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24 of 27 people found the following review helpful
VINE VOICEon 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. 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.
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72 of 88 people found the following review helpful
on December 26, 2011
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
on December 24, 2011
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. Economics has had the nickname of dismal science since the 19th century, its not new or shocking that the precise computations of current mathematical economists dont correspond to reality. On better practices for risk management Rebonato wrote Plight of the Fortune Tellers about the need for more commonsense risk management (in 2007 I might add). The authors comments about the ethical lapse of the industry should be well taken, though I would think the current transition that is currently taking place is not trivial nor shallow. This is a readable account of the author's philosophy, the history of classical and modern physics, and discussion of risk management ideas, it is not particularly insightful if one has knowledge of these fields though.
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10 of 11 people found the following review helpful
on February 22, 2012
Emanuel Derman is a "quant" of illustrious pedigree: not only a 20-year veteran of Goldman Sachs (say what you like about the Vampire Squid but over the last couple of decades Goldman's financial analysts have consistently been the smartest guys in the room), but also a close colleague of nobel laureate Fischer Black, co-inventor with Myron Scholes of the (in)famous Black Scholes option pricing model.

Given that the motion before the house concerns misbehaving financial models you might expect some fairly keen insights on this topic: It has already been well documented that Black Scholes doesn't work awfully well when the market is in a state of extreme stress - that is, precisely when you want it working awfully well. In fact, in those situations Black Scholes can create havoc, and memorably did during the Russian Crisis of 1998, during which Myron Scholes' pioneering hedge fund Long Term Capital Management catastrophically failed.

But this isn't Emanuel Derman's interest: the specific inadequacy of Black-Scholes (that it assumes that market events occur in isolation of each other and are therefore arranged according to a "normal" probability distribution) rates barely a mention. Derman's view is that reliance on *any* financial model will end in tears, simply because models are poor metaphors which are not grounded in the same reality as the sciences whose language they mimic.


Benoit Mandelbrot, whose excellent book The (Mis)Behaviour of Markets clearly outlines the "tail risk" inadequacy of Black Scholes, recognises that it is the market, not the model, that tends to misbehave. A model can't be blamed for failing to work when misapplied. Guns don't kill; the people holding them do.

This is a narrow example of a broader principle which (counterintuitively) is true of all scientific theories: they only work within pre-defined conditions in carefully controlled experimental environments. Even Newton's basic laws of mechanics only hold true where there is zero friction, zero gravity, infinite elasticity, infinite regularity and a total vacuum, conditions that in real life never prevail. "Real life" experiments are thus indulged with a margin of error: that a heartily-struck cricket ball does not prescribe precisely the trajectory Newton says it ought is not evidence that his fundamental laws are wrong, but the simply that the pure experimental requirements for its true operation are not present.

All scientific - and, for that matter, any other linguistic - theories benefit from this "get out of jail" card: they are what philosopher Nancy Cartwright calls "nomological machines", explicitly pre-defined to be "true" only in tightly circumscribed (and often practically impossible) conditions. The looseness or tightness of those constraining conditions and the consequences of marginal variations to them determine how useful the theory, or metaphor, is in practice. F=MA will be a better guide for a flying cricket ball than for the proverbial crisp packet blowing across St. Mark's Square.

Emanuel Derman thinks science really speaks truths, while models peddle something less worthwhile. He sees a qualitative difference and not merely one of degree. Models he treats as broadly analogous with metaphors, which he says depend for their validity on comparison with an unrelated scenario. Theorems and laws, on the other hand, need empirical validation but once they have it stand rooted to the ground of reality by their own two feet.

I'm not sure the distinction is as sharp as Derman thinks it is. Nevertheless, this talk of metaphors cheered me because the vital role of metaphor in constructing meaning is overlooked even by linguists, and is completely ignored by most scientists and mathematicians. But Derman makes less of it that I hoped he might.

What Derman means by metaphor is really a simile: the ability to reason by analogy with something already well understood. A model, under this reading, makes its prediction by reference to what would happen in an analogous situation. "Resemblance is always partial, and so models necessarily simplify things and reduce the dimensions of the world". But metaphors are far more powerful, expansionary operators in scientfic and literal discourse than that.

In Derman's world there is a clear line between fact and metaphor and he has trouble being patient with people who confuse it. That would include me, because I have trouble seeing the boundary between metaphorical models and theoretical (or even literal) reality: each is an abstraction, each a simplification, each a "nomological machine" which only has value within a set of parameters. Literal meaning is really a species of metaphor. The difference between a model and a theory is one of scope and degree: a model is a heuristic; a theory more of an algorithm. Models are less worked out; more rules of thumb. If so treated, both have reat practical uses provided their output is treated with an appropriately sized pinch of salt. LTCM's folly was to suppose their model could solve for something it manifestly could not. Scientists in recent times have been just as guilty of ontological overreach, so I'm not enormously sympathetic with the bee in Derman's bonnet.

There are plenty of better grounds to take umbrage at Investment Bankers at the moment, in other words.

What we are left with is really a low level, idiosyncratic grumble. There are better books written on this and similar subjects: Mandelbrot's The (Mis)behaviour of Markets remains the technical classic, and Nassim Taleb's The Black Swan: The Impact of the Highly Improbable a more entertaining popular entry. Not quite sure where this fits between.

Olly Buxton
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41 of 53 people found the following review helpful
on December 12, 2011
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.

There are some interesting explanatory sections (again, badly collated among diversions on the author's warped descritpions of some models in physics) on the making of a financial model, and then, towards the end, some moralizing about things we all learned more clearly than here in any of the many movies about the financial meltdowns of our times. These good bits could have easily fitted in a short pamphlet. Just to crown the elephantine self-aggrandizing bore, we are treated to a grand-finale of the author's mixed-up confusions between college physics, cliff notes of his fave philosophers (Spinoza reigns supreme, which is not bad), and his own adolescence and adolescent professional life.

So, if you want to hear about those questions, like me, and if you must, just go for chapters 5 and 6, which really entails 200-139 = 61 skimpy pages of large font.

But I hope this comment will spare you the time and money. Don't do what I did.
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13 of 15 people found the following review helpful
on 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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55 of 73 people found the following review helpful
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. He has seen and worked with the best modelers in the highest-stakes arena, an arena in which he excelled as much as anyone ever has. This is not a sour-grapes screed from someone who flunked math, or a condescending lecture from a sidelines spectator, it is a clear-eyed appraisal from someone who played the game and learned what works and what doesn't.

All of that would make it essential reading for anyone interested in either finance or mathematical modeling. But models.behaving.badly gives one thing more. It is a stunning literary achievement, a book that can be read for pure pleasure of the language and expressions by someone with little interest in the ideas themselves. It is a brilliant jewel of a book, to read and to treasure.
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7 of 8 people found the following review helpful
This book is a potpourri of a very intelligent man's favorite themes. An author should have an idea of his intended readership when he writes the book. He must've had himself in mind; I cannot imagine much of anybody with interests as eclectic as Emanuel Derman.

Having chosen his title, he has an obligation to explain what a model is. He begins by saying what it is not. It is not a theory, and it is not fact. A model is a metaphor, a simplified representation of reality, necessary when reality itself is too multifaceted to easily grasp. The value of the model depends on how well it represents those aspects of reality in which the user is interested. A model airplane, his example, is useful because it looks like a real airplane and has similar aerodynamics. The kid who makes a model airplane knows full well that it is much smaller and the internal structure and is nothing like a real airplane. For the kids purpose, that doesn't matter.

A theory represents reality. A theory that has been proven is the fact. The Pythagorean theorem is a fact, as our Newton's laws of gravity, Maxwell's laws of electricity and magnetism, and so on. One of the valuable parts of the book is a short history of science in the realm of electricity and magnetism. Derman, whose professional training was in physics and spent half of his career doing it, elegantly and succinctly takes the reader through the groundbreaking theorems describing these phenomena, electricity and magnetism, which can only be examined indirectly - through their effects rather than the thing in itself.

Derman was raised in Jewish neighborhoods of South Africa. His account of his childhood is fascinating, evoking in this reader a nostalgia for the kind of community that every kid should be lucky enough to have. It was a community of caring people, intellectual challenge, social involvement, and a vast amount of adventure. His description of his own involvement with apartheid seemed a little bit formulaic; what can you say? For a far better treatment of South Africa of that era, by a woman whose father led the Jewish opposition to apartheid, read "Into the Cannibals Pot" by Ilana Mercer.

There is a pretty good exegesis on the various names for God in the Hebrew language, and the two, three, and four levels of circumlocution used by the most devout to avoid saying the name of God. He somehow equates God with a theory rather than a model. To that I would not say yes or no, simply "Huh?" He then goes into philosophy with Baruch Spinoza. What he finds to be incredibly deep looks to me like navel gazing.

And at last we get into the world of finance and find not very much, at least not compared to so many other recent books such as the Black Swan, How Markets Fail, Money and Power, Boomerang and many, many others. He talks at extremes. He gives very simple, high school level descriptions of securities such as stocks and bonds, then maybe a collegiate description of derivatives, and then jumps into Black Scholes models. Is unbalanced, and fundamentally not very useful. The take-home messages are quite simple. Your hedge fund manager is not earning his 20 percent if he is making money in a rising market. No model works all the time; you should not give up your intuition and trust totally in models. Making money in the stock market is hard work. And other platitudes.

Lastly, Derman is not very sanguine about the current course of events. He considers the bailout of Wall Street an outrage, and does not sound very bullish on the future of the long-standing alliance between capitalism and democracy.
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23 of 30 people found the following review helpful
on February 19, 2013
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 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.
From the remarks here, people seem to be blaming Derman for not having written the type of books they usually read... They are blaming him for being original! This is very philistinic. This book is a personal essay; if you don't like it, don't read it, there is no need to blame the author for not delivering your regular science reporting. Why don't you go blame Montaigne for discussing his personal habits in the middle of a meditation on war inspired by Plutarch?
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17 of 22 people found the following review helpful
VINE VOICEon October 25, 2011
A model is a simplified representation of reality which tries to mirror a system by idealizing certain details and leaving others out. It is not a theory and it is certainly not reality itself. Yet many financial modelers who built models assumed their models to be real and contributed significantly to a financial crisis which will likely play out for decades. In this book Emanuel Derman, a modeler and quant par excellence, provides a refreshing and balanced outlook on the flaws in financial models and how these models are quite different from their exact theoretical counterparts in physics.

Derman would know better than almost anyone else since he is a both a veteran financial modeler and an accomplished theoretical physicist. Before pioneering the art of quantitative finance on Wall Street he was an expert in the rarefied domain of particle physics, a discipline which has produced theories agreeing with experiment to an almost unbelievable degree of accuracy. Thus Derman begins by discussing the difference between models and theories and why the former are much more approximate, uncertain and tentative than the latter. The trouble starts when we start confusing the two and expecting models in finance to be as precise as theories in physics.

In the first part of the book, Derman has elegant definitions of models, theories and intuition and pens substantial chapters on the history of physics culminating with his chapter on quantum electrodynamics, the most dazzlingly accurate theory of nature that we have uncovered. In Derman's words, a theory is something that stands on its own two feet without justification while a model is a framework that describes only a part of reality and cannot be a unique description of the world. There is also a curious digression on Spinoza's "Ethics" and why Derman thinks that Spinoza's constructs came closest to being a bonafide theory of human behavior and emotions. Derman also sprinkles these chapters with personal recollections of apartheid in Africa and a bout with an eye disorder. I thought these parts of the book were a little meandering and unclear, but Derman essentially seems to be making a point that imposing the wrong model (in these cases, assumptions behind apartheid or the diagnosis of his eye disease) on reality can lead to disaster and pain.

The second part of the book contrasts models in physics with those in finance. Unlike physics, the fickle world of human beings precludes having any kind of real theories or axioms about financial markets. Even the models in the financial world try to mirror moving targets whose complexity keeps on changing and whose parameters are hard to define in the first place. Yet as Derman describes, modelers on Wall Street believed in rather absurd entities such as a "fundamental theorem of finance" akin to the fundamental theorem of arithmetic. In an illuminating and fairly detailed chapter, Derman points out the flaws in the efficient market model (EMM) which tries to distill down the complex variables contributing to the value of a stock or company to a few simple numbers (drift and volatility in this case). But the real "value" of a company depends on unpredictable and constantly changing human decisions which cannot be captured in an incomplete quantitative model. As Derman makes clear, models like the EMM fail to predict or even explain sudden changes arising during crises akin to the present one and therefore do a rather poor job of guiding our economic choices. The basic problem of course is in trying to fit human behavior to a set of mathematical equations.

Derman concludes by summarizing the problems inherent in modeling financial markets which are systems engineered and manipulated by flawed, volatile and complex human beings. To prevent future modelers from getting carried away by their models, Derman reprints a modeling "manifesto" which he penned in 2009. The manifesto exhorts financial engineers to not get dazzled by fancy mathematics, to not assume that the complexities of human behavior could ever be boiled down to pithy equations, axioms or theories and to honestly state and evaluate the parts of reality left out from their models (even if they are sweeping these under the rug in practice).

And Derman's most important piece of advice? To always remember that financial modeling is not physics, and that models don't equal reality.
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