2013/01/28

Review: Models. Behaving. Badly

This book was written by the famous quant “Emanuel Derman”, whom I mentioned in one of my blog posts before when I commented on the Financial Modeller’s Manifesto.  I was expecting a lot from this book, I admit. And I was disappointed. That is not to say that the book did not contain valuable insight, but I was hoping for more. For a book inspired by the financial crisis, it has precious little to say about it.

Not really about finance: The very long preamble

If you were hoping to read a book about finance (or at least financial models) with some references to other material for diversion (as I was) you will be disappointed.  Most of the book hardly even mentions finance. Instead it deals with the Emanuel’s (admittedly not uninteresting) view of models in physics,  society (such as during the apartheid era) and Spinozan philosophy. The point of this, I think, was to illustrate in a more general setting the idea of a model or a theory. But given that the book is portrayed as being firstly about “Wall Street” it feels a bit like fluff.

There are some autobiographical passages about Dermans life in South Africa. I found these very interesting, but they added little value to the goal of the book. The point Derman was trying to make (that the models used in apartheid South Africa failed) could have been made in much less space.  But then the book would have been even shorter than it already is. I hardly think anyone who buys the book would be truly interested in reading about Spinoza’s theory of emotions (as interesting it might be philosophically). I certainly hoped the financial stuff would come soon.

One would have expected to get at least a good explanation of how models were used during the financial crisis and how they failed. Instead, the links that Derman makes with his descriptions of some basic financial models and the financial crisis are superficial at best. If you want insight into this part of the financial crisis, you must go elsewhere.  Early on in the book Derman laments what had happened during the crisis and before it: “decline of manufacturing; the ballooning of the financial sector; that sector’s capture of the regulatory system; ceaseless stimulus whenever the economy has waivered; tax-payer-funded bailouts…” It’s a very long list and not one item on it is treated in the book. We are told that model failure was the cause – we are never given any more insight than that.

The value of commonsense

I have been quite critical thus far, but the book does add value. There is a distinction between models used in physics, which are accurate, and those used in finance which are, at best, sometimes useful. The latter often treat people as if they are just particles or objects, which they are not. Derman calls this “pragmamorphism”. Financial models always leave out something important. The admonition to always use common sense is valid. However, I was hoping to come away with more insight than that. Perhaps that’s all there is, really.

Models and theories and facts – Derman does the unforgivable

Central to the book is the distinction between “models”, which are based on analogy, and
“theories” which attempt to describe the real world without analogy. Essentially, physics works with theories (mostly) and finance works exclusively with models. This is a useful distinction – though I am not convinced that the two categories are not instead two extremes of a continuum of models. However, as far as thinking about modelling goes, I believe it is very valuable.

Dr Derman goes one step further though, doing something I find unforgivable.  He claims that a “correct” theory becomes a fact. Physics models that say there are electrons and that they behave in certain ways are the truth. I do not think Dr Derman actually thinks this – because to do so would be to disavow even the possibility of a theory being overturned, replaced by something better. And we have seen it done: Newton’s laws, “confirmed” to be accurate for hundreds of years turned out to be a poor description of reality once you started looking at things moving near the speed of light.

Physics uses mathematics and mathematics is not and will never be the real world – though it is the most useful tool we have for describing the world. In science (all of science, including physics) we can only ever say this: IF my model or theory is correct then we would expect certain observations in the real world.

Science can never confirm a theory to be correct. Theories that are considered “facts” are just the ones that have not yet been proven to be wrong. I think that a better theory than general relativity or quantum electrodynamics may come along – it may only bring incremental changes or it may bring a revolution in the way we think about the world. But it is the way we think about the world that changes, not the world.


Verdict


I must, if I am kind, conclude that Derman’s book tries to do a little too much (or, if I am unkind, that it tries to do too little and pads it with fluff): it wants to be philosophy, biography, essay and social commentary. It does none of these particularly well. 

Reference

Derman, E., 2012. Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life, Free Press. Available at: http://www.amazon.com/Models-Behaving-Badly-Confusing-Illusion-Reality-Disaster/dp/1439164991 [Accessed January 27, 2013].

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