Warning: Physics Envy May Be Hazardous to Your Wealth!

Journal of Investment Management (JOIM), Second Quarter 2010

Posted: 13 Jul 2010

See all articles by Andrew W. Lo

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering; Santa Fe Institute

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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.

Keywords: Quantitative finance, Efficient markets, Financial crisis, History of economic thought

JEL Classification: G00

Suggested Citation

Lo, Andrew W., Warning: Physics Envy May Be Hazardous to Your Wealth!. Journal of Investment Management (JOIM), Second Quarter 2010, Available at SSRN: https://ssrn.com/abstract=1639085

Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

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