The Difference Between Academic Econometrics and Quantitative Finance

I’m going to admit something few people know about me: I love arguing on the internet and engaging in sophisticated trolling.   I’m certainly not the only person to feel this way, but I may be one of the few people to openly admit it.  The public perception of online argument is that it’s at best a waste of time, inevitably self demeaning (see right), and at worst horribly antisocial and divisive.  Since the people I argue with are always anonymous and present of their own free will, I really don’t give a shit about the later two points.  But I would suggest that arguing on the internet and broader behavior of the same sort are actually one of the best uses of your time.  Weird, right?  As we’ll see in a second that’s more or less my point.

One of these internet arguments recently went very meta.  My Facebook debate partner was some guy with a PhD mill econometrics degree of which he was very proud.  I argued that econometrics and quantitative finance were the same with one key exception – econometrics is the mathematical art of being right about financial matters only when lots of other people are also right whereas quantitative finance is the mathematical art of being right when everyone else is wrong.  This caused him to engage in the internet equivalent of raging and throwing the furniture around  which was quite entertaining to watch.  See, trolling?  But under the barb there’s a key point: being right when everyone else is wrong is much more valuable than being a part of a well informed herd.

Simply put, it’s no good to be on the right side of a bet if there’s no one to take the opposite side.  My knowledge that the world is round (roughly) is true, but I can’t make any hay (or dollars) out of it.  There’s no one but a few loons willing to bet that it’s flat.  The loons wouldn’t pay up if we bet.  My knowledge, while true, won’t do me much good. But if I’m the only one who knows the world is round then there might be some potential.

Conventional education, by its nature, is really only capable of producing herd knowledge.  The very mechanism of the classroom insures it – you get a bunch of people together and teach them the same stuff.  A herd.  You get your school accredited to make sure it’s teaching the same stuff as everyone else’s school.  A herd of herds.  Now don’t get me wrong.  I am not badmouthing conventional education here.  Being wrong when everyone else is right makes you look like a blithering idiot.  In order to be an educated person, you must engage in the process of meeting herd standards of knowledge.  Think of this as defensive education – it keeps you from being ignorant, but that’s all it can do.

The next, and more valuable, sort of education is to start being right when everyone else is wrong.  That’s where the power is.  If you you have the wacky belief that people will pay to feed virtual cows, everyone will think you’re an idiot. But when you happen to be right, you become Mr. Billionaire Idiot which is more than suitable compensation for the scorn heaped upon you.  Unfortunately the sort of thinking which produces unpopular right ideas is very hard to learn.  Almost by definition you can’t learn it from someone else.  It’s something you have to teach yourself.  And it’s tricky, because you can’t be unpopular and right without first just being unpopular.  Even in the individualist cultures of the west, that’s unpleasant.  Enter the internet…

On the internet, it’s easy to be unpopular.  Just find a bunch of people who agree, and disagree with them.  Seriously, go try it.  Do a little trolling.  The result will usually be a big argument, which for this purpose is exactly what you want.  Put on your debater hat and argue the side you’ve taken as best you can.  Look for evidence, form arguments, etc.  Whatever you do, don’t back down.  If anything, make your positions more dramatic as the argument progresses.  Initially, you’ll almost always appear to lose the argument.  This is perfectly fine.  You’re building a mental muscle here, and the whole goal is to work that muscle to the point of failure.  What will happen over time is that you’ll develop a sixth sense for the intellectual strengths and weaknesses of herds.  You’ll start to spot situations where the herd really IS wrong and their positions are bolstered by numbers rather than reality.  You will never succeed in changing the herd’s mind in such a situation.  Herds don’t have a mind.  The “winning” result in such a debate is a sort of stalemate – your facts vs. their numbers.  At this point, you can bow out of that argument.  You’ve done something that most people go their entire lives without doing: you’re unpopular and right.  Bask in it :)  You now have the first lesson in your offensive education.

If you want to make a lot of money, unpopular and right is where you must live your life. Not that you can’t have friends – I don’t mean that sort of popularity.  I mean unpopular in terms of your beliefs.  You’ve got to always be looking for situations where the herd is wrong.  This is intellectually very taxing, because at least in a narrow domain of interest you can’t believe anything at face value.  You have to doubt every ‘fact’ and check everything and build your intellectual framework up from the ground on pylons of things you have proven to yourself are true even as others repeatedly tell you they’re false.  It’s not easy, but I think if you look at great business success stories in this framework you’ll  start to recognize the pattern.  Apple was founded on the unpopular/right idea that people would want a toy version of a piece of industrial machinery in their living room.  Facebook was founded on the unpopular/right idea that college students would want to show near-strangers pictures of their drunken escapades.  You can extend the list…

In the realm of trading, being unpopular and right is the only way to make money.  If you’re right but so is everyone else, no one will take the other side of your trade.  If you’re wrong you lose no matter what everyone else thinks.  The only profitability lies in being unpopular/right.  Yet I regularly see traders ignore this principal.  Say they’ve got a trading system that’s sort of working, but not quite.  They add extra signals that “confirm” they’re right, and don’t enter a position until every star is correctly aligned.  You know what happens then?  Since all the evidence is the same direction you’ve just joined a herd.  Either you can’t get into positions if the herd is right or the position moves against them if the herd is wrong – in short you lose money overall, typically much worse than the unconfirmed system.  Instead what you want to look for is lots of obvious evidence that price is going one way, and a small amount of more accurate evidence that it’s going the other way.  That way you can be both unpopular and right.  Then you can find someone to take the other side of your right trade and make good money.

Point being, it’s profitable to build some contrarian mental muscles.  So go argue on the internet 😀

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