Thinkwell's CFO On the Importance of Math

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It's hard to imagine getting through life without knowing some math. We have to do quick mental arithmetic to compute tips we leave at restaurants. Our restaurant servers then use their own mental math to know if they are happy with what we left. Some people use math more than others in their jobs.

As the Chief Financial Officer at Thinkwell, I wind up using a lot of math every day. As a person whose job involves finances and investing, I also get asked a lot about what caused the current credit crisis and the woes on Wall Street. I want to believe that I know more about the math involved in financial transactions than the average person does.

Back in the 1980s, I worked for a supercomputer company, and that company sold ultra-fast computers to several Wall Street investment firms so those firms could try to calculate the risks, and the expected profit rewards, in making investments. These Wall Street firms hired people with PhD degrees in math and science, and nicknamed those people "Rocket Scientists." Wall Street hoped that Rocket Scientists could predict the best way to make money on Wall Street. The Rocket Scientists used supercomputers to simulate millions of possible future investment outcomes, and calculated estimates of what profit to expect from investments.

I thought back then that my math skills were pretty good, but the Rocket Scientists I met on Wall Street ran mental circles around me. By the year 2000, after about 15 years of studying and analyzing the problems, these Rocket Scientists had created some powerful mathematical equations that described most of the risks involved in investing in bonds, the debt borrowed by governments and corporations. Wall Street used this math to calculate how to insure against losing money on bonds, and they had good success.

The Wall Street companies next tried applying those same equations to bundles of home mortgages -- those mysterious investments that we now read about called "Credit Default Swaps" (CDSs) and "Collateralized Debt Obligations" (CDOs). I just read a fascinating article by Daniel Roth in the March issue of Wired Magazine, called "Recipe For Disaster: The Secret Formula That Destroyed Wall Street." As Mr. Roth explains in his article, the senior managers of the Wall Street firms didn't know as much about math as the Rocket Scientists who created the equations for measuring the risk of investments. That ignorance proved disastrous for all of us. Because the executives approving these investments weren't math experts, they allowed their companies to apply the Rocket Scientists' math formulas blindly, even in circumstances these equations were never designed to handle.

The business people believed that the math calculations showed that they had totally insured themselves against the risks in investing in home mortgages. They placed hundred-billion-dollar bets on home mortgages based on false assumptions. The executives even ignored the math experts who tried to tell them that the math wasn't right -- probably because these same executives didn't understand the math themselves. Because they believed that they had protected themselves against risk by doing what some bad math calculations suggested, Wall Street managers were later amazed when the outcome of their investments didn't agree with what the numbers had predicted. They blinded themselves with misused math.

As a result, some of their companies lost hundreds of billions of dollars and are no longer around today, including at least one of the companies who bought my supercomputers more than 20 years ago. Worse for America, a lot of people who invested their life savings on Wall Street have seen their retirement savings wiped out. Worse for the rest of the world, the resulting recession has caused the economies of other countries to suffer as well.

So, If you are a student and you are telling yourself that you won't need to know math when you're running your own multi-billion dollar Internet business some day because you'll just hire a Rocket Scientist to "do the math" for you, think again. You ought to know more math than the people who will work for you. Or at the very least, you should know enough math to know what questions to ask a Rocket Scientist. Make them "show their work," just as our math teachers made us do. Will you know if their answers are correct? Your future income might depend on your math knowledge more than you imagine.

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This page contains a single entry by Kent Fuka, CFO published on April 21, 2009 5:02 PM.

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