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A review by joejoh
Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman
4.0
I can understand why some people were disappointed with this book. It's not what I expected when I purchased it. There's a good deal of memoir, philosophy, history, and physics in the book before Derman talks about Economics and the Financial Markets. It is worth it. Derman makes the obvious case that the model is not the thing it represents (similar to how Derrida and other Deconstructionists explained that a word is a symbol for a thing, and not the thing itself). He also stresses the importance of theories and how models are very different from theories.
As a dual major in Data Analytics and Applied Mathematics, the math in this book was easy to follow. There's little of it, and it's concentrated at the end of the book. If you're math-phobic it might be difficult to understand what Derman is demonstrating. Basically, he is showing that models build on the Efficient Market hypothesis (he calls it the Efficient Market Model) and the Capital Asset Pricing Model are based on false premises. This is easy to understand when you realize that Economics, despite its adherents claims to the contrary, isn't actually a science. It's a branch of the social sciences and often doesn't stand up to the rigor of actual science. Derman's discussion of Physics earlier in the book provide an interesting contrast to the models used on Wall Street which aren't build on theory, but are simply built on other models.
The markets are unpredictable because the markets are influenced by people. This isn't a matter of just too many variables: it's a fundamental problem of markets. People react to the markets, and the markets react to people. This means that predicting future performance (generally based on present value) isn't possible because you can't predict how people will act/react. This is the fundamental flaw of any model of financial markets. Derman steers clear of the morality of things like swaps and the subprime mortgage crisis. Instead, he demonstrates that our entire financial industry is essentially built on a house of cards. The traders are worshipping at the altar of mathematics, but the mathematics of economics in general, and financial markets in particular, are built of flimsy material.
As a dual major in Data Analytics and Applied Mathematics, the math in this book was easy to follow. There's little of it, and it's concentrated at the end of the book. If you're math-phobic it might be difficult to understand what Derman is demonstrating. Basically, he is showing that models build on the Efficient Market hypothesis (he calls it the Efficient Market Model) and the Capital Asset Pricing Model are based on false premises. This is easy to understand when you realize that Economics, despite its adherents claims to the contrary, isn't actually a science. It's a branch of the social sciences and often doesn't stand up to the rigor of actual science. Derman's discussion of Physics earlier in the book provide an interesting contrast to the models used on Wall Street which aren't build on theory, but are simply built on other models.
The markets are unpredictable because the markets are influenced by people. This isn't a matter of just too many variables: it's a fundamental problem of markets. People react to the markets, and the markets react to people. This means that predicting future performance (generally based on present value) isn't possible because you can't predict how people will act/react. This is the fundamental flaw of any model of financial markets. Derman steers clear of the morality of things like swaps and the subprime mortgage crisis. Instead, he demonstrates that our entire financial industry is essentially built on a house of cards. The traders are worshipping at the altar of mathematics, but the mathematics of economics in general, and financial markets in particular, are built of flimsy material.