What really went wrong…
April 14, 2010Jon Brooks Comments OffA new paper that will be published in the Journal of Investment Management posits the theory that economists suffer from “physics envy,” aspiring to create economic models “as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics,” says the abstract, “‘physics envy’ has also created a false sense of mathematical precision in some cases.”
Here is the complete paper, titled “WARNING: Physics Envy May Be Hazardous to Your Health,” by Andrew W. Lo and Mark T. Mueller. From the introduction:
The Financial Crisis of 2007–2009 has re-invigorated the longstanding debate regarding the effectiveness of quantitative methods in economics and finance. Are markets and investors driven primarily by fear and greed that cannot be modeled, or is there a method to the market’s madness that can be understood through mathematical means? Those who rail against the quants and blame them for the crisis believe that market behavior cannot be quantified and financial decisions are best left to individuals with experience and discretion. Those who defend quants insist that markets are efficient and the actions of arbitrageurs impose certain mathematical relationships among prices that can be modeled, measured, and managed. Is finance a science or an art?
In this paper, we attempt to reconcile the two sides of this debate by taking a somewhat circuitous path through the sociology of economics and finance to trace the intellectual origins of this conflict—which we refer to as “physics envy”—and show by way of example that “the fault lies not in our models but in ourselves”. By reflecting on the similarities and differences between economic phenomena and those of other scientific disciplines such as psychology and physics, we conclude that economic logic goes awry when we forget that human behavior is not nearly as stable and predictable as physical phenomena. However, this observation does not invalidate economic logic altogether, as some have argued.
In particular, if, like other scientific endeavors, economics is an attempt to understand, predict, and control the unknown through quantitative analysis, the kind of uncertainty affecting economic interactions is critical in determining its successes and failures… Fully reducible uncertainty is the kind of randomness that can be reduced to pure risk given sufficient data, computing power, and other resources… (O)ur taxonomy is reflected in the totality of human intellectual pursuits, which can be classified along a continuous spectrum according to the type of uncertainty involved, with religion at one extreme (irreducible uncertainty), economics and psychology in the middle (partially reducible uncertainty) and mathematics and physics at the other extreme (certainty).
However, our more modest and practical goal is to provide a framework for investors, portfolio managers, regulators, and policymakers in which the efficacy and limitations of economics and finance can be more readily understood. In fact, we hope to show through a series of examples drawn from both physics and finance that the failure of quantitative models in economics is almost always the result of a mismatch between the type of uncertainty in effect and the methods used to manage it. Moreover, the process of scientific discovery may be viewed as the means by which we transition from one level of uncertainty to the next….
