Warning: Physics Envy May Be Hazardous To Your Wealth

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. The authors speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. The authors illustrated 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. The authors conclude by offering a new interpretation of tail events, proposing an “uncertainty checklist” with which their taxonomy can be implemented, and considering the role that quants played in the current financial crisis.

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