March 22, 2012

Staff Picks: Models Behaving Badly

By: 800-CEO-READ @ 9:10 PM – Filed under: Management & Workplace Culture

Models Behaving Badly has nothing to do with TMZ or a Harlequin novel. The models at the heart of this book are not beautiful people that fashion designers drape their creations over, but financial models that financiers and money managers try to drape reality over in order to make predictions about the market—and, of course, gobs of money.

The author, Emanuel Derman, is a former theoretical physicist and used to be the head quant (quantitative analyst) at Goldman Sachs, so this is not cheap or easy entertainment. You have to work for it, and your brain is going to hurt at times. I'm not even sure that I fully understood everything in the book (For instance, did you know that there's a resemblance between the Law of One Price in finance and Einstein's principle of relativity? Don't worry, he'll explain.), but I do think I came out of it with a better understanding of the world. In the first 45 pages, he delves into Spinoza, Goethe, the nature of good and evil, the luminosity of stars, and much, much more. But why? Well, to discuss the nature of reality versus the illusion of reality, of course—a discussion he uses to delve into an exploration of metaphors, models and theories that runs throughout the book.

I first came across Emanuel Derman in Scott Patterson’s The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It. He mentions him as the coauthor of The Financial Modelers' Manifesto, which was "an ethical declaration for scientists applying their skills to finance," and which is excerpted at the end of the book.

Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.
Many, including Patterson, laid much of the blame for the financial crisis on the quants of Wall Street. That seems a bit unfair to me. Firms were giving the best and brightest minds absurd amounts of money to come to Wall Street and devise these models, and they used those models recklessly and irresponsibly to ignore the real world of risk around them, over-leverage their positions, and nearly bring down the entire financial system they themselves built. It would be akin to Zeus, the god of sky and thunder, hiring meteorologists to come up with weather models, using those models to devise the storm of a century, and then blaming the meteorologists when the storm nearly destroys the world. After all, Zeus knows way more about how to control the weather than a meteorologist. Like the big firms on Wall Street, he literally creates the climate!

As Derman writes of economic and weather models, "An economic model aims to do for the economy what the weather model does for the weather. ... But an economy is an even more abstract concept than the weather." Derman loves his metaphors, and so do I. He begins Chapter 2 with this doozy:

Sleep is the interest we have to pay on the capital which is called in at death; and the higher the rate of interest and the more regularly it is paid, the further the date of redemption is postpones.

So wrote Shopenhauer, comparing life to finance in a universe that must keep its books balanced.

If you want a straightforward business book to solve a particular problem, this is not the book for you. But if you're looking to go on a metaphysical journey to explore the nature of reality and modern finance, this is going to be a fun trip.