Derman - Models. Behaving. Badly: why confusing illusion with reality can lead to disaster, on Wall Street and life

This edition first published in 2011 Copyright 2011 by Emanuel Derman

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ALSO BY EMANUEL DERMAN

My Life as a Quant: Reflections on Physics and Finance

I. MODELS

Chapter 1

A Foolish Consistency

Models that failed Capitalism and the great financial crisis Divining the future via models, theories, and intuition Time causes desire Disappointment is inevitable To be disappointed requires time, desire, and a model Living under apartheid Growing up in the movement Tat tvam asi

Pragmatism always beats principles.... Comedy is what you get when principles bump into reality.

J. M. Coetzee, Summertime

MODELS THAT FAILED I: ECONOMICS

All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face, with sober senses, his real conditions of life, and his relations with his kind, wrote Marx and Engels in The Communist Manifesto in 1848. They were referring to modern capitalism, a way of life in which all the standards of the past are supposedly subservient to the goal of efficient, timely production.

With the phrase melts into air Marx and Engels were evoking sublimation, the chemists name for the process by which a solid transmutes directly into a gas without passing through an intermediate liquid phase. They used sublimation as a metaphor to describe the way capitalisms endless urge for new sources of profits results in the destruction of traditional values. Solid-to-vapor is an apt summary of the evanescence of value, financial and ethical, that has taken place throughout the great and ongoing financial crisis that commenced in 2007.

The United States, the global evangelist for the benefits of creative destruction, has favored its own church. When governments of emerging markets complained that foreign investors were fearfully yanking capital from their markets during the Asian financial crisis of 1997, liberal democrats in the West told them that this was the way free markets worked. Now we prop up our own markets because it suits us to do so.

The great financial crisis has been marked by the failure of models both qualitative and quantitative. During the past two decades the United States has suffered the decline of manufacturing; the ballooning of the financial sector; that sectors capture of the regulatory system; ceaseless stimulus whenever the economy has wavered; taxpayer-funded bailouts of large capitalist corporations; crony capitalism; private profits and public losses; the redemption of the rich and powerful by the poor and weak; companies that shorted stock for a living being legally protected from the shorting of their own stock; compromised yet unpunished ratings agencies; government policies that tried to cure insolvency by branding it as illiquidity; and, on the quantitative side, the widespread use of obviously poor quantitative security valuation models for the purpose of marketing.

People and models and theories have been behaving badly, and there has been a frantic attempt to prevent loss, to restore the status quo ante at all costs.

THEORIES, MODELS, AND INTUITION

For better or worse, humans worry about whats ahead. Deep inside, everyone recognizes that the purpose of building models and creating theories is divination: foretelling the future, and controlling it.

When I began to study physics at university and first experienced the joy and power of using my mind to understand matter, I was fatally attracted. I spent the first part of my professional life doing research in elementary particle physics, a field whose theories are capable of making predictions so accurate as to defy belief. I spent the second part as a professional analyst and participant in financial markets, a field in which sophisticated but often ill-founded models abound. And all the while I observed myself and the people around me and the assumptions we made in dealing with our lives.

What makes a model or theory good or bad? In physics its fairly easy to tell the crackpots from the experts by the content of their writings, without having to know their academic pedigrees. In finance its not easy at all. Sometimes it looks as though anything goes. Anyone who intends to rely on theories or models must first understand how they work and what their limits are. Yet few people have the practical experience to understand those limits or whence they originate. In the wake of the financial crisis nave extremists want to do away with financial models completely, imagining that humans can proceed on purely empirical grounds. Conversely, nave idealists pin their faith on the belief that somewhere just offstage there is a model that will capture the nuances of markets, a model that will do away with the need for common sense. The truth is somewhere in between.