Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life (Free Press, 2011) is a wise book by a man who has thought deeply about his life, and not just as a quant on Wall Street. Emanuel Derman reminisces about his youth as a member of Habonim (a coeducational Zionist movement) in apartheid South Africa, his ordeal with myopic ophthalmological specialists, and his immersion in theoretical physics. He ventures into an unlikely corner of philosophy—not epistemology but Spinoza’s theory of emotions. He describes “the crooked paths that culminate in theories,” in particular classical and quantum electromagnetic theory.
Although these discussions have a life of their own, they serve to illustrate three fundamental ways of understanding the world: models, theories, and intuition. Intuition is “a merging of the understander with the understood”; “it emerges only from intimate knowledge acquired after careful observation and painstaking effort.” (pp. 96-97) Theory bears a close relationship to intuition. “[W]hen it is successful … it describes the object of its focus so accurately that the theory becomes virtually indistinguishable from the object itself. Maxwell’s equations are electricity and magnetism; the Dirac equation is the electron….” (p. 61)
Of the three, models are the most common and potentially the most troubling ways of understanding. “A model is a metaphor of limited applicability, not the thing itself.” (p. 54) It is an analogy which, although not unfounded, is partial and flawed. “Models project multidimensional reality onto smaller, more manageable spaces where regularities appear and then, in that smaller space, allow us to extrapolate and interpolate from the observed to the unknown.” (p. 58)
Since the financial markets do not obey the laws of science but are subject to the vagaries of human behavior, there can be no financial theories, only financial models. And, as Derman writes graphically, “When we make a model 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 of the essential parts.”
Models are not useless; indeed, they can be “immensely helpful in calculating initial estimates of value.” (p. 194) The best model in all of economics, Derman argues, is Black-Scholes. Although it is imperfect, it stands head and shoulders above CAPM: “an unkind way to look at CAPM is to say that it’s not very good.” (p. 182)
Reading Derman’s book is both an intellectually rewarding and a thoroughly pleasurable way to spend an afternoon. I recommend it unequivocally.