A quick note: Starting next week I’ll be unplugged and on vacation. So no articles for the next two weeks.
Financial models are meant to be used as good rules of thumb when making decisions. So simpler is usually better with highly complex, uncertain, and adaptive markets. Simplicity allows for flexibility in that type of environment.
But problems arise when people rely on models to make the uncertain certain or try to attain physics-like perfection. They get rigid complex models in the process.
A nice reminder of this was shared on Twitter this week. It’s a short manifesto on financial models written by Emanuel Derman after the financial crisis. Here are a few snippets with a link below:
Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.
We do need models and mathematics – you cannot think about finance and economics without them – but one must never forget that models are not the world. Whenever we make a model of something 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 essential parts. And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it. The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions. You must start with models and then overlay them with common sense and experience.
The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.
Charlie Munger said something similar at this year’s DJCO annual meeting:
…if you’re dealing with a complex system, the rules of thumb that worked in the complex system in year one, may not work in year forty… The laws of physics you can count on, but the rules of thumb in a complex civilization changes as the civilization changes. And so you have to live with both kinds of uncertainty and you have to work along with it.
I call it physics envy. That’s what they had in the finance field. They wanted to make their subject like physics.
Now, what kind of a nut would want to make stock markets like physics? It ain’t like physics. It’s more like a mob at a football game.
- Betting on Things that Never Change – M. Housel
- The Logic 0f Patience – Value Investor India
- Does Consumer Sentiment Predict Stock Prices? – J. Rekenthaler
- Quality and Value Without the Side Sector Bets – Morningstar
- This Metric In Dire Need Of Context – L. Swedroe
- No Mercy / No Malice: Every Seven Years – S. Galloway
- Why Tokens are Eating the World – V. Lingham
- Ed Thorp on Beating Vegas & Wall Street – Masters in Business
- Atul Gawande on Priorities, Big and Small – Medium
- Monopoly was Invented to Demonstrate the Evils of Capitalism – Aeon