Tuesday, August 17, 2010

Physics Envy

A reader referred me to this excellent paper by Andy Lo and Mark Mueller. Mark and I were both Harvard postdocs at the same time. I seem to remember long conversations about both physics and finance in the Dunster dining room :-)

Warning: Physics Envy May be Hazardous to Your Wealth!

The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems - and financial markets in particular - that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, physics envy has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an uncertainty checklist with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.

While physics envy might be a problem for economists or theoretical biologists, making physics your career (as opposed to becoming a quant, as Mark did) is certainly hazardous to your net worth!


Jin Dih said...

There certainly is such a thing as physics envy and it is misguided (to be polite), but should physics be thought of as anything more than the investigation of precisely those phenomena which allow accurate mathematical description.

BwO said...

Not to get into a theological debate with Jin, but physics should be the study of precisely AND ONLY those phenomena which allow accurate mathematical description. Some day we may build a financial system that allows that, or a mathematics that describes it, but I don't take us to be especially close to that point today.

Science fan said...

Clearly what is needed is a mathematical model of physics envy.

Alexander Repiev said...

Perhaps this will be of some interest:
“’Physics envy’ – physics abysmally misconstrued!” – http://www.repiev.ru/articles/Physics-Envy.htm

umbrarchist said...

Economists refuse to apply physics to economics.

The Laws of Physics cannot tell the difference between CAPITAL Goods and DURABLE CONSUMER GOODS. A consumer's NET WORTH goes down as their durable consumer goods wear out. But economists add those goods to GDP when purchased and do not subtract them as they wear out. So we are running a planet of seven billion people on defective grade school algebra.


It is certainly curious how economists talk about enlightened self interest and double-entry accounting is 700 years old and invented in Italy, yet Western economists do not suggest that accounting be mandatory in the schools. In economic physics the peon particles must not know how to best serve their interests.

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