Models behaving badly

The smartest quants (eventually) know their limits. Emmanuel Derman was until recently the head quant at Goldman Sachs, and pioneered many of the main quant approaches. He has now written a book, Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life about his experiences. And he is very disillusioned with those who believe financial modelling can ever be rigorous like physics.

One should be humble in applying mathematics to markets, and be wary of overly ambitious theories. Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts. Financial models, because of their incompleteness, inevitably mask risk. You must start with models but then overlay them with common sense and experience.

Remember, this is one of the foremost achievers in mathematical finance speaking.

In fact, it is usually the most brilliant quants and modellers who are also conscious of the potential limitations and quick to recognize the need for context. The biggest danger from models is less-skilled people who use techniques in a cookbook-like way without thinking for themselves. A sense of limits is essential for making the right market decisions.

We should not be surprised by the failure of models, Derman says. But we should be more surprised that we bailed out people who made the wrong judgements.

I wasn’t surprised by the failure of economic models to make accurate forecasts. Any assurance economists pretend to with regard to cause and effect is merely a pose or an illusion. They whistle in the dark while they write their regressions that ignore the humans behind the equations. I was similarly unsurprised by the failure of financial models. Financial models don’t forecast; they transform one’s forecasts of the future into present value. Everyone should understand the difference between a model and reality and be unastonished at the inability of one- or two-inch equations to represent the convolutions of people and markets.

What did shock and disturb me was the abandonment of the principle that everyone had paid lip service to: the link between democracy and capitalism. We were told not to expect reward without risk, gain without the possibility of loss. Now we have been forced to accept crony capitalism, private profits and socialized losses, and corporate welfare.

It’s a mixed book. There is a great deal of biography, stories of growing up as a semi-zionist Jew in apartheid South Africa. Publishers more or less force people to put a “personal” element or narrative into most non-fiction books these days. That didn’t stop him also getting in extensive discussions of Spinoza’s Ethics, which appeals to his neat physicist’s mind. It doesn’t all hang together.  Still, it’s worth a read if only as a reminder that it tends to be the second-rate people who claim too much for models. The first-rate people know you need context and experience to interpret them as well.

2017-05-11T17:32:58+00:00 March 8, 2013|Books, Market Behavior, Quants and Models|