Book Review: Philosophy’s Stake in Finance

Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life - Emanuel Derman

Early in Emanuel Derman's quintessential book on financial theory, he delivers the punchline: "The longer you live, the more you become aware of life's contradictions and the inability of reason to reconcile them."

In the youth of serious intellectual life, for a very long time you search for "final" truths-ideas and theories to finally explain the world, and ourselves. It's after the very long slog, decades of searching, reading thousands of books, watching ideas come and go, colliding and negating each other, seeing entirely new forms of knowledge and areas of study arise, that one arrives at something far different than the innocent objective of discovering "truth": The contradictions of life can hold the greatest wisdom.

In this way, Derman's short but powerful Models Behaving Badly ought to be on the reading list of every aspirant investor. It's perhaps the best contemporary work of financial philosophy, extant.

A former physicist-cum-financier, we reviewed Derman's first book awhile back, My Life as a Quant, to some fanfare. That book remains a laudable firsthand account of the rush to make investing like physics-deterministic, statistic and beholden to mathematical truths.

Derman's magisterial, polymathic knowledge and experience is apparent throughout this book, yet he retains the discipline of pith and respect for the reader. He's wonderfully literary. Ideas spring from the likes of Spinoza, Shopenhauer and even the contemporary Nobel laureate JM Coetzee, yet they are no mere ornamentation-these allusions deepen and strengthen the thread of his thinking. His style does what great financial thinkers should aspire toward: display a holistic sense of human knowledge, not just mathematic wizardry.

Yes, there is too much autobiography and, at times, too many physics lessons in the book's short 200 pages. But in clearing away the clutter, three important ideas emerge.

First, what a theory really is. Theories are descriptions of the world, free of analogy or metaphor. They are definitional-explaining the world as such-and therefore can be predictive. Because we've developed true theories of gravity, for example, we can predict what will happen with physical objects in the world based on those theories. The mathematics of gravity are effectively the same as the phenomenon itself.

So, true theories are reserved for God and mathematics, and basically have nothing to do with humans. This means there is no such thing as a theory in investing or finance. Derman's mere definition of theory has laid barren a century of economic thought! What economics and finance have instead, in Derman's view, are models-the second big idea of his book.

Models are metaphors, reductive simplifications focused on individual aspects of a thing, but not the totality of a thing. Any idea of the economy or financial life must be a model and not a theory-capital markets are so overwhelmingly complex that no mathematics (let alone a human psyche) could contemplate and integrate all that goes on with world markets in even a single day. Derman notes, "A model is a caricature that overemphasizes some features at the expense of others. It focuses on parts rather than the whole." Models abstract whatever you're looking at. They remove us a step from reality so as to isolate specific elements of a system and give us at least a chance of comprehending those pieces. They are all we can do because our minds simply can't fathom the world otherwise. Models are what minds do naturally. This would be ok in and of itself, but at the level of macroeconomics we aren't just abstracting by a few steps; we're making abstractions of abstractions. Banks, stocks and money are all human concepts that we then try to make models out of. To think these are accurate descriptions of reality is to misunderstand what models can do.

Clarifying theories and models reveals the grand problem of finance: Not only are true descriptive theories impossible in finance, but our models at best will always be woefully inadequate. Or, as Derman admits, "After 20 years on Wall Street I'm a disbeliever. The similarity of physics and finance lies more in their syntax than their semantics." Said differently, most financial theory is a lot of apparent rigor, with far less substance behind it.

So, does that mean all ideas about finance are false? Not at all. Models are useful as modes of thinking, but they can be dangerous. Derman is at his best toward the end of the book as he applies his argument to the efficient market hypothesis (EMH). Is EMH wrong as a theory? Oh yes, absolutely-it is hugely and continuously in error as a description of reality. But as a model to help us think about markets? It's great. It explains in a looser sense why the market is so difficult to beat, how information can flow through the market system, and it gives us the basis for extremely useful ideas like diversification. In this way, EMH is one of the best models in financial history.

Which brings us to the last big idea of the book: intuition as the highest form of human knowledge. This is sheer blasphemy in today's hyper-rational, hyper-empirical society. Today's academic world shuns the importance of intuition, of the truly staggering capability of the human mind, opting instead to criticize-don't trust your mind, you have too many biases, seek truth with verified data outside your small, bewildered head. But hear Derman out: "It takes intuition to discover theories. Intuition may sound casual, but it emerges only from intimate knowledge acquired after careful observation and painstaking effort."

He's saying human knowledge doesn't proceed from rote statistics, or the sheer force of mounds of data. It comes from the integration of decades of experience combined with the use of empirical data to see reality truly clearly. This means true knowledge is not just understanding the world "out there." It requires introspection and integration of experience-self-knowledge and self-control, the benefit of having seen so much water pass under the bridge. Science, after all, is a product of the human mind.

There are few better lessons for investors. Kids come out of schools by the thousands each year, heads filled to the brim with statistical and financial "theories," many bearing credentials, ready to take on the investing world. But are they any the wiser for it? Obviously not-all that apparent rigor hasn't produced any better results for investors over the years, and the vast majority of hedge funds flame out in no time flat. For as much as the narrative of finance wants to point toward rigor by way of data, it's the interpretation and integration of today's hardcore statistical methods that make for true knowledge and the best long-term investors. Those folks who integrate the ideas models can reveal, but never forget the realities and specifics of the world, do best.

The final investing lesson of Derman's unique and essential book: Be modest, be disciplined, think in probabilities and be skeptical of models when attempting forecasts. Find an advisor with great research acumen-but also with ample and proven experience-to help you create a long-term plan to achieve your goals with or without the overreliance and vicissitudes of all that faux theory.