Warning: Physics Envy May be Hazardous to Your Wealth!

73 Pages Posted: 5 Mar 2010 Last revised: 15 Mar 2010

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Mark T. Mueller

Massachusetts Institute of Technology, Center for Theoretical Physics

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Date Written: March 12, 2010

Abstract

The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems - and financial markets in particular - that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, physics envy has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an uncertainty checklist with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.

Keywords: Quantitative Finance, Efficient Markets, Financial Crisis, History of Economic Thought

JEL Classification: G01, G12, B16, C00

Suggested Citation

Lo, Andrew W. and Mueller, Mark T., Warning: Physics Envy May be Hazardous to Your Wealth! (March 12, 2010). Available at SSRN: https://ssrn.com/abstract=1563882 or http://dx.doi.org/10.2139/ssrn.1563882

Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

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Mark T. Mueller

Massachusetts Institute of Technology, Center for Theoretical Physics ( email )

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Cambridge, MA 02139-4307
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