Feb 16, 2012

# Rick’s Ramblings: Models. Behaving. Badly.

The title of this column (including the two extra periods) is that of Emanuel Derman’s book, which has the eye-catching subtitle, “Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life.” The book has six chapters grouped into three pairs:
I. Models;
II. Models Behaving, and
III. Cohomology of Simplicial Complexes.
Just kidding, of course, your guess is right. One thing that I am confident that you cannot guess based on the title, is that the first chapter is concerned with the author growing up in South Africa as “the accidentally-conceived last child of Jewish parents who immigrated from Poland (now Belarus) to Cape Town in the mid-1930s.” Ten interesting pages are devoted to his membership in Habonim, a coeducational Zionist youth movement, which, he says “left its marks on me, many of them good.”

Large parts of the book are about physics, for examples the puzzles of the positron, which “Dirac found to be a hole in the sea of electrons.” Reading this material made me happy that there aren’t such paradoxical things in probability to make one think deeply about the nature of reality and turn to thinkers like Schopenhauer and Spinoza for help. See the complex network of pleasure, pain and desire on pages 86–87. Most of the book is considerably more fun and filled with interesting quips. Speaking about gravity, Derman says, “Newton was confident that the power of the distance was precisely 2. Had he been a social scientist he would probably have proposed a power of 2.05 ± 0.31.”

Some of Derman’s stories are borrowed from others: Freeman Dyson wrote in his essay Frogs and Birds, “Some mathematicians are birds, others are frogs. Birds fly high in the air and survey broad vistas of mathematics out to the far horizons. They delight in concepts that unify our thinking … Frogs live in the mud below and see only the flowers that grow nearby. They delight in the details of particular objects, and they solve problems one at a time.”

Derman began his professional life as a physicist, “studying fundamentals and mastering theory. Then in 1985, I migrated to the center of the quant world at Goldman Sachs. My colleagues were as smart as academics but more interesting. Their work was an interdisciplinary mix of modeling, mathematics, statistics, and programming.” Academic experts on finance may think they know what mathematics he is referring to, but when the narrative turns to an event in his academic life at Columbia, we learn that he had to use Google to figure out what “the fundamental theorem of finance was.” I have read the statement he includes on page 141 and can’t figure it out. Google must have grown up since then.

The lack of one familiar fact is more than made up for by the new ones that I saw there. If you haven’t seen Fischer Black’s paper on “Noise” in the Journal of Finance, volume 41 (1986), 529–543, then you should go to JSTOR and read it. Derman devotes a lot of ink to discussion of deficiencies of the efficient market model and CAPM, but perhaps the most persuasive argument is given in the figure on page 184 that compares simulated stock prices to four years of the S&P 500. I almost said that the picture is worth the price of the book, but the picture can be had for the price of one photocopy so that doesn’t make much sense economically.

Of course, at its heart this is a book about models. Derman explains that the widespread shock at the failure of quantitative models in the mortgage crisis of 2007 results from a misunderstanding of the difference between models and theories. Theories describe and deal with the world on its own terms and must stand on their own two feet. Models stand on someone else’s feet. Models try to squeeze the blooming buzzing confusion into a miniature Joseph Cornell box, and then, if it more or less fits, assume that the box is the world itself. Intuition is more comprehensive. It unifies the subject with the object, the understander with the understood, and the archer with the bow.

People expect either too much or too little from financial models. One must begin boldly but expect little. If a little success is actually attained, one must grow greedy. Then when one has gone only a little too far, desist. Derman has more concrete advice, quoting from a Modeler’s Hippocratic Oath that he wrote with Paul Wilmott. The third point is “I will not be overly impressed by mathematics. I will never sacrifice reality for elegance without explaining to its end users why I have done so.”

Wise words and there many of them in the book that I haven’t quoted. At $26 it is a bargain, and I am looking forward to reading his other book, “My Life as a Quant: Reflections on Physics and Finance.” ## 5 Comments • […] in life,” summarized by Burton Malkiel (author of the famed book A Random Walk Down Wall Street). Others also find it amusing that Emanuel well balances his personal life experience, physics insights and critical comments on […] • I first met Dr. Derman nearly 20 years. I aaylws considered him lucky in the sense that his job was quite academic by bank standard and he did not have to get his hands dirty as often as traders had to do._I am glad that he has also reached the conclusion that I believe every financial professional with a conscience should have suspected by 2000 and be thoroughly convinced by 2008: Modern finance as practiced in the US is a game rigged for the powerful insiders. Contrary to what business schools have trumpeted over the years, no high level personnel in investment banks care a bit about optimal allocation of resources. The biggest rewards inevitably go to those who are the most nasty and shameless in ripping off first their customers and later the taxpayers._While this kleptocratic arrangement goes all the way to every branch of government and therefore is a much bigger problem than finance alone, it was made significantly worse by the willing and enthusiastic participation of the financial academia. It is so easy and common to buy off a few big-shot professors and have them pump out fact-warping papers to push for more deregulation or excuse blatant thefts of public goods, all without the slight bit of disclosure, that even when caught red-handed, no one will suffer any damage either legally or in reputation._All this was a little hard to stomach for an ex-physicist like myself. I have escaped a field dominated by the nonsense that was string theory only to land among an immense group of shameless thieves. Although the string theorists have wasted 30 years of public resources pursuing an increasing pointless venue, the waste pales completely in comparison to the willful and wide-spread wrong-doings by financial academics and practitioners and their incredible damage to this nation and the world._Those of you who had the fortune of not having to bear witness to the avarice and debauchery prevalent in the US banking industry of the past decade, consider yourself blessed. • Two years ago, when a new firm raised$300m to dig a STRAIGHT-line trecnh for a new fibre optics line between Chicago and New York, I had joked with a colleague that the next step would be neutrino beams, which was the only thing capable of avoiding the earth’s curvature. I guess someone else has now come up with the same idea, but not as a joke.-The reason why these investment makes sense (to varying degrees) is the physical separation of trading activities in two sets of financial assets: stocks and the stock-index-based futures. The former trades in New York, but the latter trades in Chicago. Usually, the big pension funds or mutual funds find it cheaper to enter/exit a big position by buying/selling futures than the corresponding stocks. Therefore, the futures price would move first. The competition to use this information to make money on the slower stock markets is intense. The aforementioned new fibre line saves 2ms in communication time, for which the firm charges $1m per month. Only the leading arbitrageurs in the country, typically with$500m or more in annual revenue can justify the expense.-It is important to stop this senseless race of shaving off another nano-second; there is no increased productivity once the refresh lag drops below human reaction time, roughly 200ms, a milestone that was passed in 2004. On the contrary, there is actually tremendous downside in this crazy speed race, as witnessed two years ago in the flash crash . Actually, there are plenty of simple and natural remedies, such as charging for rapid cancellations of orders on the book for less time than human can react to, but the US equity market is self-regulated , i.e. the SEC does not set the detailed rules; the exchanges do. The root cause to all this silliness can therefore be traced to the fragmentation of the equity (i.e. stocks) markets in the US. As each of the four major exchanges compete for order flows, they become beholden to the largest traders, and nobody can do more volumes than high-frequency firms.-Finally, just two weeks, the NASDAQ (in my opinion, the most professional and sensible exchange in the US) decided to take a small step in the right direction. A small fee will be charged on frivolous order placements/cancellations. So, maybe speed will lose its allure and no one will be funding the neutrino idea

• HFT caused the crash. If antihyng, it was HFT pulling out that caused the liquidity to disappear. In fact, the SEC was even considering adding rules that HFT can’t turn off like they did! Second, the flash crash was not a tremendous downside . It was something like 20 minutes. It had no consequence to most investors, and errorneous trades were busted. A few people learned that stop-loss orders with no limit are a bad idea (which was true before the flash crash, too), but overall there were few stories of real pain and there was no domino effect.Third, I think you are vastly underestimating the benefits of HFT. There most certainly are benefits to sub-200ms trading. The liquidity in stocks with HFT participants is tremendous as measured by bid-ask spread and cost of executing large orders compared to stocks without HFT participants or stocks 30 years ago. We’ve replaced a large number of slow humans taking huge bid-ask spreads with a smaller number of very fast computers fighting for a few pennies. Needless to say, the latter is much more efficient (in the sense of market efficiency AND use of human talent) and is a better deal for investors.Sure, it’s silly people can make a lot of money reducing their network ping. But it’s diminishing returns, so it won’t last forever. Over the next 20 years (uneducated guess) things will stabilize as traders pull out the last bits of arbitrage that are still left. We might as well accept the silliness for now, and be happy there are people investing in communication technology, no?

• in The study of economics has been again and again led atsary by the vain idea that economics must proceed according to the pattern of other sciences. The mischief done by such misconstructions cannot be avoided by admonishing the economist to stop casting longing glances upon other fields of knowledge or even to ignore them entirely. Ignorance, whatever subject it may concern, is in no case a quality that could be useful in the search for truth. What is needed to prevent a scholar from garbling economic studies by resorting to the methods of mathematics, physics, biology, history or jurisprudence is not slighting and neglecting these sciences, but, on the contrary, trying to comprehend and to master them. He who wants to achieve anything in praxeology must be conversant with mathematics, physics, biology, history, and jurisprudence, lest he confuse the tasks and the methods of the theory of human action with the tasks and the methods of any of these other branches of knowledge. What was wrong with the various Historical Schools of economics was first of all that their adepts were merely dilettantes in the field of history. No competent mathematician can fail to see through the fundamental fallacies of all varieties of what is called mathematical economics and especially of econometrics. No biologist was ever fooled by the rather amateurish organicism of such authors as Paul de Lilienfeld.When I once expressed this opinion in a lecture, a young man in the audience objected. You are asking too much of an economist, he observed; nobody can force me to employ my time in studying all these sciences. My answer was: Nobody asks or forces you to become an economist.

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