on quantitative investment

Why do I like quantitative investment? Because it combines two of my favorite things: 1) interesting mathematical and computational problems, and 2) the ever present specter of uncertainty. In fact, it’s worse than just uncertainty. It includes volatility, uncertainty, complexity, and ambiguity, or VUCA as the acronym. On top of this, you put in human psychology and you have fear, greed, indecision, and the infinite capacity for self-delusion.

These are very interesting problems to me. If you want to be wildly successful in your field, not only do you have to master the craft of quantitative finance, you need to master the craft of successful operation in VUCA-space. This last one is hard to teach, and the lessons can be found in a wide variety of disciplines and stories. However, most of the core theory comes from warfare and has been developed over thousands of years.

In the past few decades in the U.S. military, there has been a recognition that military success has little do with technological or numerical superiority, but more to do with the prevailing party’s ability to handle VUCA. That is, the side that can more quickly react and operate in complexity, confusion, and chaos, is the side that is more likely to win. While one side is busying filling out forms, taking role call, taking inventory of assets, and organizing his troops into orderly columns, the opposing side has already smashed into the front of his army and is busy putting a strike force into flanking position without him knowing it’s coming.

The key lesson here is not that trading is a form of warfare, but that warfare is the ultimate laboratory for building systems that succeed in confusion and adversarial environments. Any lessons that can be gleaned and applied to our present problems in business would give you an edge.

These lessons have been studied and recognized as important for millennia. The early Greek civilizations studied warfare intently because it was such a part of their lives and failure would result in death and enslavement of the losers. Sun Tzu recorded his famous writings which encode many of these lessons. The more modern Col. John Boyd had to re-educate the American military on the principles of war after it became so focused on technology superiority as the hammer with which to win wars.

There is something very peculiar about these these principles of war: they are often forgotten. In fact, whenever a generation experiences safety, wealth, and comfort, or even experiences a major victory from successful application of war principles, they fool themselves into applying what worked in the past as a recipe for the future, when it reality, it should be a dynamic process to find out what works in the present.

Trading has many similarities to war in that the methods of success are constantly shifting under one’s feet. What may work this year, may not work next year. In fact, the rules of the game are constantly changing. Other firms use better technology than you, more funds than you, and better talent than you. How can you hope to compete when you are so hopelessly outmatched? The way you do it is discovering and adapting to the new rules faster than anyone else.

Though you cannot bend the laws of physics and economics to win, rapid change in the marketplace is your friend if you can build the organization to capitalize on it. While incumbent firms have calcified their positions and trading strategies, your small and agile organization will be quickly recognizing new opportunities and rapidly retooling to capitalize on them.

So what are the secrets to success? How do you transfer strategies of war into a business context? There are many examples of successful organizations that have adopted some of these principles, although they may not be always aware of their warfare analogues. You can read a lot of about these success stories, but it is difficult to internalize the key components that made them a success. You can say that doing A resulted in B, but the story does not include the fact that A was not previously known, nor does it include what the process to find A was, or what were the environmental conditions that made A successful and not C.

There are some modern industrial practices the embody some of these warfare principles and they are often called Agile methods. There is Agile Development in software engineering and Lean Manufacturing in the area of product manufacturing. There is also Lean Startup in the “discipline” of starting a new company. Successful application of these concepts in industry have seen their productivity, quality, and profit multiply after successful implementation.

The implementation of these agile methods involve subverting the normal hierarchical and traditional process of software development and product manufacturing respectively, into hotbeds of talent, productivity, creativity, and rapid response. It involves establishing trust and dialogue between the team members, leveraging the team members talent into guiding decisions, and investing the team members into the final outcome of the project.

Can we apply these concepts into the world of securities trading? If you look at it, securities markets are very difficult environments to work in. They are characterized by volatility, uncertainty, complexity, and ambiguity (VUCA). Your competitors are investment banks, day traders, hedge funds, mutual funds, and anyone else who is trying to turn risk into profit. They are human, subject to making emotional decisions, incapable of knowing everything, slow to notice new trends, and indecisive in the face of uncertainty. Those that can mitigate these factors are going to have a huge edge on the competition.

Suggested reading would be “Certain to Win” by Chet Richards to get a good understanding of what could best be described as Boydian strategy. It has only one business case, Toyota, which is still kind of thin. I will be going over this stuff in more detail and tying it more to our domain of interest, quantitative finance, in future blog posts.