|BUSINESSWEEK ONLINE : DECEMBER 20, 1999 ISSUE|
Using Chaos to Make a Bundle
How a Band of Maverick Physicists Used Chaos Theory to
Trade their Way to a Fortune on Wall Street
By Thomas A. Bass
Henry Holt 309pp $25
In the chaotic early 1990s, chaos theory was widely heralded as the investment technique that would rescue investors from their reliance on old-fashioned methodology. You know, earnings and stuff. Using computer-driven methods borrowed from physics and--literally--rocket science, chaos theory is supposed to predict the unpredictable. Weather, for example--and the markets. The basis of the theory was the view that ''order must underlie everything, however disorderly it may appear.''
Of the array of ''chaos trading'' firms that popped up during the 1990s, the most famous was Prediction Co. It was founded by math wizards Doyne Farmer and Norman Packard, who in the 1980s had beaten the roulette tables in Las Vegas using such things as tiny computers concealed in their shoes. Founded in Santa Fe in 1991--just after the market-roiling Persian Gulf crisis--the company had by the middle of the decade become a part of Swiss Bank Corp. Its apparently successful trading strategies were a bright point in a not-altogether-illustrious period for the bank, which soon merged with Union Bank of Switzerland. By 1998, when the math-intense traders at Long-Term Capital Management (LCTM) were practically belly-up, Prediction Co. was still on a winning streak.
The Farmer-Packard exploits in Vegas were chronicled in The Eudaemonic Pie by Thomas A. Bass. Now, in The Predictors, Bass takes us through the adventures of Farmer and Packard as they attempt to use chaos theory to beat the turbulent markets of the 1990s. It is an engaging tale, a good read filled with folksy anecdotes of computer geeks, bankers, traders, and even the occasional investment luminary--such as George Soros, who surfaces in the latter part of the narrative. There are personal details, and plenty of them, which Bass expertly weaves into his narrative. But there is something missing, something pretty darn important when you're writing about investors or traders. And that can be summed up in one word: numbers.
For a book about people who devote themselves to numbers--after all, that is what investing is all about--The Predictors is maddeningly deficient in describing how their theories translated into performance. ''Players in the world financial markets believe the numbers speak for themselves,'' Bass writes. But he adds that ''the numbers do not speak for themselves. They are as opaque as any other text requiring interpretation, and they rewrite themselves every second.'' And that is true. Numbers must have interpretation. How do traders get their numbers? What did they buy or sell--or steal? Numbers without technique are barren and opaque. But here we have virtually no numbers and, for that matter, not a heck of a lot of revelation as to how Farmer and Packard manage to arrive at their figures.
Explaining financial machinations is always difficult, of course, and that is particularly true when something like chaos theory is at work. People without knowledge of mathematics are likely to find discussion of such things as ''fractals'' and ''algorithms'' to be mighty tough going. Bass does his best, and his description of the vagaries of chaos theory come close to describing just how these people made money. Close, but not quite. For example, he describes how fluid mechanics, of all things, was used in the effort to predict markets. In 1970, he recounts, two aeronautical engineers at California Institute of Technology built a wind tunnel that displayed images of mixing gases. At the edge of the two gases were ''kaleidoscopic inlays, as neatly patterned as snowflakes.'' These were fractals--the ''thumbprint of order in chaos.'' Now, ''instead of blowing gas down a wind tunnel, imagine blowing money, all the money in the world, which is tumbling in great rivers of investment capital,'' Bass writes. ''These flows appear at first to be random''--but in fact, they are not. When translated into equations, they can mean winning investments.
Bass excels in these moments of pop science. Even mathematical ignoramuses can get some flavor, at least, of what these guys were doing. Clearly they have found a way of exploiting those not-so-random money flows, even at times like 1998, when other ''black box'' computer investment methods fell flat. Bass was given special access, apparently, to the people at Prediction Co.--I presume that all those verbatim quotes in the book are not reconstructed. But it seems he was not given a heck of a lot of access to their performance statistics, which makes reading this book at times a bit like following a successful football team--without knowing any of the games they won or what points they scored. The really big game, so to speak, the awful markets of late 1998, which sent LTCM and a host of other investors reeling, is dealt with almost as an afterthought.
That is why The Predictors is, ultimately, disappointing. It is long on amusing stories and background, and we see that science can indeed become a servant of the investing world. Nice. But investors will learn nothing except that investment houses use techniques that are difficult to understand. It's a valuable lesson, but one already taught by the not-so-glorious story of LTCM. Alas, nobody reading this book will gain the slightest understanding of how Prediction Co. managed to avoid the fate of its intellectual kinsmen in Connecticut.
By GARY WEISS
Senior Writer Weiss covers the markets.
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Using Chaos to Make a Bundle
PHOTO: Cover, ``The Predictors''
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