Models.Behaving.Badly
Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life
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Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs, one of the financial engineers whose mathematical models usurped traders' intuition on Wall Street. The reliance traders put on such quantitative analysis was catastrophic for the economy, setting off the series of financial crises that began to erupt in 2007 with the mortgage crisis and from which we're still recovering. Here Derman looks at why people--bankers in particular--still put so much faith in these models, and why it's a terrible mistake to do so. Though financial models imitate the style of physics by using the language of mathematics, ultimately they deal with human beings. Their similarity confuses the fundamental difference between the aims and possible achievements of the phsyics world and that of the financial world. When we make a model involving human beings, 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. Physicists and economists have been too enthusiastic to recognize the limits of their equations in the sphere of human behavior--which of course is what economics is all about. Models.Behaving.Badly includes a personal account Derman's childhood encounter with failed models--the utopia of the kibbutz, his experience as a physicist on Wall Street, and a look at the models quants generated: the benefits they brought and the problems they caused. Derman takes a close look at what a model is, and then he highlights the differences between the success of modeling in physics and its relative failure in economics. Describing the collapse of the subprime mortgage CDO market in 2007, Derman urges us to stop relying on these models where possible, and offers suggestions for mending these models where they might still do some good. This is a fascinating, lyrical, and very human look behind the curtain at the intersection between mathematics and human nature.
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I can understand why some people were disappointed with this book. It's not what I expected when I purchased it. There's a good deal of memoir, philosophy, history, and physics in the book before Derman talks about Economics and the Financial Markets. It is worth it. Derman makes the obvious case that the model is not the thing it represents (similar to how Derrida and other Deconstructionists explained that a word is a symbol for a thing, and not the thing itself). He also stresses the importance of theories and how models are very different from theories.
As a dual major in Data Analytics and Applied Mathematics, the math in this book was easy to follow. There's little of it, and it's concentrated at the end of the book. If you're math-phobic it might be difficult to understand what Derman is demonstrating. Basically, he is showing that models build on the Efficient Market hypothesis (he calls it the Efficient Market Model) and the Capital Asset Pricing Model are based on false premises. This is easy to understand when you realize that Economics, despite its adherents claims to the contrary, isn't actually a science. It's a branch of the social sciences and often doesn't stand up to the rigor of actual science. Derman's discussion of Physics earlier in the book provide an interesting contrast to the models used on Wall Street which aren't build on theory, but are simply built on other models.
The markets are unpredictable because the markets are influenced by people. This isn't a matter of just too many variables: it's a fundamental problem of markets. People react to the markets, and the markets react to people. This means that predicting future performance (generally based on present value) isn't possible because you can't predict how people will act/react. This is the fundamental flaw of any model of financial markets. Derman steers clear of the morality of things like swaps and the subprime mortgage crisis. Instead, he demonstrates that our entire financial industry is essentially built on a house of cards. The traders are worshipping at the altar of mathematics, but the mathematics of economics in general, and financial markets in particular, are built of flimsy material.
