"Boards don't hit back."

[randomness]

Rick Bookstaber, in post today called Physics Envy in Finance:

But the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, that there are not many jobs for physicist [sic] in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.

Andrew Lo and Mark Meuller have has [sic] a recent paper that addresses the issue of physics envy. They focus on the applicability of the tools of physics as the type of uncertainty becomes more profound, pointing out that while physics can generate useful models if there is well-parameterized uncertainty, where we know the distribution of the randomness, it becomes less useful if the uncertainty is fuzzy and ill-defined, what is called Knightian uncertainty.

I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well.

In the Bruce Lee movie, Enter the Dragon, Lee faces his arch enemy in a fight. To intimidate Lee, his opponent holds up a board, and splits it in two with his fist. Lee watches passively and says, “Boards don’t hit back”. That gets to the reason physics does not work in finance: markets do hit back.

The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

Via a post in FT Alphaville.

(The Lo and Meuller paper can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1563882)

Comments

[contrariety.livejournal.com]

AWESOME article.

[r-ness.livejournal.com]

I'm glad you liked it. I often a little apprehensive about posting dense, longish excerpts from articles about finance; this one was no exception. So I'm happy you replied.

I wanted to post this one because I have run into techies who think they can figure out the market. Perhaps they can, but it seems to me that the difficult bit is figuring out what the people will do.

[allessindra.livejournal.com]

FWIW, I don't always read these things, but I'm usually glad you post them -- I've periodically pointed someone back to your post as a "I saw something about that *here*, and it had a pointer to more information."

And figuring out what the people will do is ALWAYS the hard part of any system that involves people.

[achinhibitor.livejournal.com]

More exactly, if a part of the uncertainty in the market can be modelled well, the most astute market players will act on the model, thus eliminating that component of the uncertainty.

Thus, the best market players need a squadron of physicists to find and model the modelable uncertainty to avoid being exploited by other market players that have squadrons of physicists.

It is not all inevitable, it is not just that this is the way the world works.

Well, if you eliminate markets, you can eliminate gaming the markets in this particular way. Otherwise, you're stuck with it.