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WARNING: Physics Envy May Be Hazardous To Your Wealth!

Author

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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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    Full references (including those not matched with items on IDEAS)

    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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    22. Steve J. Bickley & Ho Fai Chan & Benno Torgler, 2022. "Artificial intelligence in the field of economics," Scientometrics, Springer;Akadémiai Kiadó, vol. 127(4), pages 2055-2084, April.
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