WARNING: Physics Envy May BeHazardous To Your Wealth!
Andrew W. Lo
and Mark T. Mueller
This Draft: March 19, 2010
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.
: Quantitative Finance; Eﬃcient Markets; Financial Crisis; History of EconomicThought.
: 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,
Senior Lecturer, MIT Sloan School of Management, and Visiting Scientist, MIT Departmentof Physics, Center for Theoretical Physics, 77 Massachusetts Avenue, Cambridge, MA 02142–1347,