Warning: Physics Envy May be Hazardous to Your Wealth!
Andrew W. Lo
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
Mark T. Mueller
Massachusetts Institute of Technology, Center for Theoretical Physics
March 12, 2010
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.
Number of Pages in PDF File: 73
Keywords: Quantitative Finance, Efficient Markets, Financial Crisis, History of Economic Thought
JEL Classification: G01, G12, B16, C00
Date posted: March 5, 2010 ; Last revised: March 15, 2010