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
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
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