It’s not the length of the equations, but what you do with them | FT Alphaville

It’s not the length of the equations, but what you do with them

Rick Bookstaber has a fascinating post about “physics envy”, which is how he describes the affliction suffered by those who would explain activity in financial markets according to sophisticated mathematical models (and base decisions on them).

Building on research by Andrew Lo and Mark Meuller, Bookstaber writes that this is not a new phenomenon, and adds:

…the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, that there are not many jobs for physicist in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.

Bookstaber also writes that the problem with these models isn’t that the world is an uncertain place that won’t conform to models, but that financial markets contain a particular kind of uncertainty (emphasis ours):

I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well. …

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

The whole piece is insightful and interesting (read it!), and it also gave us an excuse to post one of our favorites from the XKCD collection. We’re guessing the economists would probably be somewhere to the right of psychologists:

Related links:
Physics envy in finance – Rick Bookstaber
Warning: Physics envy may be hazardous to your wealth – SSRN
Dismal Science – Long Room