when Quants began making a marked presence in financial firms, the term “Quant” was not endearing. “Back then we practitioners of quantitative finance didn’t refer to ourselves as quants,” said Emanuel Derman who is the Head of Risk Management for Prisma Capital Partners and directs Columbia University’s financial engineering program. “That’s what ‘real businesspeople’–traders, investments bankers, salespeople–called us, somewhat pejoratively.”

Derman, who wrote a book entitled “My Life as a Quant”, defines a Quant as “someone who works on quantitative finance,” which is simply “the application of mathematics/physics modeling techniques to the evaluation and trading of financial securities.” The field is also called financial engineering.

Much of the work that Quants perform involves optimization problems, stochastic processes, econometric analysis of data, partial differential equations (including Monte Carlo methods), as well as other advanced mathematics, says Andrew Davidson, a Quant whose focus is in mortgage-backed securities. He serves as President of his own firm, Andrew Davidson & Co., Inc., which provides advice and analytics for fixed income investment management. His company works in an area called “Credit Modeling”, which essentially involves predicting defaults and foreclosures.

Today, Quants are considered prized members of their organizations. Derman suggests that the shift in how they are perceived was instigated by three events over the last two decades: 1) all the securities that people trade got much more complicated; 2) the people who trade simple securities became more sophisticated about how they trade them (especially as more exchanges were done electronically); and 3) as a few firms began significantly employing quantitative techniques to their exchange work resulting in profits (and incidentally and coincidentally losses) in the billions of dollars, people took notice of the influence Quants have over the market.

So what specific skills do physicists bring to Wall Street? “Physicists and engineers [are] jacks-of-all-trades, simultaneously skilled mathematicians, modelers, and computer programmers who [pride] themselves on their ability to adapt to new fields and put their knowledge into practice,” wrote Derman.

Although Davidson has a physics degree from Harvard and leads a team of Quants, he still doesn’t consider himself one. Yet, he does acknowledge that his work in mortgage-backed securities has been quantish and greatly influenced by his physics education. He wrote in the book, “How I Became a Quant,” “Little did I know [in college] that the diffusion equations and probability operators that I was studying then would prove useful later in life.”

Indeed, quantitative finance is calculation-heavy, and as Davidson explains, requires a great degree of rigorous analysis. It also requires you to jump from problem to problem and adapt quickly to new circumstances, which are driven by market conditions and affect the math problem at hand.

Ron Kahn, whom along with Derman is described as an über Quant by Davidson, is the Global Head of Advanced Equity Strategies for Barclays Global Investors. His particular focus is in Asset Management. He has a PhD from Harvard and says his physics training absolutely comes in handy. He recalls that as he made his transition from cosmologist to Quant, he thought to himself, “Evidently physics was excellent training for finance. I didn’t know the difference between a stock and a bond, but the idea of applying rigorous scientific analysis to investing sounded intuitively appealing.”

His decision to enter finance was motivated by recognition of his own skills and characteristics and a need for job security and excitement. Looking back, he says, “in many ways, I was much better suited for [finance] problems [than those in physics]…In physics, you work on a problem for many years, not knowing if you’re making progress or not…you wander in the dark a long ways.” But as a Quant, Kahn likes having smaller problems that require quicker solutions. He finds satisfaction in this unique return on investment as well as the constant human feedback you get in the industry, he says.

Davidson chose his path based on a belief shared by many physics-educated professionals in non-traditional careers: “In college it became clear to me that I wasn’t going to be a star [in physics].” It wasn’t difficult for him to figure out what subjects he could be a star in. He did a self-skill inventory and realized that not only was he good in physics and math, but he also excelled in business, and in particular had an interest in international business and financial mathematics. This epiphany led him to pursue an MBA. His first job after business school was in the treasurer’s department at Exxon, a position he called “a dream come true”.

Derman, whose PhD in theoretical particle physics is from Columbia, worked for Bell Labs for five years before making the leap. “I liked being in physics because people value what you do,” he says, but at Bell Labs in the 1980s, he encountered a very “corporate” and political machine that did not interest him.

Through contacts he was able to get a job in the Financial Strategies Group at Goldman, Sachs, & Co., which immediately appealed to him. “The stuff was interesting and [people] were interested in it, and it didn’t matter who you were, it mattered if you could do something,” he says. “You didn’t have to be a manager or boss people around to be valuable [contrary to Bell Labs]”. Furthermore, it was informal–“there was a flat management structure, so you could talk to anybody if you needed it.”

Today Quants are seen as extremely strategic to the success of the companies that employ them. Their models determine what moves traders make and can destine the rise and fall of countless bank accounts. Quants “have become much more powerful than before,” quoth the Quant Kahn, as “scientific investing”, or utilizing a scientific approach to decision-making, “has become more compelling to large numbers of investors.”

To become a Quant, Kahn recommends learning as much as you can about the industry and talking to a lot of people. But according to Derman, “it’s harder now [to enter quantitative analysis than years ago] because when I went in, there wasn’t much preparatory education you could get.”

Whereas physicists of yesteryear could learn on the job, today many financial firms look for something more than a predilection towards particles. “You are expected to know something now [about Wall Street firms and their business],” says Derman, and in fact, there are now scores of financial engineering master’s programs offered at universities around the country (including the one that Derman administers at Columbia).

Years ago, Derman, Davidson, and Kahn took a divergent path from physics and hedged their bets to become Quants. They dreamed of merging their scientific know-how with an interest in unique problem-solving and a desire to influence world economics. Their assets now include exceptional experience in various areas of quantitative finance and sought-after skills in market analysis and model-building. And all of them are still bullish over their decision to trade the bonds of physics for the securities of The Street called Wall.

Alaina G. Levine can be reached through her web site.

Quotes taken from personal interviews as well as the following:
Derman, Emanuel, “Finance by the Numbers”, The Wall Street Journal, August 22, 2007.

Derman, Emanuel. My Life as a Quant: Reflections on Physics and Finance. Hoboken, NJ: Wiley, 2004.

Lindsey, Richard R. and Schachter, Barry. How I Became a Quant: Insights from 25 of Wall Street’s Elite. Hoboken, NJ: John Wiley & Sons, Inc., 2007.

© Alaina G. Levine, 2008.