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Be a Financial Woz


Ross M. Miller
Miller Risk Advisors
January 8, 2007

[This commentary  appears in the January/February 2007 issue of Financial Engineering News. This is the raw, unedited version of that commentary.]

The HP 65 programmable calculator occupies a special position in the annals of financial engineering. It was the first handheld device that could compute the Black-Scholes value of an option from its five inputs in one fell swoop. The HP 65 also happened to be in the right place (the Chicago Board Options Exchange) at the right time (1974).

Many have profited from the HP 65, but it difficult to imagine that anyone got a higher rate of return from his HP 65 than Steve Wozniak did. "Woz" (as he is affectionately known by his legion of worshippers) sold this prized possession to invest the proceeds in a start-up called Apple Computer. Woz worked as an engineer for Hewlett-Packard designing calculators, which he could buy at a substantial discount, and HP made their contribution to Apple by waiving its rights to the computers that he designed in his spare time.

With the recent publication of his memoirs, iWoz: From Computer Geek to Cult Icon: How I Invented the Personal Computer, Co-Founded Apple, and Had Fun Doing It, Woz has stepped into the limelight usually associated with the other Steve, who is still very much connected to both Apple and options. Woz's tales are not particularly suited to the printed page; however, one can hear Woz tell many of the same stories with his own voice on an IT Conversations MP3 of a 2004 Gnomedex talk.  If nothing else, this peek inside Woz's brain provides a refreshing look at engineering out in the physical world.

Woz enthralls us with his account of the events leading up to the creation of the first mass-market personal computer. Growing up amid fruit orchards and defense contractors in what would come to be known as Silicon Valley, Woz earned his ham radio license at a tender age and wired his neighborhood with a voice network that would presage his later work in toll-free telecommunications.

It was digital logic, however, that really grabbed Woz. His eighth-grade science fair project, an adder that transformed into a subtracter with the flip of a switch, captured the Air Force's first prize at the [San Francisco] Bay Area Science Fair. This clever machine was among the first in a series of parsimonious designs that would culminate in the machine that changed the world.

Growing up in a time when you could actually count the number of transistors on what few integrated circuits were manufactured on both hands, digital logic was not cheap. Woz's obsession was to build a computer of his own that could run FORTRAN. When his father told that such a machine would cost as much as a house, Woz responded that he could live in an apartment.

Even if Woz could not afford to build computers as a teenager, that did not stop him from designing them. He would request schematics for the hot minicomputers from companies like Digital Equipment and Data General, pore over them as if they were sacred documents, and then make a game of redesigning each one using the fewest possible parts. Perhaps if he got the component count low enough, he could afford to build one.

As components became smaller, more powerful, and less expensive in the early 1970s, Woz and hobbyists like him would see their digital dreams come true. The appearance of the MITS Altair, a computer in kit form, on the cover of the January 1975 issue of Popular Electronics, would inspire the creation of hundreds of computer companies, including Apple and Microsoft. In quick succession, Woz designed the Apple I, a strictly hobbyist affair, and then the Apple II, the machine that made him famous.

Hitting the market in 1977, the Apple II prevailed against competitors both large and small. At a time when HP's entries into the computer market were pricey and built around balky tape cartridge drives, Apple had a machine that provided direct data access with floppy disk drive that Woz's gift for minimalism had made affordable. This drive combined with a willingness to accommodate software developers would bring the Apple II its "killer app" in the form of VisiCalc, the first personal computer spreadsheet program. While Woz may not have personally worked in financial engineering, a careful look reveals that his fingerprints are all over the field.

The beauty of Woz's story is that the Apple II emerges as the natural consequence of his life experiences. Combining sheer talent with a taste of simplicity, Woz single-handedly achieved what many teams of engineers could not. Indeed, when IBM saw what was happening and decided that it was time to take Apple's threat to its business seriously, it determined that it could never succeed within the fences of its own bureaucratic operation and set up its personal computer business as a division unto itself.

But what do the achievements of one Woz in a time long past have to do with financial engineering today?

Take Woz's love of simplicity. Whatever the financial world may be, it is not simple. In fact, simplicity is rarely rewarded. The guiding principal behind the development of derivatives at major financial institutions has been to make products sufficiently complicated that only their creators could value them. Complexity-for-profit is not limited to over-the-counter products. Many exchange-traded contracts intentionally eschew simplicity. Adding some "dirt" (as it is known in the industry) to a product, such as providing a choice of deliverables for a futures contract, can actually enhance its liquidity by giving speculators a basis for trading.

Now Woz may not have perfected the art of programmable calculator arbitrage—he only received $250 of the $500 sale price of that HP 65 that help finance Apple—but he knew how to generate alpha in the form of an immensely profitable computer. Those who seek alpha in the financial markets can learn something from him. At the end of his memoirs, Woz sums up his secret to creating computers with fewer chips and more functionality than his competitors' machines in two words: Work Alone.

Now no one, not even Woz, can truly work alone. Once the computers were designed and built, it took a ton of marketing to get Apple where it is today. The way Woz saw it, there was no way that he could create a tight and efficient machine if a bureaucracy had to sign off on his every move, and that was at a time when "process control" methods had yet to be patented and trademarked.

In the financial markets, it is even more difficult to work alone. The mere act of trading requires someone to take the other side of every transaction as well as, in most cases, someone to intermediate it. Nonetheless, Woz may have a point when it comes to money management, where "working alone" means shutting off access to other people's money (OPM). Now OPM is a good thing—it provides leverage, so a small, good idea can turn into a large, highly profitable one. And any fees that can be taken off the top are gravy.

But OPM can drastically alter the rules of financial engagement. This is not often appreciated and few money managers build the biases that come from relying on external assets (including margin) into their models. The problem with OPM is that when you need it most, it wants to go elsewhere. In a purely imaginary world without drawdowns, the buffer that capital provides would be unnecessary. Oddly enough, there are many investors who think that their hedge fund manager inhabits such a world, so that the first bad month or quarter sends them (and their money) running for cover.

The inherent fickleness of OPM is just one of many issues that can make working alone in the financial markets eminently desirable. Indeed, academic studies of hedge funds miss the key point that many of the best "hedge funds" deliberately choose to be off the radar screen because they operate entirely in-house, avoiding all the gotchas that come with OPM. (Fortunately, the SEC has yet to attempt to regulate those who manage their own funds.) Increasingly, money is being run by the intellectual offspring of Woz who found that computer design just does not have the alpha that it once had. Just hope that you do not find yourself on the other side of one their trades.

Copyright 2007 by Miller Risk Advisors and Financial Engineering News.