Chapter 1. Neural Networks and Gradient-Based Optimization

The financial services industry is fundamentally an information processing industry. An investment fund processes information in order to evaluate investments, an insurance company processes information to price their insurances, while a retail bank will process information in order to decide which products to offer to which customers. It is, therefore, no accident that the financial industry was an early adopter of computers.

The first stock ticker was the printing telegraph, which was invented back in 1867. The first mechanical adding machine, which was directly targeted at the finance industry, was patented in 1885. Then in 1971, the automatic teller banking machine, which allowed customers to withdraw cash using a plastic card, was patented. That same year, the first electronic stock exchange, the NASDAQ, opened its doors, and 11 years later, in 1982, the first Bloomberg Terminal was installed. The reason for the happy marriage between the finance sector and computers is that success in the industry, especially in investing, is often tied to you having an information advantage.

In the early days of Wall Street, the legends of the gilded age made brazen use of private information. Jay Gould, for example, one of the richest men of his time, placed a mole inside the US government. The mole was to give notice of government gold sales and through that, tried to influence President Ulysses S. Grant as well as his secretary. Toward the end of the 1930s, the SEC and CFTC stood between investors and such information advantages.

As information advantages ceased to be a reliable source of above-market performance, clever financial modeling took its place. The term hedge fund was coined back in 1949, the Harry Markowitz model was published in 1953, and in 1973, the Black-Scholes formula was first published. Since then, the field has made much progress and has developed a wide range of financial products. However, as knowledge of these models becomes more widespread, the returns on using them diminish.

When we look at the financial industry coupled with modern computing, it's clear that the information advantage is back. This time not in the form of insider information and sleazy deals, but instead is coming from an automated analysis of the vast amount of public information that's out there.

Today's fund managers have access to more information than their forbearers could ever dream of. However, this is not useful on its own. For example, let's look at news reports. You can get them via the internet and they are easy to access, but to make use of them, a computer would have to read, understand, and contextualize them. The computer would have to know which company an article is about, whether it is good news or bad news that's being reported, and whether we can learn something about the relationship between this company and another company mentioned in the article. Those are just a couple of examples of contextualizing the story. Firms that master sourcing such alternative data, as it is often called, will often have an advantage.

But it does not stop there. Financial professionals are expensive people who frequently make six- to seven-figure salaries and occupy office space in some of the most expensive real estate in the world. This is justified as many financial professionals are smart, well-educated, and hard-working people that are scarce and for which there is a high demand. Because of this, it's thus in the interest of any company to maximize the productivity of these individuals. By getting more bang for the buck from the best employees, they will allow companies to offer their products cheaper or in greater variety.

Passive investing through exchange-traded funds, for instance, requires little management for large sums of money. Fees for passive investment vehicles, such as funds that just mirror the S&P 500, are often well below one percent. But with the rise of modern computing technology, firms are now able to increase the productivity of their money managers and thus reduce their fees to stay competitive.