Models. Behaving. Badly.

Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs,one of the financial engineers whose mathematical models becamecrucial for Wall Street. The reliance investors put on suchquantitative analysis was catastrophic for the economy, setting offthe ongoing string of financial crises that began with the mortgagemarket in 2007 and continues through today. Here Derman looks atwhy people -- bankers in particular -- still put so much faith inthese models, and why it's a terrible mistake to do so. Though financial models imitate the style of physics and employthe language of mathematics, ultimately they deal with humanbeings. There is a fundamental difference between the aims andpotential achievements of physics and those of finance. In physics,theories aim for a description of reality; in finance, at best,models can shoot only for a simplistic and very limitedapproximation to it. When we make a model involving human beings,we are trying to force the ugly stepsister's foot into Cinderella'spretty glass slipper. It doesn't fit without cutting off some ofthe essential parts. Physicists and economists have been tooenthusiastic to acknowledge the limits of their equations in thesphere of human behavior--which of course is what economics is allabout. Models.Behaving.Badly includes a personal account ofDerman's childhood encounters with failed models--the oppressionsof apartheid and the utopia of the kibbutz. He describes hisexperience as a physicist on Wall Street, the models quantsgenerated, the benefits they brought and the problems, practicaland ethical, they caused. Derman takes a close look at what a modelis, and then highlights the differences between the successes ofmodeling in physics and its failures in economics. Describing thecollapse of the subprime mortgage CDO market in 2007, Derman urgesus to stop the naïve reliance on these models, and offerssuggestions for mending them. This is a fascinating, lyrical, andvery human look behind the curtain at the intersection betweenmathematics and human nature.