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Unformatted text preview: Electronic copy available at: http://ssrn.com/abstract=1563882 WARNING: Physics Envy May Be Hazardous To Your Wealth! Andrew W. Lo and Mark T. Mueller This Draft: March 12, 2010 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 systemsand financial markets in particularthat are as predictive as those in physics. While this per- spective 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 ori- gins 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 : G01, G12, B16, C00 * The views and opinions expressed in this article are those of the authors only, and do not necessarily represent the views and opinions of AlphaSimplex Group, MIT, or any of their affiliates and employees. The authors make no representations or warranty, either expressed or implied, as to the accuracy or completeness of the information contained in this article, nor are they recommending that this article serve as the basis for any investment decisionthis article is for information purposes only. Research support from AlphaSimplex Group and the MIT Laboratory for Financial Engineering is gratefully acknowledged. We thank Jerry Chafkin, Peter Diamond, Arnout Eikeboom, Doyne Farmer, Gifford Fong, Jacob Goldfield, Tom Imbo, Jakub Jurek, Amir Khandani, Bob Lockner, Paul Mende, Robert Merton, Jun Pan, Roger Stein, Tina Vandersteel for helpful comments and discussion. Harris & Harris Group Professor, MIT Sloan School of Management, and Chief Investment Strategist, AlphaSimplex Group, LLC. Please direct all correspondence to: MIT Sloan School, 50 Memorial Drive, E52454, Cambridge, MA 021421347, firstname.lastname@example.org (email). Senior Lecturer, MIT Sloan School of Management, and Visiting Scientist, MIT Department of Physics, Center for Theoretical Physics, 77 Massachusetts Avenue, Cambridge, MA 021421347, email@example.com (email). Electronic copy available at: http://ssrn.com/abstract=1563882 Contents 1 Introduction 1 2 Physics Envy 3 2.1 The Mathematization of Economics and Finance . . . . . . . . . . . . . . . . 4 2.2 Samuelsons Caveat . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Samuelsons Caveat ....
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