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WARNING: Physics Envy May Be Hazardous To Your Wealth!

  • Andrew W. Lo
  • Mark T. Mueller

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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File URL: http://arxiv.org/pdf/1003.2688
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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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  1. Lo, Andrew W & MacKinlay, A Craig, 1990. "Data-Snooping Biases in Tests of Financial Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 3(3), pages 431-67.
  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. 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.
  4. Jon Elster, 1998. "Emotions and Economic Theory," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 47-74, March.
  5. Rabin, Matthew, 2002. "A Perspective on Psychology and Economics," Department of Economics, Working Paper Series qt2wr3z049, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  6. Bruce N. Lehmann, 1988. "Fads, Martingales, and Market Efficiency," NBER Working Papers 2533, National Bureau of Economic Research, Inc.
  7. 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.
  8. 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.
  9. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  10. Lo, Andrew W & MacKinlay, A Craig, 1990. "When Are Contrarian Profits Due to Stock Market Overreaction?," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 175-205.
  11. George Loewenstein, 2000. "Emotions in Economic Theory and Economic Behavior," American Economic Review, American Economic Association, vol. 90(2), pages 426-432, May.
  12. Robert C. Merton, 1992. "Financial Innovation And Economic Performance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(4), pages 12-22.
  13. Matthew Rabin., 1997. "Psychology and Economics," Economics Working Papers 97-251, University of California at Berkeley.
  14. Paul A. Samuelson, 1998. "How Foundations Came to Be," Journal of Economic Literature, American Economic Association, vol. 36(3), pages 1375-1386, September.
  15. Lehmann, Bruce N, 1990. "Fads, Martingales, and Market Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 1-28, February.
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