Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life: Emanuel Derman: 9781439164983: Amazon.com: Books

Review

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 life....it 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 failA 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, especiallybut not onlyin 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 Dermans My Life as a Quant:

"There are few "gentlemen bankers" left these days. That is why Emanuel Derman's memoirs are so compellingDerman'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:

Models.Behaving.Badly

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

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Customer Reviews

2.9 out of 5 stars

(41)

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“ I unfortunately learned very little from this book other than substance about the author's life. ” A. Menon | 15 reviewers made a similar statement

“ In short, a book with a totally misleading title dealing largely with unrelated stories and a content so incredibly shallow, that it is a real waste of time to read. ” Beau Sabreur | 11 reviewers made a similar statement

“ This is probably not why most people would buy the book (expecting something even vaguely related to finance). ” J. Schmittmann | 8 reviewers made a similar statement

Most Helpful Customer Reviews

55 of 68 people found the following review helpful

1.0 out of 5 stars belabored December 26, 2011

By Suez

Format:Hardcover

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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19 of 22 people found the following review helpful

3.0 out of 5 stars Interesting concept, so-so execution. January 27, 2012

By Nicholas E. Johansen VINE™ VOICE

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.... His examples are impossible to follow unless you're a physicist or engineer, and the discussion is way too technical for non-scientists to understand. Worse, the discussion is pointless, as it does not relate back to the core thesis of the book, which revolves around CAPITAL MARKETS. I get that there are theories in science, and that they are generally indisputable tenants of reality. However, it is unnecessary and BORING to devolve into a 30+ page discussion about the intricacies of electromagnetic theory.

The philosophy was sometimes interesting, at least, but again, it was only tenuously linked to the core point of capital markets. It's interesting when he brings up the idea of life being "negative" and sleep/death being "positive" (or something akin to this), but it's out of place. If, after reading the previous sentence, you're wondering "Surely he relates that back SOMEHOW," then I have news for you: he doesn't. It's just kind of hanging out there. Interesting point, but completely irrelevant to his main topic of discussion.

The philosophy/biographical/physics sections should have been edited down into a single chapter as a SUPPORT to his main point: that bad models caused the market meltdown. His main point is good -- and, for what it's worth, I think he's right on -- but he spends WAY too much time getting there, and not enough time discussing capital markets. If you even get that far -- the section entitled Models. Behaving. Badly., where he finally gets to the point of the book, is located about 50 pages from the end. And it is brutally difficult to get there.

Oh, and then when he finally does get there, in the first part of that section he refers to a CDO as a collateralized default obligation -- which kind of makes me wonder how accurate his physics diagrams etc. were. To make matters worse, if you're not a Finance major or investment professional, this section -- like the physics one -- is going to make very little sense to you. Be prepared for lots of technical terms and jargon and definitions that assume familiarity with certain concepts. If you didn't know what the CAPM, Efficient Market Hypothesis or Sharpe Ratio were before reading this book, I doubt Derman will help shed much light on these topics.

I gave this book 3 stars because at points, when it does come together, it's fascinating -- and I believe that his core thesis (that financial models are crap) is dead-on, not to mention refreshing. Unfortunately,the rest of the text is dry, usually pointless and meandering without a clear purpose. If this had been 100 pages and focused more upon investing/finance, I think this would be a 4 - 4.5 star book. As it stands, I can only offer my recommendation to people who have experience in Finance/markets, or to those with TONS of patience and the will to look up a lot of concepts on Investopedia. Read more ›

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17 of 20 people found the following review helpful

3.0 out of 5 stars Readable but unfocused December 24, 2011

By A. Menon

Format:Hardcover|Amazon 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.... Read more ›

54 of 71 people found the following review helpful

5.0 out of 5 stars An instant classic October 25, 2011

By Aaron C. Brown TOP 500 REVIEWERVINE™ VOICE

The heart of this book is a discussion of the nature of models, primarily in finance but more generally as well. The author contrasts the best models in physics, which aspire to describe reality, with other models that can be no more than metaphors. Now metaphors are not useless, they can simplify reality to highlight essential features, and thereby lead to great insight. Metaphors are deeply embedded in human thought and can be the basis of productive action (Stephen Pinker in The Stuff of Thought demonstrates that the Declaration of Independence is a string of ancient and powerful metaphors). But metaphors are not reality; they do not even aspire to approximate it, only to provide insight into individual aspects.

Many people will see this Cliff's Notes version of the argument in reviews and decide they don't need to read the book. That will be a tremendous mistake. What makes this book an instant classic is not the general thrust of the argument. Lots of people have criticized, and no one defends, blind reliance on models. This book goes well beyond the usual version to embed the ideas in life, politics, human relations and philosophy. This is not academic speculation, the author begins with intensely personal autobiographic details and finishes with some highly practical interpretations of serious philosophers (Spinoza gets an entire chapter).

In between, when the author focuses on mathematical modeling, he brings the wisdom from his years as the most respected quant on Wall Street, running the Quantitative Strategies group at Goldman Sachs and now directing the financial engineering program at Columbia University.... Read more ›