Models. Behaving. Badly. (PDF)

Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs,
one of the financial engineers whose mathematical models became
crucial for Wall Street. The reliance investors put on such
quantitative analysis was catastrophic for the economy, setting off
the ongoing string of financial crises that began with the mortgage
market in 2007 and continues through today. Here Derman looks at
why people -- bankers in particular -- still put so much faith in
these models, and why it's a terrible mistake to do so.

Though financial models imitate the style of physics and employ
the language of mathematics, ultimately they deal with human
beings. There is a fundamental difference between the aims and
potential achievements of physics and those of finance. In physics,
theories aim for a description of reality; in finance, at best,
models can shoot only for a simplistic and very limited
approximation to it. When we make a model 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 of
the essential parts. Physicists and economists have been too
enthusiastic to acknowledge the limits of their equations in the
sphere of human behavior--which of course is what economics is all
about.

Models.Behaving.Badly includes a personal account of
Derman's childhood encounters with failed models--the oppressions
of apartheid and the utopia of the kibbutz. He describes his
experience as a physicist on Wall Street, the models quants
generated, the benefits they brought and the problems, practical
and ethical, they caused. Derman takes a close look at what a model
is, and then highlights the differences between the successes of
modeling in physics and its failures in economics. Describing the
collapse of the subprime mortgage CDO market in 2007, Derman urges
us to stop the naïve reliance on these models, and offers
suggestions for mending them. This is a fascinating, lyrical, and
very human look behind the curtain at the intersection between
mathematics and human nature.