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Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life [Kindle Edition]

Emanuel Derman
2.9 out of 5 stars  See all reviews (41 customer reviews)

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Book Description

Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs, one of the financial engineers whose mathematical models became crucial for Wall Street. The reliance investors put on such quantitative analysis was catastrophic for the economy, setting off the ongoing string of financial crises that began with the mortgage market in 2007 and continues through today.. 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 and employ the language of mathematics, ultimately they deal with human beings. There is a fundamental difference between the aims and potential achievements of physics and those of finance. In physics, theories aim for a description of reality; in finance, at best, models can shoot only for a simplistic and very limited approximation to it. 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 acknowledge the limits of their equations in the sphere of human behavior--which of course is what economics is all about.

includes a personal account of Derman's childhood encounters with failed models--the oppressions of apartheid and the utopia of the kibbutz. He describes his experience as a physicist on Wall Street,  the models quants generated, the benefits they brought and the problems, practical and ethical, they caused. Derman takes a close look at what a model is, and then highlights the differences between the successes of modeling in physics and its failures in economics.  Describing the collapse of the subprime mortgage CDO market in 2007, Derman urges us to stop the naïve reliance on these models, and offers suggestions for mending them.  This is a fascinating, lyrical, and very human look behind the curtain at the intersection between mathematics and human nature.

Editorial Reviews


Review of: Models. Behaving. Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life
Emanuel Derman Free Press 240 pp. $26 (2011)

"Ranging wittily across philosophy, literature and the arcane world of high finance, Derman's argument is a heady mix of physics, economics and memoir" -- NATURE, 2011

“A readable, even eloquent combination of personal history, philosophical musing and honest confession concerning the dangers of relying on numerical models not only on Wall Street but also in is undeniable that Models.Behaving.Badly. itself performs splendidly.” —Burton Malkiel, Wall Street Journal

"An erudite yet pleasantly readable exploration of why financial models failed during the U.S. mortgage meltdown and why modelers must learn to use them more wisely. Derman has distilled a lifetime of reading, research and thinking into these pages, and I read the book twice to see how he pulled the threads together without losing the reader." Bloomberg News

"Ranging wittily across philosophy, literature, and the arcane world of high finance, Derman's argument is a heady mix of physics, economics, and memoir." Nature

“A fascinating cross-disciplinary exploration of how and why financial and scientific models fail…A unique examination of the limits of models and theories in understanding and predicting human behavior, and a nice rejoinder to the equations-can-solve-or-explain-everything crowd.” Kirkus Reviews

Emanuel Derman has written my kind of a book, an elegant combination of memoir, confession, and essay on ethics, philosophy of science and professional practice. He convincingly establishes the difference between model and theory and shows why attempts to model financial markets can never be genuinely scientific. It vindicates those of us who hold that financial modeling is neither practical nor scientific. Exceedingly readable.” —Nassim N. Taleb, author of The Black Swan

"This is a compelling, accessible and provocative piece of work, that forces us to question many of the assumptions that we work with. As Derman explains so clearly, models are not "bad" in themselves; on the contrary, they are crucial for modern society. However, they have been used in a dangerously sloppy and careless way, with sometimes terrible results. Derman explains this clearly, and draws heavily onhis own lifetime experiences - ranging from growing up in appartheid south africa, working in the scientific field and then as a financial engineer on wall street - to provide a moving and fascinating set of illustrations of these principles. The conclusion is unexpectedly otpimistic - if people choose to listen." —Gillian Tett, author of Fool's Gold

"Models. Behaving. Badly. is an engaging and personal meditation on the limitations of our ability to predict the future, especially—but not only—in the context of financial markets. He is not interested in blame or politics, but in the deeper lessons to be drawn from the financial crisis. As a physicist who was also highly placed in the financial world, he explains clearly the difference between prediction and advice, theory and model and knowledge and wisdom." —Lee Smolin, Senior Researcher at Perimeter Institute for Theoretical Physics, author of The Trouble with Physics; Life of the Cosmos, and Three Roads to Quantum Gravity

"If you don't want your models to behave badly, you should study carefully these words of wisdom on the philosophy of quantitative modeling. Emanuel Derman has always been one of the most respected quants on Wall Street.  Now he has proven that he is also one of the most thoughtful. Though, in the sequel he should tell us what happened to the large man over the Sudan!"
—Clifford S. Asness, Ph.D., Managing & Founding Principal AQR Capital Management

“I found this book fascinating. Derman has a skill of mixing the personal with the abstract. You will not find another that takes you from the vagaries of the human eye to the vagaries of the stock market with stops at quantum electrodynmics. It is quite a ride.” —Jeremy Bernstein, author of Quantum Leaps, and Plutonium

"This is a thoughtful book for anyone interested in the overlap between the hard sciences and the soft sciences, from physicists to bankers. But finance academics beware, Professor Derman, with an iron fist in a velvet glove, gives them a good slapping." —Paul Wilmott, co-author "Financial Modelers' Manifesto"

Praise for Emanuel Derman’s My Life as a Quant:

"There are few "gentlemen bankers" left these days. That is why Emanuel Derman's memoirs are so compelling…Derman's wry humour and sense of irony are apparent throughout the book." Financial Times

"That sense of being an intruder in outlaw territory lends an intriguing mood to Derman's My Life as a Quant, a literate and entertaining memoir." BusinessWeek

“Reads like a novel, but tells a lot about brains applied to making money grow.” —Paul A. Samuelson, MIT, Nobel Laureate in Economic Sciences

From the Author

This is an outline of the book:


  • Part I. Models

Chapter 1. A Foolish Consistency
 A personal account of my experiences with models that failed.

Models that failed *  Capitalism and the Great Financial Crisis * Divining the future: models, theories, and intuition * Time causes desire * Disappointment is inevitable * To be disappointed requires time, desire and a model * Living under apartheid * Growing up in "The Movement" * Tat Tvam Asi

Chapter 2. Metaphors, Models and Theories

The various ways we have of understanding the world and predicting its future. Theories tell you what something is. Models tell you merely what something is like. Intuition is a merging of the understander and the understood.

* Language is a tower of metaphors * The hole in the Dirac sea  * Metaphors become real: the discovery of the positron * Absence is a presence * Analytic continuation * Every fact is a theory * Building a model airplane * Why is a model a model? * Why is a theory a theory? * A puzzling case of monocular diplopia * Making the unconscious conscious again

  • Part II. Models Behaving

Chapter 3. The Absolute

An illustration of a theory: Spinoza's Theory of the Emotions

* The Tetragrammaton * The Name of the Name of the Name * The Irreducible Nonmetaphor * Spinoza's Theory of the Emotions * Fiat Money * How to Live in the Realm of the Passions

Chapter 4. The Sublime
Electromagnetism, a perfect theory. The role of intuition.

* The Birds of the Air * The Best Theory in the World * No Logical Path to It
 * Electricity and Magnetism * Their Qualities * Their Quantitative Laws * Ampère's Sympathetic Understanding of the Phenomena * Faraday's Imaginary Lines of Force * Maxwell's Factual Field * The Beasts of the Field

The ultimate goal would be: to grasp that everything in the realm of fact is already theory.
      Goethe,Maxims and Reflections
  • Part III. Models Behaving Badly

Chapter 5. The Inadequate
The efficient market model: a model and an analogy but NOT a valid theory.

* Financial models are not the physics of markets  * In finance, uncertainty is everywhere * The difference between uncertainty and risk * The Efficient Market Model  * The relation between risk and return * Risk is like pleasure * The Black-Scholes Model * CAPM * Alpha and beta * Why the Efficient Market Model fails * The unbearable futility of modeling

There is nothing so terrible as activity without insight.    
Goethe,Maxims and Reflections

Chapter 6. Breaking The Cycle

How to cope with the inadequacies of models, via ethics and pragmatism.

* The Perfect Cage * The Mysteries of the World * Models That Failed * How to use financial models * Beware of Idolatry * The Financial Modelers' Manifesto * Markets and Morals * Tat Tvam Asi

Product Details

Customer Reviews

Most Helpful Customer Reviews
65 of 79 people found the following review helpful
1.0 out of 5 stars belabored December 26, 2011
By Suez
This book got me excited. Then, just as the economic models I teach,it became a disappointment. It's refreshing to start something that's different -- that isn't Michael Lewis. But this book quickly became tedious -- a self-promoting reflection of pieces of the author's life, a not-detailed-enough (you can't get much out of it if you don't already know it) and yet too-detailed (pages and pages) review of philosophy and physics, and very shallow comments about economic and financial models. It's also unfortunate that no one caught the error in defining a CDO, which is a collateralized debt obligation, not a collateralized "default" obligation. Mistakes such as this compromise the author's credibility. Don't buy this book. Spend your money on Daniel Kahneman's Thinking Fast and Slow -- it's fascinating and gives you the real meat of why economic and financial models behave badly.
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20 of 23 people found the following review helpful
3.0 out of 5 stars Interesting concept, so-so execution. January 27, 2012
Here's a quick summary of this review, for those who are short on time: this book lacks focus and I would not recommend it unless you have A LOT of patience. It is a LONG 200 page read.

As a cross-disciplinary individual (I studied Finance and English in college), this type of "crossover" book intrigues me. A mashup of philosophy, physics and finance, Models Behaving Badly is, at the very least, a very unique book. Indeed, I've never quite read anything like it. While centered around the markets -- and the idea that most of the models used to describe them are garbage -- Derman supports his points with quotes from Goethe, discussions on Maxwell's electromagnetic theory and anecdotes about his own youth as a Jewish boy in the era of South African apartheid. The fields that are of interest to me, likewise, are eclectic, and I think that most of the stuff I was taught in undergraduate Finance was wholly useless. I mention these facts simply because I feel as if I am precisely the demographic Derman targeted with this book.

And, unfortunately, he missed the mark.

The reason is simple: he never reconciles the three disciplines into any sort of coherent argument. On a broad level, he uses each separate field to show that theories are reflective of reality, whereas models are merely an approximation. He never, however, goes beyond this generalization and provides a good reason WHY he's talking about the philosophy/physics (other than, presumably, that they interest him). I have no doubt that Derman is an intelligent guy; his prose is generally decent and he clearly knows a lot about the markets as well as physics. Unfortunately, there is NO reason to have the physics (and, to a lesser extent, the philosophy) in this book.
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18 of 21 people found the following review helpful
3.0 out of 5 stars Readable but unfocused December 24, 2011
Format:Hardcover|Verified Purchase
Emanuel Derman is a very prominent former financial modeller who trained as a physicist. Models Behaving Badly is a combination of personal philosophy, practical reality and ethical retrospective. Each focus is readable and there is much personal experience shared which makes the book very personal, but the contents never really come together particularly well.

The book has three sections, Models, Models Behaving, and Models Behaving Badly. The author starts with a description of his childhood, describing how experience affects perspective, how people are not generally not objective about themselves. He discusses his youth in South African apartheid. The author spends a lot of time philosophizing about the nature of reality and the differences between physical theories and theories about human behaviour. He discusses Spinoza and the residualizing of human motivation to Pain, Pleasure and Desire. The author then discusses what I think most readers assumed what the book was about, financial models. In particular the failures of the Efficient Market Hypotheses and the non stationary behaviour of people and the recursiveness that prevents a theory of human behaviour to be possible. The book ends with a dissappointment in the lack of consequence faced by financial services despite the recession we are currently faced with.

I unfortunately learned very little from this book other than substance about the author's life. This is not because the book does not offer information, but rather because it only has a very light history of science discussion and shallow analysis of financial modelling failure.
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11 of 12 people found the following review helpful
2.0 out of 5 stars Save your money. glad i borrowed it from the library. January 31, 2012
only the last quarter of the book deals w/ financial models that caused the economic crisis. the rest is the author's life in south africa, basic physics, philosophy etc that have little to do w/ economics. odd book considering the author's impressive background.
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39 of 50 people found the following review helpful
1.0 out of 5 stars Don't do this December 12, 2011
Format:Hardcover|Verified Purchase
Don't do what I did: if you are interested in any of the following, don't waste your money -and worse still, your time- with Derman's book:

What happened in 2008; how models lead people astray; what models are actually used in the financial world; "why confusing illusion with reality can lead to disaster on wall street and in life"; "the modeller's manifesto"; "the modeller's Hippocratic Oath".

I was. I also read, like you did, some internet review or comment on the book. I, like many of us who deal with science, also feel the urge to restore (or establish for the first time?) the ethical and moral keel to the listing ship of the Enlightment. I ordered the book.

What I got was promising: A well-bound book with generous paper and type-font. Nice, clean dust-jacket in bright off-white promised a measured, even conservative take on what should be a revolutionary or at the very least revealing statement of a book. I cracked it open and soon realized that I would have to go through some personal mythologizing by the author talking about his life among the white South African middle class: nothing to be scared by, it is always nice to learn where a revolutionary comes from.

Page after page, trouble crept upon me more like the subconscious realization of the fourth-tier "investor" in a pyramid scheme as he realizes that there may be no exit from it. By now I was more informed about the poorly archived memoir notes of a mediocre bean-counter (flashily described as a "quant", for "quantitave analyst") than I ever wanted to be, well past the middle of the book and still not at the beginning of any of my questions.
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Most Recent Customer Reviews
2.0 out of 5 stars Models for Derman's Books
The book is about the difference between "theories" and "models", and how they diff in fields of Physics and Finance. Read more
Published 10 months ago by A Reader
1.0 out of 5 stars Poor, with Misleading Title
I was hoping for a critical discussion about various models pertaining to finance and investing primarily, and maybe other applications as well. Read more
Published 11 months ago by Frederic M. Blum
2.0 out of 5 stars Interesting thoughts-Not well developed
A collection of experiences from his life; unfortunately, Mr Derman fails to convincingly demonstrate how they are connected to the central idea he would like to develop in his... Read more
Published 12 months ago by Reader
2.0 out of 5 stars Big let down.
I looked forward to this book having read Derman's earlier work, unfortunately I found this book very unfocussed and rambling for the most part. Read more
Published 13 months ago by G. Elston
2.0 out of 5 stars Didn't find anything of value in it
Based on the author's impressive bio and the blurbs from really intelligent people, I expected more from this book. I really found it to be a waste of time. Read more
Published 13 months ago by MT57
5.0 out of 5 stars Original, Personal, Deep
Here is what I wrote in my endorsement: Emanuel Derman has written my kind of a book, an elegant combination of memoir, confession, and essay on ethics, philosophy of science and... Read more
Published 14 months ago by N N Taleb
The book's subtitle is "Why confusing loose-association metaphysics with a sound argument can lead to absurdity, in finance and in philosophy". Read more
Published 14 months ago by John Vos
I have many times bitterly complained about authors putting a misleading title to attract more interest and thus increase sales; this one is the worst offender I have ever seen... Read more
Published 15 months ago by Beau Sabreur
3.0 out of 5 stars Charming book, but very undisciplined
This is really more of a memoir/ramble than a systematic treatment. But it's fun to read, and not too technical for those not versed in economics.
Published 15 months ago by Robert Fink
5.0 out of 5 stars An Enjoyable Book Worth Reading
Models Behaving Badly is part memoir, part history, and part science -- Emanuel Derman does a nice job of explaining the difference between a model and a theory, and overall it's... Read more
Published 16 months ago by Greg Linster
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More About the Author

EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life As A Quant, one of Business Week's top ten books of the year, in which he introduced the quant world to a wide audience. His latest book is Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disasters,On Wall Street and in Life.

He was born in South Africa but has lived most of his professional life in Manhattan in New York City, where he has made contributions to several fields. He started out as a theoretical physicist, doing research on unified theories of elementary particle interactions. At AT&T Bell Laboratories in the 1980s he developed programming languages for business modeling. From 1985 to 2002 he worked on Wall Street, running quantitative strategies research groups in fixed income, equities and risk management, and was appointed a managing director at Goldman Sachs & Co. in 1997. The financial models he developed there, the Black-Derman-Toy interest rate model and the Derman-Kani local volatility model, have become widely used industry standards.

In his 1996 article Model Risk Derman pointed out the dangers that inevitably accompany the use of models, a theme he developed in My Life as a Quant. Among his many awards and honors, he was named the SunGard/IAFE Financial Engineer of the Year in 2000. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.

He blogs at
Twitter @emanuelderman

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