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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.

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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    References listed on IDEAS

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    Citations

    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. links for 2010-05-01
      by Jim in Our Word is Our Weapon on 2010-05-02 08:02:37
    2. Physics envy?
      by Economic Logician in Economic Logic on 2010-04-26 19:24:00
    3. An attack on "Old-Fashioned Economics"
      by Mark Thoma in Economist's View on 2010-04-29 12:33:00
    4. In which I “attack old-fashioned economics,” i.e. utility maximization
      by Nick Krafft in open economics on 2010-04-28 05:35:05
    5. Investor Warning: Physics Envy May Be Hazardous To Your Wealth!
      by Miguel in Simoleon Sense on 2010-04-28 07:24:55

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    9. Andrew Kumiega & Ben Van Vliet & Apostolos Xanthopoulos, 2012. "Preventing Another Crisis: Quality Data for MBS Markets," Accounting and Finance Research, Sciedu Press, vol. 1(1), pages 162-162, May.
    10. van Dijk, M.A., 2014. "The Social Value of Finance," ERIM Inaugural Address Series Research in Management EIA-2014-055-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam..
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    12. 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.
    13. Dirk G. Baur & Thomas K.J. McDermott, 2011. "Safe Haven Assets and Investor Behaviour Under Uncertainty," The Institute for International Integration Studies Discussion Paper Series iiisdp392, IIIS, revised Feb 2012.
    14. Tian, Dejian & Tian, Weidong, 2014. "Optimal risk-sharing under mutually singular beliefs," Mathematical Social Sciences, Elsevier, vol. 72(C), pages 41-49.
    15. Michael Dempsey, 2015. "Stock Markets, Investments and Corporate Behavior:A Conceptual Framework of Understanding," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number p1007, November.
    16. Maria Camila De-La-Hoz & Carlos Pombo, 2015. "Institutional Investors and Firm Valuation: Evidence from Latin America," Documentos CEDE 12849, Universidad de los Andes, Facultad de Economía, CEDE.
    17. Matteo Burzoni & Frank Riedel & H. Mete Soner, 2021. "Viability and Arbitrage Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 89(3), pages 1207-1234, May.
    18. 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.
    19. Asmeret Naugle & Adam Russell & Kiran Lakkaraju & Laura Swiler & Stephen Verzi & Vicente Romero, 2023. "The Ground Truth program: simulations as test beds for social science research methods," Computational and Mathematical Organization Theory, Springer, vol. 29(1), pages 1-19, March.
    20. Trojan, Sebastian, 2013. "Regime Switching Stochastic Volatility with Skew, Fat Tails and Leverage using Returns and Realized Volatility Contemporaneously," Economics Working Paper Series 1341, University of St. Gallen, School of Economics and Political Science, revised Aug 2014.
    21. Apurv Jain, 2017. "Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy," Business Economics, Palgrave Macmillan;National Association for Business Economics, vol. 52(2), pages 123-125, April.
    22. Mark R. Powell, 2015. "Risk‐Based Sampling: I Don't Want to Weight in Vain," Risk Analysis, John Wiley & Sons, vol. 35(12), pages 2172-2182, December.
    23. Stavros Drakopoulos & Ioannis Katselidis, 2015. "From Edgeworth to econophysics: a methodological perspective," Journal of Economic Methodology, Taylor & Francis Journals, vol. 22(1), pages 77-95, March.
    24. 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.
    25. Rainer Sachs, 2023. "The governance of uncertainty: how to respond to non-quantifiable risk?," Environment Systems and Decisions, Springer, vol. 43(4), pages 537-543, December.

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