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Warning- Physics Envy May Be Hazardus to Your Health-MIT Paper

Warning- Physics Envy May Be Hazardus to Your Health-MIT Paper

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WARNING: Physics Envy May BeHazardous To Your Wealth!
Andrew W. Lo
and Mark T. Mueller
This Draft: March 19, 2010
Abstract
The quantitative aspirations of economists and financial analysts have for many years beenbased on the belief that it should be possible to build models of economic systems—andfinancial markets in particular—that are as predictive as those in physics. While this per-spective has led to a number of important breakthroughs in economics, “physics envy” hasalso created a false sense of mathematical precision in some cases. We speculate on the ori-gins of physics envy, and then describe an alternate perspective of economic behavior basedon a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with twoconcrete examples: the classical harmonic oscillator with some new twists that make physicslook more like economics, and a quantitative equity market-neutral strategy. We concludeby offering a new interpretation of tail events, proposing an “uncertainty checklist” withwhich our taxonomy can be implemented, and considering the role that quants played in thecurrent financial crisis.
Keywords
: Quantitative Finance; Efficient Markets; Financial Crisis; History of EconomicThought.
JEL Classification
: G01, G12, B16, C00
The views and opinions expressed in this article are those of the authors only, and do not necessarilyrepresent the views and opinions of AlphaSimplex Group, MIT, or any of their affiliates and employees. Theauthors make no representations or warranty, either expressed or implied, as to the accuracy or completenessof the information contained in this article, nor are they recommending that this article serve as the basis forany investment decision—this article is for information purposes only. Research support from AlphaSimplexGroup and the MIT Laboratory for Financial Engineering is gratefully acknowledged. We thank JerryChafkin, Peter Diamond, Arnout Eikeboom, Doyne Farmer, Gifford Fong, Jacob Goldfield, Tom Imbo,Jakub Jurek, Amir Khandani, Bob Lockner, Paul Mende, Robert Merton, Jun Pan, Roger Stein, TinaVandersteel for helpful comments and discussion.
Harris & Harris Group Professor, MIT Sloan School of Management, and Chief Investment Strategist,AlphaSimplex Group, LLC. Please direct all correspondence to: MIT Sloan School, 50 Memorial Drive,E52–454, Cambridge, MA 02142–1347,
alo@mit.edu
(email).
Senior Lecturer, MIT Sloan School of Management, and Visiting Scientist, MIT Departmentof Physics, Center for Theoretical Physics, 77 Massachusetts Avenue, Cambridge, MA 02142–1347,
 mark.t.mueller@mac.com
(email).
 
Contents
1 Introduction 12 Physics Envy 3
2.1 The Mathematization of Economics and Finance . . . . . . . . . . . . . . . . 42.2 Samuelsons Caveat . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62.3 Economics vs. Psychology . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3 A Taxonomy of Uncertainty 9
3.1 Level 1: Complete Certainty . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.2 Level 2: Risk without Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . 103.3 Level 3: Fully Reducible Uncertainty . . . . . . . . . . . . . . . . . . . . . . 113.4 Level 4: Partially Reducible Uncertainty . . . . . . . . . . . . . . . . . . . . 113.5 Level 5: Irreducible Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . 133.6 Level
: Zen Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.7 The Uncertainty Continuum . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4 The Harmonic Oscillator 14
4.1 The Oscillator at Level 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144.2 The Oscillator at Level 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164.3 The Oscillator at Level 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174.4 The Oscillator at Level 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
5 A Quantitative Trading Strategy 25
5.1 StatArb at Level 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265.2 StatArb at Level 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265.3 StatArb at Level 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305.4 StatArb at Level 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
6 Level-5 Uncertainty: Black Swan Song? 36
6.1 Eclipses and Coin Tosses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376.2 Uncertainty and Econometrics . . . . . . . . . . . . . . . . . . . . . . . . . . 406.3 StatArb Revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
7 Applying the Taxonomy of Uncertainty 43
7.1 Do You Really Believe Your Models?? . . . . . . . . . . . . . . . . . . . . . . 447.2 Risk Models vs. Model Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . 457.3 Incentives and Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . 477.4 Timescales Matter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487.5 The Uncertainty Checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
8 Quants and the Current Financial Crisis 52
8.1 Did the SEC Allow Too Much Leverage? . . . . . . . . . . . . . . . . . . . . 538.2 If Formulas Could Kill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578.3 Too Many Quants, or Not Enough? . . . . . . . . . . . . . . . . . . . . . . . 61i
 
9 Conclusion 65References 67
ii

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