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
“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 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
This is an outline of the book:Models.Behaving.BadlyChapter 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
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 PassionsChapter 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
Chapter 5. The Inadequate
- Part III. Models Behaving Badly
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