Jun - 27 - 2017

Models.Behaving.Badly - Emanuel Derman

Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life is perhaps the best book about financial modeling that I have ever read, and I've read many.

Financial modeling is about using some tool, typically software, that allows you to take information about the past and use it to predict the future. Of course the future is not calculable, but that does not stop anyone from trying. To be fair, we must create models of the world around us and then use those models to attempt to predict the future, and to that end, the past is unquestionably our best guide.  There is nothing wrong with this. The problem comes when we begin to have so much confidence in the model's prediction that we quit set wisdom aside and believe that, through the model, we know the future. This book is about that problem.

This is not a book about the technical aspects of making models, that is amply covered in many other texts. Instead, this book is about understanding the assumptions and limitations of any model, and the consequences of basing significant ethical and social decisions on them without understanding their assumptions and limitations.

Emanuel Derman is, if not uniquely, extremely qualified to write this book. With a Ph.D. in theoretical physics, and having worked as a theoretical researcher and analyst at Goldman Sachs, and Solomon Brothers, and now teaching Financial Engineering at Columbia, his qualifications to comment on the world of financial modeling are unquestionable.

The final chapter, entitled Breaking the Cycle, discusses a proper mindset to use when creating models. This chapter should be taught in every college finance course that covers financial modeling. My favorite section of this chapter is entitled Good Models Are Vulgar in a Sophisticated Way. The essence of this section is to reduce the number of variables in the model and make them explicit assumptions. This helps reduce the false sense of precision and reliability that we tend to give to a calculated assumption.

The book is divided into three sections:

  1. Models - a careful evaluation of models in general, our motivations for making them, and the inherent limitations that come with them.
  2. Models Behaving - a look as some models that work, as far as we can tell, perfectly. These are mostly models of physical phenomena that are not actively trying to deceive, react, or gain advantage.
  3. Models Behaving Badly - a look as some of the physics-inspired models that are used in finance and economics; models that seem to ignore the fact that the underlying particle being modeled is a human being that will try to deceive, react, and gain advantage.

In January of 2009, Mr. Derman and Paul Wilmott developed:

The Modelers' Hippocratic Oath 1

~ I will remember that I didn't make the world, and it doesn't satisfy my equations.

~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

~ I will never sacrifice reality for elegance without explaining why I have done so.

~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

Rating: Highly Recommended
Amazon link: Models.Behaving.Badly

1. http://www.wilmott.com/blogs/eman/index.cfm/2009/1/8/The-Financial-Modelers-Manifesto


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