Models Behaving Badly

Wed Dec 14 12:35:24 EST 2011

Although the book reviewed below pertains to the relationship of physics
to economics, it also has relevance to the stuff being done in
scientometrics, etc.  The review is written by Burton Malkiel, whose
stock market model and advice I have followed to my great profit.

Stephen J Bensman

LSU Libraries

Lousiana State University

Baton Rouge, LA 70803

BOOKSHELF
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ADER_TEXT=Bookshelf> 

DECEMBER 14, 2011

Physics Envy 

Creating financial models involving human behavior is like forcing 'the
ugly stepsister's foot into Cinderella's pretty glass slipper.'

By BURTON G. MALKIEL
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esearch=true>  

Trained as a physicist, Emanuel Derman once served as the head of
quantitative analysis at Goldman Sachs and is currently a professor of
industrial engineering and operations research at Columbia University.
With "Models Behaving Badly" he offers a readable, even eloquent
combination of personal history, philosophical musing and honest
confession concerning the dangers of relying on numerical models not
only on Wall Street but also in life. 

Mr. Derman's particular thesis can be stated simply: Although financial
models employ the mathematics and style of physics, they are
fundamentally different from the models that science produces. Physical
models can provide an accurate description of reality. Financial models,
despite their mathematical sophistication, can at best provide a vast
oversimplification of reality. In the universe of finance, the behavior
of individuals determines value-and, as he says, "people change their
minds."

In short, beware of physics envy. When we make models involving human
beings, Mr. Derman notes, "we are trying to force the ugly stepsister's
foot into Cinderella's pretty glass slipper. It doesn't fit without
cutting off some of the essential parts." As the collapse of the
subprime collateralized debt market in 2008 made clear, it is a terrible
mistake to put too much faith in models purporting to value financial
instruments. "In crises," Mr. Derman writes, "the behavior of people
changes and normal models fail. While quantum electrodynamics is a
genuine theory of all reality, financial models are only mediocre
metaphors for a part of it."

Throughout "Models Behaving Badly," Mr. Derman treats us to vignettes
from his interesting personal history, which gave him a front-row seat
for more than one model's misbehavior. Growing up in Cape Town, South
Africa, he witnessed the repressive and failed political model of
apartheid. Later he became disillusioned with the utopian model of the
kibbutz in Israel. He started out professionally in the 1970s as a
theoretical physicist. He then migrated to the center of the financial
world in the 1980s, using a mix of mathematics and statistics to value
securities for the trading desk at Goldman Sachs in New York. He had
hoped to use the methods of physics to build a grand, unified theory of
security pricing. After 20 years on Wall Street, even before the
meltdown, he became a disbeliever.

Enlarge Image

Models Behaving Badly

By Emanuel Derman 
(Free Press, 231 pages, $26)

He sums up his key points about how to keep models from going bad by
quoting excerpts from his "Financial Modeler's Manifesto" (written with
Paul Wilmott), a paper he published a couple of years ago. Among its
admonitions: "I will always look over my shoulder and never forget that
the model is not the world"; "I will not be overly impressed with
mathematics"; "I will never sacrifice reality for elegance"; "I will not
give the people who use my models false comfort about their accuracy";
"I understand that my work may have enormous effects on society and the
economy, many beyond my apprehension."

Sampling from models that behave well, Mr. Derman gives an eloquent
description of James Clerk Maxwell's electromagnetic theory in a chapter
titled "The Sublime." He writes: "The electromagnetic field is not like
Maxwell's equations; it is Maxwell's equations." In another chapter,
titled "The Absolute," he outlines Spinoza's "Theory of Emotions"-a
description of the nature of emotions that did for man's inner life, Mr.
Derman says, "what Euclid did for geometry." But then he turns to
financial models-behaving badly.

The basic problem, according to Mr. Derman, is that "in physics you're
playing against God, and He doesn't change His laws very often. In
finance, you're playing against God's creatures." And God's creatures
use "their ephemeral opinions" to value assets. Moreover, most financial
models "fail to reflect the complex reality of the world around them."

It is hard to argue with this basic thesis. Nevertheless, Mr. Derman is
perhaps a bit too harsh when he describes EMM-the so-called Efficient
Market Model. EMM does not, as he claims, imply that prices are always
correct and that price always equals value. Prices are always wrong.
What EMM says is that we can never be sure if prices are too high or too
low. 

The Efficient Market Model does not suggest that any particular model of
valuation-such as the Capital Asset Pricing Model-fully accounts for
risk and uncertainty or that we should rely on it to predict security
returns. EMM does not, as Mr. Derman says, "stubbornly assume that all
uncertainty about the future is quantifiable."

The basic lesson of EMM is that it is very difficult-well nigh
impossible-to beat the market consistently. This lesson, or "model,"
behaves very well when investors follow it. It says that most investors
would be better off simply buying a low-cost index fund that holds all
the securities in the market rather than using either quantitative
models or intuition in an attempt to beat the market. The idea that
significant arbitrage opportunities are unlikely to exist (and certainly
do not persist) is precisely the mechanism behind the Black-Scholes
option-pricing model that Mr. Derman admires as a financial model
behaving pretty well.

Such a quibble aside, it is undeniable that "Models Behaving Badly"
itself performs splendidly. Bringing ethics into his analysis, Mr.
Derman has no patience for coddling the folly of individuals and
institutions who over-rely on faulty models and then seek to escape the
consequences. He laments the aftermath of the 2008 financial meltdown,
when banks rebounded "to record profits and bonuses" thanks to taxpayer
bailouts. If you want to benefit from the seven fat years, he writes,
"you must suffer the seven lean years too, even the catastrophically
lean ones. We need free markets, but we need them to be principled."

Mr. Malkiel is the author of "A Random Walk Down Wall Street." 

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