Playing God

Economists (particularly those involved in financial research) are often accused of suffering from an acute case of "physics envy." If only the economic landscape could be as mathematically tractable as the physical landscape. If only terrifyingly precise theoretical predictions held in economics as well as they do in physics. If only we could also be deemed scientists.

Economics, of course, is not physics. For one very simple, yet inevitably powerful reason: in one case the laws are immutably God-made and thus permanently exact (all one has to do is go find them and, with luck, express their structure down on paper); in the other, the rules are dictated not by God, but by His creatures, us humble humans. And if there is something that we know about ourselves it is that, when it comes to economic activity (which of course includes the financial markets), we tend to be reliably unreliable. Our behaviour is not set in stone, pre-programmed or preordained. It is not law-abiding, but rather entirely anarchic and ever changing. While the physical terrain is characterised by its divine lawfulness, the human-determined economic domain is shaped by pagan lawlessness.

Few have explained this dichotomy better than Emanuel Derman, a former top Goldman Sachs executive and now a professor at Columbia University, and someone who, as a leading "quant" has spent a big chunk of his professional life trying to determine whether the markets are mathematically tamable. Derman, who has a PhD in physics and is a globally revered expert, once offered the following beautifully stated clarifications: "It’s not that physics is better, but rather that finance is harder. In physics you are playing against God, and He doesn’t change His laws very often. In finance, you are playing against God’s creatures, agents who value assets based on their ephemeral opinions."

That is, while accurate modelling and forecasting may be possible (and, naturally, desirable) in the physical world, they are likely to be impossible (and possibly entirely undesirable) in the financial world. The eventual level of asset prices will depend on the actions of millions of individual investors, constantly buying and selling. Can anybody honestly claim to be able to register such behaviour with a few equations? Who knows why and when people would revert to dumping an asset, or to accumulate it?

Can any type of math capture those wild spirits? Where will the yield curve be tomorrow? That will depend on bond prices, which in turn depend on the actions of people buying and selling bonds. Where will stock prices be next week? That will depend solely on human action, too. Where will the dollar be next month? Supply and demand. Can we really aspire to predict those actions? Seems far-fetched, and Derman agrees: "No mathematical model can capture the intricacies of human psychology. Watching people put too much faith in the power of formalism and mathematics, I saw that if you listen to the models’ siren song for too long, you may end up on the rocks or in the whirlpool."

Physicists can search for truth because in the physical world truth really exists. Once one of nature’s explicitly mechanical laws is discovered by a clever scientist, it can be relied upon not to change. Ever. But there are no immutable laws when it comes to the values of financial assets. No permanent rules set at the time of genesis. No divine inevitability. In finance, there is no truth. A new reality is created every minute through the unpredictable actions of utility-seeking humans.

Let Derman deliver the final nail in the coffin: "As a physicist, when you propose a model of Nature, you are pretending you can guess the structure created by God. Perhaps it is possible because God doesn’t pretend. But as a quant, when you propose a new model of value, you are pretending you can guess the structure created by other people. As you say that to yourself, if you are honest, your heart sinks. You are just a poor pretender and you know immediately there is no chance at all that you are truly right. When you take on other people, you are pretending you can comprehend other pretenders, a much more difficult task."

As a financial modeller you try and guess what other people are going to do. But their actions will depend on what they think you are going to do. So you have to correctly guess what other people are going to guess regarding your own future actions. Plausible? Like the notion of gravitation suddenly ceasing to work.

From Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets? Copyright Pablo Triana, with permission from John Wiley & Sons, Inc.