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.
“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].
