How to understand the limits of financial models

Aca

"After 20 years on Wall Street, I’m a disbeliever in grand financial theories. We do have a variety of financial models, but financial modeling is not the physics of markets. The similarity of physics and finance lies more in their syntax than in their semantics. In physics you’re playing against God, and He doesn’t change His laws very often. In finance you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions."

"If you are someone who cannot distinguish between God’s creations and man’s idols, you may mistake models for deep laws. Many economists are such people."

"Economists for the most part have never seen a genuinely successful theory. The simple models they work with fail to reflect the complex reality of the world around them. That lack of success is not the fault of economists, for people, unlike matter, are difficult to theorize about. But it is the economists’ fault that they take their simple models so seriously."

"At the end of the cold war, we imagined a future with no more history, a smooth stroll into the sunrise accompanied by democracy, privatization and free markets. It hasn’t worked out that way. Authoritarian versions of capitalism have spread. Privatization has become oligarchy. The gaps between rich and poor, managers and workers, and owners and employees have widened. Economic models have misfired, and financial models have proved to be enormously inaccurate. More recently, the prescribed cure of a Keynesian stimulus to jump-start spending and employment has had only a muted effect. Low interest rates, the Federal Reserve’s cure for past crises and the progenitor of future ones, are being prescribed again. Lessons have not been learned."

"Any assurance economists pretend to with regard to cause and effect is merely a pose"

"Everyone should understand the difference between a model and reality, and no one should be astonished by the inability of one- or two-inch equations to represent the convolutions of people and markets."

"• Think of models as gedanken experiments. No model is correct, but models can provide immensely helpful ways to estimate value. I like to think of financial models as gedanken, or thought, experiments, like those Einstein carried out when he pictured himself surfing a light wave, or Schrödinger when he pictured a macroscopic cat subject to quantum interference. I believe that’s the right way to use mathematical models in finance, and the way experienced practitioners do use them. Models are only models, not the thing in itself. Models are better regarded as a collection of parallel thought universes to explore. Each universe should be consistent, but, unlike the world of matter, the world of financial concepts and the minds of the humans that interact with them are going to be infinitely more complex than any model you make.

• Beware of idolatry. The greatest conceptual danger is idolatry: believing that someone can write down a theory that encapsulates human behavior and thereby free you of the obligation to think for yourself. A model may be entrancing, but no matter how hard you try, you will not be able to breathe life into it. To confuse a model with a theory is to believe that humans obey mathematical rules, and to invite future disaster."