There’s Enough Math in Finance Already. What’s Missing is Imagination.
Emanuel Derman | Big Think
Author, Professor of Financial Engineering, Columbia University
October 21, 2011
Emanuel Derman: In some sense, all of finance is about imagination because finance is about saying, what should something be worth today based on what I think is going to happen in the future? Nobody knows what’s going to happen in the future. And so all financial models are specifying in some way an imagined future and then saying, if that future is true, what should I pay for something today?
And so for example, if you’re building an option model, you’re saying, what will volatility be in the future? And given my estimate of volatility in the future, I can value an option today. If you’re looking at CDO’s, which sort of came in a cropper in the big financial crisis, essentially human beings are saying, what will housing prices do in the future? What will defaults on loans be and defaults on mortgages be? And given my imagined scenario for the future, what should
I pay for something today that’s sensitive to that future behavior?
The big failures, I think, are failures of imagination, not of mathematics. The big mistakes are when you don’t’ think of something that does come to fruition eventually.
When I was in graduate school, I went to see a movie the night before my qualifying exams called, “Bedazzled” with Peter Cook and Dudley Moore. It’s about 40 years old, but I think it was remade a few years ago. Dudley Moore – I think they’re both dead now, Dudley Moore and Peter Cook – he was a short-order cook at a Wimpy’s in London and he’s in love with the waitress that serves him. Peter Cook plays the devil and offers him seven chances to seduce the waitress in exchange for his soul. And so he agrees. And then he tries to specify the circumstances under which he will be with the waitress. And so the first time, he says something like, he’d like to be in a fancy castle in Oxfordshire and with her and both of them in love with each other and both of them wealthy. And the devil snaps his fingers, and there they are in this castle and they’re around the billiard table and they’re in love with each other, but she’s married to the owner of the castle and he’s just a guest. And she has scruples, so she’s not willing to get involved with him.
And in every scenario he tries of these seven scenarios he gets it wrong. In the last one he asks if they can both just be somewhere quiet with nobody to interfere with them and nobody talking, and they make them both nuns in a sort of Trappist monastery.
And so his imagination can never specify precisely enough the future that he’d like to have. And I think that’s sort of what goes wrong with a lot of financial models. You can’t really write down one short description of all the things that markets may do in the future.
Tweet
Facebook
Reddit
Digg this!
October 23rd, 2011 at 7:11 am
[...] There’s plenty of math in finance already, what we need is more imagination. (Big Picture) [...]
October 23rd, 2011 at 11:56 am
This is a great piece that could be expanded on in so many ways. For example: since LinkedIn came into being, I have been able to join forums on investing and economics and get exposure from other professionals I could never hope to come by before, and even get to participate in discussions. Yet many of the contributors, some of whom are trained and educated to an inch of their lives, seem to be witless dullards whose minds can’t stray one inch beyond the bounds of their prejudices. Its like the old story of being “book smart” versus “street smart.” There is a large gulf between the truly brilliant versus the merely competent, and the ones whose sparks fire brightly inside their heads are the ones who make the real difference.
Those are the people who imagine outcomes, and are not slaves to process.
October 23rd, 2011 at 12:58 pm
I find it hard to have to argue this with a professor in the field, but clearly, the problem is the math. Or perhaps the fact that those who are in charge of the people that understand the math, do not understand the math. I can construct a portfolio that’s risk-neutral with some approximation in some model. I – being a math/stat kinda guy – will put in statistical error bars and model-derived systematic error bars, which will be duely ignored by the traders or managers executing on the model. If I am very honest with myself, the error bars will indicate fairly large uncertainties. But even accurate error bars only indicate what’s likely to happen, not what can happen. This is the black swan kinda issue. Nothing new here. Main point: when math gives the impression of control over processes that are beyond control, it merely encourages recklessness. To that degree, the math is the issue. And since the rest of it really is just human nature, math remains the only issue.
October 23rd, 2011 at 1:07 pm
@flocktard. You miss the point. Those that are brilliant at selling things, rely on those that are brilliant at creating things to sell, and they in turn rely on teams of math wizzes to create and analyze things that do not yet exist. At the interface, these brilliant minds usually meet and bad ideas get nixed appropriately. The system, however, is set up such that you will never know how many ideotic things never get made. You only hear about those that make it to the market, and only those minds that didn’t meet at the crucial points will get the rewards… Add Darwin or free market forces and you have a system where only the bad communicators thrive, and mainly bad products get to market. This is not fixable, you need to get the entire approach (i.e. complex derivative products) out of the way.
October 23rd, 2011 at 1:15 pm
The bigger problem within Mathematical Finance is the belief in:
1- Efficient Markets – WRONG!
2- Normal (Guassian) Distributions – WRONG!
3- Frictionless Markets – WRONG!
4- The Idea that everything can be modeled (Correlated)- WRONG!
5-Random Events are non random – WRONG!
It is an imagination problem alright.
These so called smart guys all imagine the above.
October 23rd, 2011 at 7:40 pm
No imagination? You mean “creative bookkeeping” is dead?
October 23rd, 2011 at 10:42 pm
i don’t think the always “immediate” problem is with imagination at all but the simple fact that the human capacity for self-delusion can be predicted even mathematically at “infinite”…and that’s a fact. In other words try as humans might “you can’t account for feelings.” All markets run on intuition. Period. The problem with modeling of any sort (and humans “model” everything…i think it’s called “game theory”) is statistical or “gaussing” distrubutions simply our irrelevant when talking about money. The aquisition of wealth especially at the billion dollar level simply ceases to be about “rational expectations” and is run purely on emotion. “Feelings” as i said. That’s why Wall Street blowing itself up is so predictable: long gone are rational expectations and it’s time for pure mark to model “feelings.” The same is true of course on the downside: “irrational pessimism” yields yet another “turn of the screw” of the forever battle of emotions between bull and bear. As i’ve posted elsewhere “you’ll learn more from a witch doctor” in the sense that from that perspective simple reality of the emotion is recognized whereas the insane mathematical nut jobs (including here) keeping looking at things through “the lens of the sheeple.” these people (and they are legion and currently are all on the bearish side this time) are just as easy to read as the bulls were back in 2000 and back in 2007. That’s why the only “gaming” that goes on in the system is with government…and obviously that’s nothing but intuition trying to read that tea leaf. Welcome to the move from “histrionics” to “historynomics.”
October 24th, 2011 at 10:25 pm
[...] Source: http://www.ritholtz.com/blog/2011/10/there%E2%80%99s-enough-math-in-finance-already-what%E2%80%99s-m… [...]
October 25th, 2011 at 2:17 pm
There was more than enough imagination as the financial bubble expanded. There was not enough *good* math to recognize that it was not sustainable. Ordinary risk control measures with simple math would have detected most of the firms and markets that would fail.
Imagination is useful with new products and services. I’m more wary with imagination in finance.