3
service firms is still largely on fiscal and regulatory issues, not on the processes and pro-
cedures that determine the quality of the service.)
Deming laid the foundation for transforming a company into a quality firm in his
book Out of the Crisis.^4 In his second book, The New Economics , Deming laid out his
System of Profound Knowledge (SoPK), which consists of four parts:● Appreciation for a System. All the parts of a business are interdependent.
Successful management aims to optimize the performance of the system.
Optimizing only one part will cause other parts to suffer.
● Knowledge about Variation. A system may be in statistical control or it may not
be. “ The variation to expect in the future is predictable. ”
● Theory of Knowledge. “ Management is prediction. Rational prediction requires
theory and we build knowledge through systematic revision. ”
● Psychology. People are different and management must optimize everyone ’ s abilities.^5The goal of Deming ’ s management methodologies is to create an organizational cul-
ture of continuous improvement in order to reduce waste, enhance productivity, lower
costs, and generate higher profits and consistent long-term growth. Initial applications
of quality principles to new product development started with attempts to force quality
into products and services through inspections. But, companies quickly learned to stop
reacting to inspection events, and started using process patterns, such as Design for Six
Sigma, to design quality into the product from the start, building according to specifica-
tion.^6 Many of Deming ’ s ideas can be applied to trading and money management firms
involved in systematic innovation.1.2. A Brief History of Finance and Engineering
Over the last hundred years or so, the sciences of finance and engineering have become
linked through the efforts of famous theoreticians like Louis Bachelier, Harry Markowitz,
Fisher Black, and Myron Scholes. Black and Scholes ’ parabolic differential equation for
the pricing of options is, mathematically, of the same type as the heat, or diffusion, equa-
tion from engineering.^7 Their equation became a foundation of the options trading indus-
try and won a Nobel Prize. The success of engineers and mathematicians at explaining
complex financial instruments and markets has encouraged thousands of Ph.D.s in these
disciplines to join trading and investment firms to build new and better pricing, forecast-
ing, and risk management models for all manner of listed and over-the-counter securities
and derivatives and portfolios.
These quantitatively oriented professionals brought with them to Wall Street many of
the tools of their prior trades: operating systems like Unix, programming languages like
C, and engineering software tools like MATLAB and Mathematica. However, it often
seems that some engineering tools were left behind, namely the tools of quality.
Here is the question: if quantitative analysts in the financial markets hail from predomi-
nantly the same engineering-related backgrounds as the people that put planes in the air
and nuclear power plants online, why is it they end up building so many trading/invest-
ment systems that are riddled with the kinds of mathematical and technological errors that
have been responsible for some spectacular financial disasters? To solve these problems,
the financial industry is now focusing on quality. In the new world of competing trading
systems where competitive edges are razor thin, even small errors and waste are becoming
too costly.1.2. A BRIEF HISTORY OF FINANCE AND ENGINEERING