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WARNING: Physics Envy May Be Hazardous To Your Wealth!

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  • Andrew W. Lo
  • Mark T. Mueller

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.

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Bibliographic Info

Paper provided by arXiv.org in its series Papers with number 1003.2688.

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Date of creation: Mar 2010
Date of revision: Mar 2010
Handle: RePEc:arx:papers:1003.2688

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References

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  1. Rabin, Matthew, 1997. "Psychology and Economics," Department of Economics, Working Paper Series qt8jd5z5j2, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  2. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
  3. Rabin, Mathew, 2002. "A Perspective on Psychology and Economics," Department of Economics, Working Paper Series qt4z78n1r9, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  4. Andrew W. Lo & A. Craig MacKinlay, 1989. "When are Contrarian Profits Due to Stock Market Overreaction?," NBER Working Papers 2977, National Bureau of Economic Research, Inc.
  5. Lehmann, Bruce N, 1990. "Fads, Martingales, and Market Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 1-28, February.
  6. Andrew W. Lo & A. Craig MacKinlay, 1989. "Data-Snooping Biases in Tests of Financial Asset Pricing Models," NBER Working Papers 3001, National Bureau of Economic Research, Inc.
  7. George Loewenstein, 2000. "Emotions in Economic Theory and Economic Behavior," American Economic Review, American Economic Association, vol. 90(2), pages 426-432, May.
  8. Thomas Philippon & Ariell Reshef, 2007. "Skill Biased Financial Development: Education, Wages and Occupations in the U.S. Financial Sector," NBER Working Papers 13437, National Bureau of Economic Research, Inc.
  9. Paul A. Samuelson, 1998. "How Foundations Came to Be," Journal of Economic Literature, American Economic Association, vol. 36(3), pages 1375-1386, September.
  10. Jon Elster, 1998. "Emotions and Economic Theory," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 47-74, March.
  11. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  12. Robert C. Merton, 1992. "Financial Innovation And Economic Performance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(4), pages 12-22.
  13. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  14. Bruce N. Lehmann, 1988. "Fads, Martingales, and Market Efficiency," NBER Working Papers 2533, National Bureau of Economic Research, Inc.
  15. Paul A. Samuelson, 2009. "An Enjoyable Life Puzzling Over Modern Finance Theory," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 19-35, November.
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Citations

Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Physics envy?
    by Economic Logician in Economic Logic on 2010-04-26 14:24:00
  2. An attack on "Old-Fashioned Economics"
    by Mark Thoma in Economist's View on 2010-04-29 07:33:00
  3. In which I â??attack old-fashioned economics,â? i.e. utility maximization
    by Nick Krafft in open economics on 2010-04-28 00:35:05
  4. Investor Warning: Physics Envy May Be Hazardous To Your Wealth!
    by Miguel in Simoleon Sense on 2010-04-28 02:24:55
  5. links for 2010-05-01
    by Jim in Our Word is Our Weapon on 2010-05-02 03:02:37
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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Cited by:
  1. Larry G. Epstein & Shaolin Ji, 2013. "Ambiguous Volatility and Asset Pricing in Continuous Time," Review of Financial Studies, Society for Financial Studies, vol. 26(7), pages 1740-1786.
  2. Gradojevic, Nikola & Gençay, Ramazan, 2013. "Fuzzy logic, trading uncertainty and technical trading," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 578-586.
  3. Andrew W. Lo, 2012. "Reading about the Financial Crisis: A Twenty-One-Book Review," Journal of Economic Literature, American Economic Association, vol. 50(1), pages 151-78, March.

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  1. Economic Logic blog

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