Book Review: Models.Behaving.Badly

Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life. 2011. Emanuel Derman.

Emanuel Derman spent two decades at Goldman Sachs, making valuable contributions to financial modeling. Before that, as recounted in My Life as a Quant (John Wiley & Sons, 2004), he was a physicist. Today, Derman is the head of risk management at Prisma Capital Partners and directs Columbia University’s financial engineering program. He also devotes energy to combating the belief that security markets can be analyzed with the same mathematical precision as heavenly bodies and subatomic particles.

Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life continues this campaign. To illustrate why inanimate objects are fit subjects for the scientific method, unlike economic events driven by human decisions, Derman devotes one full chapter (out of six) to the history of electromagnetic theory. Another chapter draws on the writings of Baruch Spinoza to shed light on the nature of scientific theories. According to Derman, the seventeenth-century philosopher’s analysis of human passions “bears a close relationship . . . to the twentieth-century theory of financial derivatives.”

Derman deals at length with his childhood in apartheid-era South Africa, including a detailed discussion of the several factions of the Zionist movement that were active there in the 1950s. He finds another instructive incident in the successful treatment of a vision problem he initially, but mistakenly, thought was the residual effect of getting bashed in the eye by a wayward tennis ball. Derman even manages to slip in a sly allusion to Russian political theorist Nikolay Chernyshevsky (1828–1889).

Although Models.Behaving.Badly ranges more widely than the typical book reviewed here, Derman provides many genuinely useful insights for practitioners. For example, he notes that the initial response to the U.S. financial crisis of 2007–2008 was incorrect in pinning blame on complex mortgage securities. Paul Krugman and Robin Wells have pointed out that comparable disasters occurred in such countries as Spain, where only simple mortgages existed.

At the same time, Derman criticizes the explanation of the crisis that Krugman and Wells offer. The husband-and-wife economists cite a savings glut resulting from the Asian currency crisis of 1997–1998, which induced the Asian countries to take steps to avoid a recurrence. This is an example of what Spinoza would call an inadequate explanation—because it forces us to ask what, in turn, caused the Asian currency crisis.

This philosophical approach to finance can deepen the reader’s understanding of the markets but can also lead into a metaphysical briar patch. For instance, Derman writes, “Anyone with hindsight can see that the market is sometimes wrong about value.” A few pages earlier, however, he states that “there is nothing absolute about the value of a financial asset” and that value is merely “what you think” a security is worth. If you cannot be sure what an asset’s value was at a given time, how can you be certain the market was wrong about it?

The hairsplitting that inevitably arises from philosophical discourse casts doubt even on Derman’s seemingly innocuous statement, “Nothing can have less risk than a riskless bond.” In reality, so-called riskless bonds are devoid of only default risk. Some have initial maturities as great as 30 years. The associated interest rate risk places holders in jeopardy of a very sizable loss of market value. In a philosophically rigorous sense, a bond becomes riskless only at the instant before it matures.

Models.Behaving.Badly is most valuable when it steps down to a more practical level. Chapter 5 justifies with great intellectual force the intuitive skepticism many practitioners feel toward literal application of elegant but abstract models. Derman takes particular aim at what he terms pragmamorphism, defined as “the tendency to attribute the properties of things to human beings.” As he explains, construing the efficient market hypothesis as a description of reality effectively assumes that stock prices behave like smoke diffusing through a room, which is not even remotely factual.

Acknowledging that humans are inherently prone to modeling, Derman concludes by tackling the question of how models can be used wisely and well. One such intelligent application is interpolating or extrapolating from the known prices of liquid securities to the estimated values of illiquid securities. A model can also provide a useful starting point for ranking securities by value.

Derman teaches his lessons with many well-turned phrases and delightful footnotes. His pithy description of technical analysis as “a combination of rational and magical thinking” is inspired. That Derman has delivered an important message in such an eloquent manner is fortunate in view of the vast sums lost in the financial crisis through the misuse of models. Models.Behaving.Badly will consequently be read by many policymakers and financial executives who are in a position to improve the future functioning of the markets.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.