In his 2004 autobiography, My Life as a Quant, Reflections on Physics and Finance, Emanuel Derman recounts his experiences as a physicist driven by the forces of employment supply and demand to redirect his labor toward quantitative financial analysis/strategy. Knowledge and skills critical to his transition are: a sense of how the world works, modeling and programming. Much of the book is a straightforward recounting of activities, personalities and reactions, culminating in Mr. Derman’s derivatives modeling accomplishments. Toward the end of the book, he offers a few essential distillations, as follows:
From pages 237-238:
“In physics, the beauty and elegance of a theory’s laws, and the intuition that led to them, is often compelling, and provides a natural starting point from which to proceed to phenomena. In finance, more of a social than a natural science, there are few beautiful theories and virtually no compelling ones, and so we have no choice but to take the phenomenological approach. There, much more often, one begins with the market’s data and calibrates the model’s laws to fit…”
In other words, Mr. Derman finds that financial experts do not understand market dynamics. The best they can do is mimic historical data.
And, a couple of “buts” from pages 256-257 and page 261:
“But the past doesn’t repeat itself verbatim; people learn enough from their past experiences to make new mistakes as they struggle between greed and the effort to avoid the old ones.”
“But no mathematical model can capture the intricacies of human psychology.”
More philosophically, from page 249 and pages 266-267:
“A decade of speaking with traders and theorists has made me wonder what ‘correct’ means. If you are a theorist you must never forget that you are traveling through lawless roads where the local inhabitants don’t respect your principles. The more I look at the conflict between markets and theories, the more that limitations of models in the financial and human world become apparent to me.”
“Trained economists have never seen a really first-class model. It’s not that physics is ‘better,’ but rather that finance is harder… In finance, you’re playing against…agents who value assets based on their ephemeral opinions… When you take on other people, you’re pretending you can comprehend other pretenders…”
In summary, Mr. Derman’s life-work conclusions are relevant to assessment of the latest more-than-confident pronouncements of doom, gloom or boom, and all the forecasts in between.
