By Jason Zweig | May 26, 2017 12:13 pm ET
Image credit: Thomas Phillips, “David Ricardo” (ca. 1821), National Portrait Gallery, London, Wikimedia Commons
One of the greatest economists who ever lived was also one of the earliest — and most successful — quants.
David Ricardo (1772-1823) developed principles of trade and monetary theory that helped lay the foundations of the global economy. But it was his success at quantitative trading that made him into the man of leisure who could theorize to his heart’s content.
Beginning in 1793, Ricardo used his remarkable mathematical skills to calculate differences between the market price and intrinsic value of government bonds (then called “stocks”).
The civil servant John Lewis Mallet, who knew him well, wrote in 1823 that Ricardo “is said to have possessed an extraordinary quickness in perceiving in the turns of the market any accidental difference which might arise between the relative price of different stocks, and to have availed himself of this advantage, by selling out of one, and buying into another stock, or vice versa.”
Here, Mallet is describing what sounds like an early form of statistical arbitrage, in which Ricardo apparently took a long position in, or bought, the security he had determined was cheap (most likely a 3% British government “consol,” or bond). Simultaneously, Ricardo sold short, or bet against, a similar asset (presumably another consol of slightly different maturity) that his analysis showed to be overpriced. As the cheap bond went up in price and the expensive one fell, he captured the convergence as pure profit.
Mallet added that Ricardo “is also said never to have carried his stock transactions to any speculative extent; but to have always, or generally, sold out on the turn of the market, so as to realise[sic] a small percentage upon a large sum.”
“I play for small stakes,” Ricardo wrote to his friend James Mill in 1811, “and therefore if I’m a loser I have little to regret.”
Thus, like many of today’s quants, Ricardo seldom traded large amounts of a security and rarely held them for long. But these high-frequency trades in small increments added up to vast sums over time. Piero Sraffa, a modern biographer, estimates that Ricardo bought at least £2 million worth of “consols,” the leading form of British government securities, in each year from 1805 through 1814. In today’s money, that works out to something well in excess of £150 million annually.
Ricardo also devised, or at least popularized, guidelines that many quants still claim to follow: An early observer recalls Ricardo claiming that two of his “golden rules” were “cut short your losses” and “let your profits run on.”
Ricardo retired from active trading in 1819. When he died in 1823, he left an estate estimated to be worth at least £675,000 — the equivalent, in terms of its share of the British gross domestic product, to something like £2.8 billion today.
Very few economists — and not that many quants, for that matter — have done as well while also doing good.
Source: WSJ.com, MoneyBeat blog, http://on.wsj.com/2qjKu8g
Resources:
Russ Roberts on Adam Smith, David Ricardo, and trade
Definitions of ECONOMIST and QUANT in The Devil’s Financial Dictionary
Piero Sraffa (ed.), The Works and Correspondence of David Ricardo