The Santa Futures markets suggest that I am likely to receive Emanuel Derman’s Models.Behaving.Badly come Christmas morning. I am looking forward to it, more so after reading the great Burton Malkiel’s review in today’s Wall Street Journal (perhaps behind a paywall, but maybe not). Malkiel speaks highly of the cross-disciplinary erudition that runs through the book – and its underlying criticism of financial economic theory as offering itself as physics when it is really something like The Imitation of Physics – a metaphor and a simulacrum:
Trained as a physicist, Emanuel Derman once served as the head of quantitative analysis at Goldman Sachs and is currently a professor of industrial engineering and operations research at Columbia University. With “Models Behaving Badly” he offers a readable, even eloquent combination of personal history, philosophical musing and honest confession concerning the dangers of relying on numerical models not only on Wall Street but also in life.
Mr. Derman’s particular thesis can be stated simply: Although financial models employ the mathematics and style of physics, they are fundamentally different from the models that science produces. Physical models can provide an accurate description of reality. Financial models, despite their mathematical sophistication, can at best provide a vast oversimplification of reality. In the universe of finance, the behavior of individuals determines value—and, as he says, “people change their minds.”
In short, beware of physics envy. When we make models involving human beings, Mr. Derman notes, “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.” As the collapse of the subprime collateralized debt market in 2008 made clear, it is a terrible mistake to put too much faith in models purporting to value financial instruments. “In crises,” Mr. Derman writes, “the behavior of people changes and normal models fail. While quantum electrodynamics is a genuine theory of all reality, financial models are only mediocre metaphors for a part of it.”
This is not a new critique; it is the core of that made by George Soros and his theory of “reflexivity” of markets; the core of criticisms made by social theorists of market relations. But coming from Derman’s special place in finance, it carries special interest, and I look forward to immersing myself in it and giving my own assessment of the book. Of interest from Burton Malkiel – I own most if not all of the successive editions of A Random Walk Down Wall Street – is his criticism of Derman’s presentation of the Efficient Market Hypothesis (or Model):
Nevertheless, Mr. Derman is perhaps a bit too harsh when he describes EMM—the so-called Efficient Market Model. EMM does not, as he claims, imply that prices are always correct and that price always equals value. Prices are always wrong. What EMM says is that we can never be sure if prices are too high or too low.
The Efficient Market Model does not suggest that any particular model of valuation—such as the Capital Asset Pricing Model—fully accounts for risk and uncertainty or that we should rely on it to predict security returns. EMM does not, as Mr. Derman says, “stubbornly assume that all uncertainty about the future is quantifiable.”
The basic lesson of EMM is that it is very difficult—well nigh impossible—to beat the market consistently. This lesson, or “model,” behaves very well when investors follow it. It says that most investors would be better off simply buying a low-cost index fund that holds all the securities in the market rather than using either quantitative models or intuition in an attempt to beat the market. The idea that significant arbitrage opportunities are unlikely to exist (and certainly do not persist) is precisely the mechanism behind the Black-Scholes option-pricing model that Mr. Derman admires as a financial model behaving pretty well.
Perhaps this is all that the EMH ever meant for Malkiel and other leading sophisticates of finance theory: “What EMM says is that we can never be sure if prices are too high or too low.” Put that way, it is a demure theory, a sweet theory of downcast eyes and modest mien. But I have two doubts. One is simply that this is not what I took away from the general presentation of it by leading finance theorists in the 1980s, when I first learned it in classes at Harvard Law School and sitting in on classes at Harvard Business School and sitting in on my undergraduate girlfriend’s econ classes. Perhaps I misunderstood drastically, but it seemed to be regarded as a much stronger proposition than that. Indeed, in the hands of my law school corporate finance professor, it was not an empirical proposition so much as a logical one because it described the necessity of an equilibrium system and then imputed it to the real world, Dr. Pangloss-style. As a former philosophy student, it troubled me as a logical move, but what did I know about finance?
Second, even if the leading finance theorists had some more modest theory than I took from my professors, as applied in the world at large, it did take on the characteristics of an a priori theorem grounded in logical necessity. Like many subtle theorems applied mechanically, and without practical skill, it took on a life of its own and became its own authority. One reason for this is that the version of the EMM that Professor Malkiel proffers above is purely a skeptical one – the inability to know. To have application in the real world, it has to be converted from a proposition in skepticism to a positive proposition about a realm of bounded rationality; in making that move, however, we have gone a far, far distance in what we are proposing we might know and, moreover, we are apt to forget that the rationality of equilibrium applies only within bounds. There is a reason that each time I read papers on the foundations of the EMH, I think mostly of my first classes in Skepticism and Rationality, not economics; it appears that Derman (like Soros) has that same reaction, more or less.
So I am not sure I agree with Professor Malkiel that Derman is overly harsh on the EMH as preached and applied in the world. I think its strength – its epistemic status – has gone up and down in waves over the decades, and of course part of that is reflected in the successive discussions of it in Professor Malkiel’s own book (and I should add that his last book on practical investing is the only one I’ve ever handed to my daughter). So let me put it to our readers:
What year did you first learn the EMH, what was the disciplinary setting (undergrad econ or business, grad econ, B-school, law school, etc.), and what was the strength of the proposition (not just the usual weak, semi-strong, strong, but its epistemic status – empirical thesis or logical corollary of equilibrium). And does it appear to have been re-stated and re-formulated over the course of your awareness of it? Comments are open.
PS. These comments are very interesting; I am interested in the actual years when you learned about the EMH and how because I think it (perhaps) has been framed somewhat differently at different moments over the last couple of decades, so the actual years matter. In my case, in the early 1980s. I should add two things. One is that I revere Professor Malkiel, which is why I was intrigued to see him review this book. The other is that there is a special, super-weak, but alas incontrovertible version of the EMH, viz., that neither Anderson, nor any Anderson gene-bearers, will ever beat the market.