The Physics of Wall Street: a brief History of Predicting the Unpredictable

Epilogue: Send Physics, Math, and Money! 
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the default rate was low, this was a good assumption—a few isolated 
defaults didn’t have much effect on the housing market. But once the 
default rate picked up, sometime in 2006, the model stopped mak-
ing sense. When lots of people defaulted on their mortgages, housing 
prices in the default-heavy neighborhoods dropped — leading to still 
more defaults. Moreover, the rise in defaults indicated some deeper 
problems in the economy.
But putting all of the blame for the 2007–2008 crisis on Li’s model, 
or even securitized consumer loans, is a mistake. the crisis was partly 
a failure of mathematical modeling. But even more, it was a failure 
of some very sophisticated financial institutions to think like physi-
cists. the model worked well under some conditions, but like any 
mathematical model, it failed when its assumptions ceased to hold. 
And it seems that the people who were empowered to make decisions 
about risk management didn’t think through when Li’s model would 
fail them. everyone was making money, and so they threw caution to 
the winds. But even this is too easy. the crisis was equally a failure of 
government policy and regulation, since the shadow banking system 
that ultimately collapsed ran with essentially no oversight. either regu-
lators didn’t know what was happening, they didn’t understand the 
risks, or they believed that the industry would regulate itself. the crisis 
resulted from failures on all fronts.
It’s worth emphasizing once again that just as o’connor survived 
the 1987 crash by being a little more sophisticated in how it used its 
models than anyone else, Jim Simons’s renaissance technologies re-
turned 80% in 2008 — again by being smarter than the competition. 
What’s the difference between renaissance and other hedge funds? It’s 
that renaissance has figured out a way to do what my dissertation ad-
visor claimed was impossible: do science on Wall Street. this has not 
involved airing its ideas publicly. Indeed, renaissance is more secre-
tive than most. But its employees haven’t forgotten how to think like 
physicists, how to question their assumptions and constantly search 
for the chinks in their models’ armor. Much of the company’s advan-
tage comes from the quality of the people who work there — they are, 
by all accounts, simply smarter than most other quants. But equally 
important is the way the firm is structured: it has a large group of dedi-

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t h e p h y s i c s o f wa l l s t r e e t
cated researchers who are given forty hours a week of unstructured 
time during which they are encouraged to pursue their own ideas. It 
is embracing its roots, more than anything else, that has allowed the 
company to flourish where others have not. renaissance shows that 
mathematical sophistication is the remedy, not the disease.
As I finish this book, in early 2012, the world economy still hasn’t re-
covered from the 2008 crisis. If anything, it seems poised for another 
collapse. And no one expects matters to improve any time soon. the 
obama administration has issued predictions that unemployment will 
hover around 8% through the end of 2012, with sluggish growth in 
GdP. Both political parties in the United States are simply repeating 
the same tried-and-failed policy proposals they’ve been trotting out 
for a generation. And it’s not just the United States. Most of southern 
europe is on the verge of default on its sovereign debt — and despite 
Germany’s best efforts, it is hard to see how the euro has a future. even 
china and India have showed signs of slowing down. Prospects look 
dim for the world economy. And the most remarkable thing of all is 
that no one seems to have any ideas about how to fix it.
there’s an ancient Latin proverb that I think applies: “Extremis malis