Monday, June 27, 2011

The problem with finance: Engineers

Few people have any real insight into the financial sector. We see the finance guys in the news, and in movies (typically as villains).

What we don't hear about very often, is the fact that a lot of finance guys... aren't even finance guys in the first place!

You see, during the last boom (and earlier as well to some extent), Wall Street was invaded by a lot of people who didn't know a thing about finance.

It's well-known that having a job within the financial sector, in particular if it's on Wall Street, means you don't have to worry about being able to afford the phone bills or electricity. A lot of young students are doing degrees in Finance, economics and business hoping to be able to land a finance job when they graduate, so that they can live that models & bottles lifestyle and have a million dollars in their bank accounts by the time they are 30. Of course, that's a glamorized view (as they are soon to discover), and most of them will probably end up as "back office monkeys" or bank tellers.

The students are dreamers. That's not a problem. The problem is: There are cheaters.

These are people who didn't go to Business school, but who instead majored subjects such as engineering, mathematics and theoretical physics. They get a job a job, for example as an engineer, but soon decide that their life is boring. Not only is it boring, they're not getting paid very well. Sure they can pay their utility bills, but they can only dream of getting bottle service in Vegas. However, they take a look in the mirror, or maybe a look in their textbooks from college more the like, and they realize: I already know all the math those finance wizards are using! I can calculate return, variance, covariance, standard deviation and everything - I should totally be in finance!

Unfortunately, there are Managing Directors (ie, bosses, the guys responsible for hiring decisions) within finance who agrees - so they hire engineers instead of real finance graduates, because the engineers are at least as good at math.

A lot of trading today are done with mathematical formulas alone. Algorithmic trading, they call it - you program a computer into selecting shares, bonds or derivatives. Even regular traders rely more on math than they do on common sense.

The problem is that human behavior (and ultimately, consumer behavior is what decides which firms will be successful and which won't) cannot be summarized into just a few equations. Humans are irrational, and investors can certainly be as well. One of the main reasons why no-one saw this credit crisis coming was because all these engineers thought "Surely the banks can't be so stupid as to give millions of people loans they can't pay back? That would be totally irrational, and we all know humans are rational, so it can't be possible, at least according to the neat little formulas I've been taught".

They never really understood finance. If you have a degree in Finance/economics, you will have learned about the Great Depression, the stagflation in the 1970's, the dotcom bubble and just in general about the limits of market efficiency. You will be mentally prepared for these things, knowing they have happened before and can happen again.

But most of all; you will be interested in finance. See, the only reason why an engineer wants to do finance is because he wants to be rich. He isn't interested in finance per se, nor in macroeconomics or anything remotely relevant. He wants to pad his pockets, end of story. Therefore, he is more prone to take huge risks for short-term gain than the people who actually love what they are doing and the field they work in

Engineers also have a fallback - if everyone goes awry, they can simply go back to engineering again. So whatever happens, they'll always have a job. If you have a degree in finance, it's much more serious: If you screw up, that will be a black mark on your record forever. If you worked at Lehman, you can count on getting questions about what did and didn't do to stop the collapse of the firm on any job interview you get for the rest of your life. An engineer who contributed to Lehman's collapse (and they did) can simply leave his time at Lehman of his resume, apply for a regular engineering job and never have to think about it again. A finance graduate has nowhere to go, the personal cost of failure is higher and he will therefore naturally be more careful.

During times of financial crisis, all the mathematical models break down. They don't work anymore, that's what characterizes every crisis. Panic occurs, and irrationality follows. Since rationality is a basic assumption of every model, this means traders and other investors will now have to "fly without autopilot" - algorithmic trading, blindly basing decisions on whatever the computer spits out, is no longer an option. This is the kind of environment which separates the weak from the strong, and the serious finance guys from the overpaid mathletes.

To be a good investor, you need not only know mathematics and statistics, you need to understand psychology (for instance, to understand how consumers react to stock market crashes), politics (to understand and be able to predict seemingly irrational changes in tax rates and subsidies) and game theory (to understand how "everyone doing what's good for themselves" can lead to an undesirable outcome). And that's just a sample of the things you need to understand, other than just mathematics, in order to be good at finance.

Maybe we should all require that everyone who works in finance get a license? Everyone, from the back office IT support guy to the front office derivatives trader, should be required to take a test to prove that they are suitable to work in finance. Those who work in finance are responsible for the financial system, and when they screw up, we all get screwed. Dreams are crushed, homes are lost, college fees can no longer be paid and food stamps have to be printed and handed to parents who can no longer provide for their kids. Is it too much to ask that the people who have such a great responsibility, actually get a license?

Medical doctors have to get a license after all, the concept is far from new. This way, by forcing everyone who works in finance to renew their licenses (kind of like you have to renew your drive's license every now and then), we can make sure their knowledge is up to date.

No, it's not an easy thing to arrange, I can see a lot of problems with the approach. But allowing people with no feel and no interest in the markets to ruin our financial system simply cannot be the best solution. We cannot afford it to happen another time.

And if we don't do something, it will. Throw out the engineers and let the guys who love finance run the show

John Gustavsson

11 comments:

Anonymous said...

Let me guess. Some engineer beat you at something (job, sports, or love), and you're having a hard time accepting the fact that a geeky nerd showed you up.

Am I right?

John said...

Haha, it's funny, because my entire life I've been seen as a geeky nerd :)

No, no engineer has beaten me in anything. I'm just telling it like it is; finance is a too important field to be put in the hands of people with no feel for it who are just working there to pad their pockets.

Massachusetts Conservative said...

As an engineer myself, I am baffled by your assertion that engineers move over to finance in large enough waves to actually influence how the industry works.

Where is the basis for this?

I don't know a single engineer who ever went into finance. Perhaps you do, but I don't.

In fact, most good engineers who move out of the industry go into patent law or entrepreneurship.

John said...

Massachusetts Conservative:

Not just engineers, I just wrote engineers because "theoretical physics graduates" was too clumsy. Yes, engineers do go into finance, and so do mathematicians, those with degrees in theoretical physics etc. People who are great with the mathematical aspect of finance, but have no understand of the market as a whole.

Engineer said...

So, I'm sure engineers were responsible for every other crash, including Great Depression? And, the financial industry management responsible for setting policy and direction had nothing to do with the bad decisions those evil engineers made? Pathetic. In any case, engineers going into finance is destroying America because we need them to create true economic value, not the bloated and imaginary value created by moving money around in circles. And, what exactly is a finance major interested in? Also padding pockets. What else? Oh, and every ABET accredited engineering curriculum and the PE body of knowlege has emphasis on ethics. We are trained to analyze risk. Where is ethics in financial education? Yeah, what killed real GDP and innovation in American industry and economy: business majors.

Stephen Anderson said...

While I am not a resident in the USA, I am studying to become an engineer. I must comment that I find that this article is completely bias and the reason why wall street crashs (and the entire world's, except Asia, economies) has nothing to do with money hungry "engineers". I don't know where you get your assumptions from but people in the finance sector are currently highering engineers to solve the problem that money hungry "people" caused.

Nice said...

Im late but, you jelly?

Josh said...

I realize this is old, but I have to disagree with you completely. Engineers don't go into finance solely to make more money. I myself am an engineer doing well enough, but I am fascinated by finance and the stock market. I would love to transition to a related career.

You assume that engineers learn nothing about the Great Depression or other historical events. Even if that's true, it's wrong to assume knowing about these events will make today's market any more predictable. The world economy is completely different than it was.

You think engineers with no finance knowledge are bad? How about finance majors with no finance or math knowledge?

Engineer with an MBA said...

There are many engineers who switch over to finance because they are bored. And yes, they want to make more money. What you don't realize is that the reason these guys are hired is not just because they are "good at math", as you so eloquently stated. The reason why engineers are hired into finance positions and are good at it is because they are disciplined problem-solvers with accurate decision-making skills. Finance is not some sort of exclusive club that only people with undergraduate business degrees should have access to. If you think otherwise, perhaps you should go start another club instead of complaining.

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