The downside of the beauty of physics

November 3, 2011
excerpt of Emanuel Derman's new book today; I can highly recommend both the excerpt and the whole book.

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We have an excerpt of Emanuel Derman’s new book today. I can highly recommend both the excerpt and the whole book, which is a very readable generalist’s guide — by a physicist-turned-quant — to models, their uses, and their abuses.

“First,” writes Derman, “one must recognize that there are no genuine theories in finance.”

To understand this, you need to understand how a physicist views a theory. So let me also excerpt for you one of the more wonderful passages in the book:

Newton’s theory is general and precise. The gravitational force is inversely proportional to exactly the square of the distance between the planets; Newton was confident that the power of the distance is precisely 2. Had he been a social scientist performing statistical regressions in psychology, economics, or finance, he would probably have proposed a power of 2.05 ± 0.31.

A theory is not a fetish; when it is successful (see the quantum theory of electricity and magnetism in chapter 5) it describes the object of its focus so accurately that the theory becomes virtually indistinguishable from the object itself. Maxwell’s equations are electricity and magnetism; the Dirac equation is the electron; the Weinberg-Salam model of weak and electromagnetic interactions matches the electrons and quarks in almost every detail, as closely as one can measure. You can layer metaphors on top of the equation, but the equation is the essence.

This takes me back to Nigel Wood, my great high-school physics teacher, and the three-volume Feynman Lectures on Physics that my dad gave me as a birthday present one year. It’s infectious and addictive stuff — but it’s also very dangerous when, as happens with great frequency, physicists come pale and blinking out of their post-doctoral studies and get thrown into the bowels of an investment bank somewhere.

The point is that when you’ve spent a decade or so in a world of true theories, it’s incredibly hard to understand, on a deep level, any series of pro-forma warnings about how there aren’t really any theories in finance and how models can explode. And it’s not just quants, it’s regulators, too, who pine for a world of certainty and who can be astonishingly blind to real-world risks that live outside their models.

How do we fix this problem? With great difficulty. Wilmott’s Certificate in Quantitative Finance is a start: if we’re going to have quants, and we are, then they should be trained well, in the real world. But I think in general this is one of those endemic and unhedgeable risks. And a decidedly unexpected side-effect of the amazing accuracy of forecasts in the world of quantum physics.


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