Why do financial models work so badly?
Because people mistake them for theories. Theories are attempts to grasp the way the world actually is, even if we don't know why.
|Answer provided by Emanuel Derman, Professor of Industrial Engineering and Operations Research, director of the Financial Engineering Program
Photo by Eileen Barroso
Take Newton's laws for matter or Maxwell's equations for light. You can’t ask why they hold. That’s the way the world is. End of story.
Models are distinctly different, though they use the same language of mathematics as do theories, and as a result people mistake them for truth. This applies to models in physics too, but even more so to models in finance, where there are no real theories. Models are only metaphors or analogies. We say, ‘The brain is like a computer,’ or ‘Stock prices change the way smoke diffuses through a room.’ Models are merely attempts to describe something by using theories that already work in a different field.
When I first came to finance, I imagined I could use the principles of physics to try to build something just as truthful. I discovered that although the techniques appear similar, the resemblance is deceptive. When we make analogies, we simplify things. Many on Wall Street believed their models represented reality, but reality does what it likes, not what people's models dictate, and so they were disabused of that notion in 2008.
“Models. Behaving. Badly.” is the tentative title for my next book. It’s about the different approaches people use to understand the behavior of the world. I distinguish how theories differ from models and explain how the unwarranted assumptions of models can lead to incorrect conclusions.