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WARNING: Physics Envy May Be Hazardous To Your Wealth!

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Listed:
  • 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.

Suggested Citation

  • Andrew W. Lo & Mark T. Mueller, 2010. "WARNING: Physics Envy May Be Hazardous To Your Wealth!," Papers 1003.2688, arXiv.org, revised Mar 2010.
  • Handle: RePEc:arx:papers:1003.2688
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    File URL: http://arxiv.org/pdf/1003.2688
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    References listed on IDEAS

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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 19:24:00
    2. An attack on "Old-Fashioned Economics"
      by Mark Thoma in Economist's View on 2010-04-29 12:33:00
    3. In which I “attack old-fashioned economics,” i.e. utility maximization
      by Nick Krafft in open economics on 2010-04-28 05:35:05
    4. Investor Warning: Physics Envy May Be Hazardous To Your Wealth!
      by Miguel in Simoleon Sense on 2010-04-28 07:24:55
    5. links for 2010-05-01
      by Jim in Our Word is Our Weapon on 2010-05-02 08:02:37

    Citations

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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. Bautista, Rafael, 2014. "A quantitative model of the human capital contribution to the value of a project," Galeras. Working Papers Series 039, Universidad de Los Andes. Facultad de Administración. School of Management.
    3. Mike Dempsey, 2014. "The Modigliani and Miller Propositions: The History of a Failed Foundation for Corporate Finance?," Abacus, Accounting Foundation, University of Sydney, vol. 50(3), pages 279-295, September.
    4. Gradojevic, Nikola & Gençay, Ramazan, 2013. "Fuzzy logic, trading uncertainty and technical trading," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 578-586.
    5. Henry T. C. Hu, 2011. "Systemic Risk and Financial Innovation: Toward a "Unified" Approach," NBER Chapters,in: Quantifying Systemic Risk, pages 11-28 National Bureau of Economic Research, Inc.
    6. Tian, Dejian & Tian, Weidong, 2014. "Optimal risk-sharing under mutually singular beliefs," Mathematical Social Sciences, Elsevier, vol. 72(C), pages 41-49.
    7. Maria Camila De-La-Hoz & Carlos Pombo, 2015. "Institutional Investors and Firm Valuation: Evidence from Latin America," DOCUMENTOS CEDE 012849, UNIVERSIDAD DE LOS ANDES-CEDE.
    8. Arnab Acharya & Giulia Greco & Edoardo Masset, 2010. "The economics approach to evaluation of health interventions in developing countries through randomised field trial," Journal of Development Effectiveness, Taylor & Francis Journals, vol. 2(4), pages 401-420.
    9. repec:pal:buseco:v:52:y:2017:i:2:d:10.1057_s11369-017-0027-3 is not listed on IDEAS
    10. 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 151-178, March.

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