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Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life [Hardcover]

Emanuel Derman
3.5 out of 5 stars  See all reviews (4 customer reviews)
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Book Description

8 Nov 2011
Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs, one of the financial engineers whose mathematical models became crucial for Wall Street. The reliance investors put on such quantitative analysis was catastrophic for the economy, setting off the ongoing string of financial crises that began with the mortgage market in 2007 and continues through today. Here Derman looks at why people –– bankers in particular –– still put so much faith in these models, and why it′s a terrible mistake to do so. Though financial models imitate the style of physics and employ the language of mathematics, ultimately they deal with human beings. There is a fundamental difference between the aims and potential achievements of physics and those of finance. In physics, theories aim for a description of reality; in finance, at best, models can shoot only for a simplistic and very limited approximation to it. When we make a model involving human beings, we are trying to force the ugly stepsister′s foot into Cinderella′s pretty glass slipper. It doesn′t fit without cutting off some of the essential parts. Physicists and economists have been too enthusiastic to acknowledge the limits of their equations in the sphere of human behavior––which of course is what economics is all about. Models.Behaving.Badly includes a personal account of Derman′s childhood encounters with failed models––the oppressions of apartheid and the utopia of the kibbutz. He describes his experience as a physicist on Wall Street, the models quants generated, the benefits they brought and the problems, practical and ethical, they caused. Derman takes a close look at what a model is, and then highlights the differences between the successes of modeling in physics and its failures in economics. Describing the collapse of the subprime mortgage CDO market in 2007, Derman urges us to stop the naïve reliance on these models, and offers suggestions for mending them. This is a fascinating, lyrical, and very human look behind the curtain at the intersection between mathematics and human nature.

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Product details

  • Hardcover: 240 pages
  • Publisher: John Wiley & Sons; 1st edition (8 Nov 2011)
  • Language: English
  • ISBN-10: 1119967163
  • ISBN-13: 978-1119967163
  • Product Dimensions: 16.2 x 23.5 cm
  • Average Customer Review: 3.5 out of 5 stars  See all reviews (4 customer reviews)
  • Amazon Bestsellers Rank: 399,260 in Books (See Top 100 in Books)
  • See Complete Table of Contents

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“Emanuel Derman has written my kind of a book, an elegant combination of memoir, confession, and essay on ethics, philosophy of science and professional practice. He convincingly establishes the difference between model and theory and shows why attempts to model financial markets can never be genuinely scientific. It vindicates those of us who hold that financial modeling is neither practical nor scientific. Exceedingly readable.” — Nassim N. Taleb, author of The Black Swan

"This is a compelling, accessible and provocative piece of work, that forces us to question many of the assumptions that we work with. As Derman explains so clearly, models are not "bad" in themselves; on the contrary, they are crucial for modern society. However, they have been used in a dangerously sloppy and careless way, with sometimes terrible results. Derman explains this clearly, and draws heavily on his own lifetime experiences--ranging from growing up in appartheid south africa, working in the scientific field and then as a financial engineer on wall street--to provide a moving and fascinating set of illustrations of these principles. The conclusion is unexpectedly otpimistic--if people choose to listen." --Gillian Tett, author of Fool's Gold

"Models. Behaving. Badly. is an engaging and personal meditation on the limitations of our ability to predict the future, especially--but not only--in the context of financial markets. He is not interested in blame or politics, but in the deeper lessons to be drawn from the financial crisis. As a physicist who was also highly placed in the financial world, he explains clearly the difference between prediction and advice, theory and model and knowledge and wisdom." —Lee Smolin, Senior Researcher at Perimeter Institute for Theoretical Physics, author of The Trouble with Physics; Life of the Cosmos, and Three Roads to Quantum Gravity

“I found this book fascinating. Derman has a skill of mixing the personal with the abstract. You will not find another that takes you from the vagaries of the human eye to the vagaries of the stock market with stops at quantum electrodynmics. It is quite a ride.” —Jeremy Bernstein, author of Quantum Leaps, and Plutonium

"This is a thoughtful book for anyone interested in the overlap between the hard sciences and the soft sciences, from physicists to bankers. But finance academics beware, Professor Derman, with an iron fist in a velvet glove, gives them a good slapping." —Paul Wilmott, co-author "Financial Modelers' Manifesto"

"If you don't want your models to behave badly, you should study carefully these words of wisdom on the philosophy of quantitative modeling. Emanuel Derman has always been one of the most respected quants on Wall Street. Now he has proven that he is also one of the most thoughtful. Though, in the sequel he should tell us what happened to the large man over the Sudan!" —Clifford S. Asness, Ph.D., Managing & Founding Principal AQR Capital Management

′Powerful′ Gillian Tett, Financial Times

Praise for Emanuel Derman’s previous book, My Life as a Quant:
"There are few "gentlemen bankers" left these days. That is why Emanuel Derman's memoirs are so compelling…Derman's wry humour and sense of irony are apparent throughout the book."- Financial Times "That sense of being an intruder in outlaw territory lends an intriguing mood to Derman's My Life as a Quant, a literate and entertaining memoir."—BusinessWeek

“Reads like a novel, but tells a lot about brains applied to making money grow.” --Paul A. Samuelson, MIT, Nobel Laureate in Economic Sciences

From the Author

This is an outline of the book:


• Part I. Models

Chapter 1. A Foolish Consistency
A personal account of my experiences with models that failed.

Models that failed * Capitalism and the Great Financial Crisis * Divining the future: models, theories, and intuition * Time causes desire * Disappointment is inevitable * To be disappointed requires time, desire and a model * Living under apartheid * Growing up in "The Movement" * Tat Tvam Asi

Chapter 2. Metaphors, Models and Theories

The various ways we have of understanding the world and predicting its future. Theories tell you what something is. Models tell you merely what something is like. Intuition is a merging of the understander and the understood.

* Language is a tower of metaphors * The hole in the Dirac sea * Metaphors become real: the discovery of the positron * Absence is a presence * Analytic continuation * Every fact is a theory * Building a model airplane * Why is a model a model? * Why is a theory a theory? * A puzzling case of monocular diplopia * Making the unconscious conscious again

• Part II. Models Behaving

Chapter 3. The Absolute

An illustration of a theory: Spinoza's Theory of the Emotions

* The Tetragrammaton * The Name of the Name of the Name * The Irreducible Nonmetaphor * Spinoza's Theory of the Emotions * Fiat Money * How to Live in the Realm of the Passions

Chapter 4. The Sublime
Electromagnetism, a perfect theory. The role of intuition.

* The Birds of the Air * The Best Theory in the World * No Logical Path to It
 * Electricity and Magnetism * Their Qualities * Their Quantitative Laws * Ampère's Sympathetic Understanding of the Phenomena * Faraday's Imaginary Lines of Force * Maxwell's Factual Field * The Beasts of the Field The ultimate goal would be: to grasp that everything in the realm of fact is already theory.
 Goethe,Maxims and Reflections

• Part III. Models Behaving Badly

Chapter 5. The Inadequate The efficient market model: a model and an analogy but NOT a valid theory.

* Financial models are not the physics of markets * In finance, uncertainty is everywhere * The difference between uncertainty and risk * The Efficient Market Model * The relation between risk and return * Risk is like pleasure * The Black-Scholes Model * CAPM * Alpha and beta * Why the Efficient Market Model fails * The unbearable futility of modeling

There is nothing so terrible as activity without insight. Goethe, Maxims and Reflections

Chapter 6. Breaking The Cycle

How to cope with the inadequacies of models, via ethics and pragmatism.

* The Perfect Cage * The Mysteries of the World * Models That Failed * How to use financial models * Beware of Idolatry * The Financial Modelers' Manifesto * Markets and Morals * Tat Tvam Asi

Inside This Book (Learn More)
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Front Cover | Copyright | Table of Contents | Excerpt | Index
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Customer Reviews

Most Helpful Customer Reviews
4 of 5 people found the following review helpful
By Paul Bowes TOP 500 REVIEWER
Emanuel Derman is an eminent financial modeller - author of 'My Life As a Quant' - with a background in physics. As such, he is well placed to appreciate the differences between the theories that have transformed our understanding of the universe and the models that physicists have used to develop those theories. In essence, the present book argues that many aspects of the financial crisis that has engulfed us since 2007 have their roots in the persistent confusion of models - simplified accounts of imaginary worlds that bear only an analogical or metaphorical relation to the real world - with true theories, which describe how that real world is. The physics envy of financial modellers and the mathematics envy of economists have led in recent years to inescapably crude financial models being oversold as theories with the certainty of axiomatic truths and the rigour of mathematical theorems.

Professor Derman has chosen an unusual form for this interesting book, with lengthy diversions into his personal history as a youth growing up in a racist South Africa, as a young physicist in the United States, and into Spinoza's theory of the emotions. This is not meaningless digression; Derman is laying the ground for the reader to understand his later insistence that the world of finance is dominated by the human in a way that makes comparisons with the world of elementary particles - whose behaviour can now be described with astonishing accuracy - wholly misleading.

In the third part of the book, Derman offers a lean, pungent analysis of the consequences of these conceptual failures in the real world and argues for a 'Modellers' Manifesto' that would recognise the limits of models as tools of financial analysis and impose a voluntary ethical code on those who develop and advertise them.
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7 of 9 people found the following review helpful
3.0 out of 5 stars Nice Title. But - 22 Feb 2012
Format:Hardcover|Verified Purchase
Emanuel Derman is a "quant" of illustrious pedigree: not only a 20-year veteran of Goldman Sachs (say what you like about the Vampire Squid but over the last couple of decades Goldman's financial analysts have consistently been the smartest guys in the room), but also a close colleague of nobel laureate Fischer Black, co-inventor with Myron Scholes of the (in)famous Black Scholes option pricing model.

Given that the motion before the house concerns misbehaving financial models you might expect some fairly keen insights on this topic: It has already been well documented that Black Scholes doesn't work awfully well when the market is in a state of extreme stress - that is, precisely when you want it working awfully well. In fact, in those situations Black Scholes can create havoc, and memorably did during the Russian Crisis of 1998, during which Myron Scholes' pioneering hedge fund Long Term Capital Management catastrophically failed.

But this isn't Emanuel Derman's interest: the specific inadequacy of Black-Scholes (that it assumes that market events occur in isolation of each other and are therefore arranged according to a "normal" probability distribution) rates barely a mention. Derman's view is that reliance on *any* financial model will end in tears, simply because models are poor metaphors which are not grounded in the same reality as the sciences whose language they mimic.


Benoit Mandelbrot, whose excellent book The (Mis)Behaviour of Markets clearly outlines the "tail risk" inadequacy of Black Scholes, recognises that it is the market, not the model, that tends to misbehave. A model can't be blamed for failing to work when misapplied.
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2.0 out of 5 stars Boring 11 Aug 2013
Format:Paperback|Verified Purchase
You would expect from a "quant" a completely different book. The first chapters are bad philosophy. The last chapter is "baby finance". A waste of time.
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5.0 out of 5 stars stunning book 30 Jun 2013
Format:Hardcover|Verified Purchase
It was a good surprise to read this book, now it became an addiction. The author explain complex ideas as they were simple concepts. Very easy to read
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Most Helpful Customer Reviews on (beta) 2.9 out of 5 stars  41 reviews
64 of 78 people found the following review helpful
1.0 out of 5 stars belabored 27 Dec 2011
By Suez - Published on
This book got me excited. Then, just as the economic models I teach,it became a disappointment. It's refreshing to start something that's different -- that isn't Michael Lewis. But this book quickly became tedious -- a self-promoting reflection of pieces of the author's life, a not-detailed-enough (you can't get much out of it if you don't already know it) and yet too-detailed (pages and pages) review of philosophy and physics, and very shallow comments about economic and financial models. It's also unfortunate that no one caught the error in defining a CDO, which is a collateralized debt obligation, not a collateralized "default" obligation. Mistakes such as this compromise the author's credibility. Don't buy this book. Spend your money on Daniel Kahneman's Thinking Fast and Slow -- it's fascinating and gives you the real meat of why economic and financial models behave badly.
20 of 23 people found the following review helpful
3.0 out of 5 stars Interesting concept, so-so execution. 28 Jan 2012
By Nicholas E. Johansen - Published on
Here's a quick summary of this review, for those who are short on time: this book lacks focus and I would not recommend it unless you have A LOT of patience. It is a LONG 200 page read.

As a cross-disciplinary individual (I studied Finance and English in college), this type of "crossover" book intrigues me. A mashup of philosophy, physics and finance, Models Behaving Badly is, at the very least, a very unique book. Indeed, I've never quite read anything like it. While centered around the markets -- and the idea that most of the models used to describe them are garbage -- Derman supports his points with quotes from Goethe, discussions on Maxwell's electromagnetic theory and anecdotes about his own youth as a Jewish boy in the era of South African apartheid. The fields that are of interest to me, likewise, are eclectic, and I think that most of the stuff I was taught in undergraduate Finance was wholly useless. I mention these facts simply because I feel as if I am precisely the demographic Derman targeted with this book.

And, unfortunately, he missed the mark.

The reason is simple: he never reconciles the three disciplines into any sort of coherent argument. On a broad level, he uses each separate field to show that theories are reflective of reality, whereas models are merely an approximation. He never, however, goes beyond this generalization and provides a good reason WHY he's talking about the philosophy/physics (other than, presumably, that they interest him). I have no doubt that Derman is an intelligent guy; his prose is generally decent and he clearly knows a lot about the markets as well as physics. Unfortunately, there is NO reason to have the physics (and, to a lesser extent, the philosophy) in this book. His examples are impossible to follow unless you're a physicist or engineer, and the discussion is way too technical for non-scientists to understand. Worse, the discussion is pointless, as it does not relate back to the core thesis of the book, which revolves around CAPITAL MARKETS. I get that there are theories in science, and that they are generally indisputable tenants of reality. However, it is unnecessary and BORING to devolve into a 30+ page discussion about the intricacies of electromagnetic theory.

The philosophy was sometimes interesting, at least, but again, it was only tenuously linked to the core point of capital markets. It's interesting when he brings up the idea of life being "negative" and sleep/death being "positive" (or something akin to this), but it's out of place. If, after reading the previous sentence, you're wondering "Surely he relates that back SOMEHOW," then I have news for you: he doesn't. It's just kind of hanging out there. Interesting point, but completely irrelevant to his main topic of discussion.

The philosophy/biographical/physics sections should have been edited down into a single chapter as a SUPPORT to his main point: that bad models caused the market meltdown. His main point is good -- and, for what it's worth, I think he's right on -- but he spends WAY too much time getting there, and not enough time discussing capital markets. If you even get that far -- the section entitled Models. Behaving. Badly., where he finally gets to the point of the book, is located about 50 pages from the end. And it is brutally difficult to get there.

Oh, and then when he finally does get there, in the first part of that section he refers to a CDO as a collateralized default obligation -- which kind of makes me wonder how accurate his physics diagrams etc. were. To make matters worse, if you're not a Finance major or investment professional, this section -- like the physics one -- is going to make very little sense to you. Be prepared for lots of technical terms and jargon and definitions that assume familiarity with certain concepts. If you didn't know what the CAPM, Efficient Market Hypothesis or Sharpe Ratio were before reading this book, I doubt Derman will help shed much light on these topics.

I gave this book 3 stars because at points, when it does come together, it's fascinating -- and I believe that his core thesis (that financial models are crap) is dead-on, not to mention refreshing. Unfortunately,the rest of the text is dry, usually pointless and meandering without a clear purpose. If this had been 100 pages and focused more upon investing/finance, I think this would be a 4 - 4.5 star book. As it stands, I can only offer my recommendation to people who have experience in Finance/markets, or to those with TONS of patience and the will to look up a lot of concepts on Investopedia.
18 of 21 people found the following review helpful
3.0 out of 5 stars Readable but unfocused 24 Dec 2011
By A. Menon - Published on
Format:Hardcover|Verified Purchase
Emanuel Derman is a very prominent former financial modeller who trained as a physicist. Models Behaving Badly is a combination of personal philosophy, practical reality and ethical retrospective. Each focus is readable and there is much personal experience shared which makes the book very personal, but the contents never really come together particularly well.

The book has three sections, Models, Models Behaving, and Models Behaving Badly. The author starts with a description of his childhood, describing how experience affects perspective, how people are not generally not objective about themselves. He discusses his youth in South African apartheid. The author spends a lot of time philosophizing about the nature of reality and the differences between physical theories and theories about human behaviour. He discusses Spinoza and the residualizing of human motivation to Pain, Pleasure and Desire. The author then discusses what I think most readers assumed what the book was about, financial models. In particular the failures of the Efficient Market Hypotheses and the non stationary behaviour of people and the recursiveness that prevents a theory of human behaviour to be possible. The book ends with a dissappointment in the lack of consequence faced by financial services despite the recession we are currently faced with.

I unfortunately learned very little from this book other than substance about the author's life. This is not because the book does not offer information, but rather because it only has a very light history of science discussion and shallow analysis of financial modelling failure. Economics has had the nickname of dismal science since the 19th century, its not new or shocking that the precise computations of current mathematical economists dont correspond to reality. On better practices for risk management Rebonato wrote Plight of the Fortune Tellers about the need for more commonsense risk management (in 2007 I might add). The authors comments about the ethical lapse of the industry should be well taken, though I would think the current transition that is currently taking place is not trivial nor shallow. This is a readable account of the author's philosophy, the history of classical and modern physics, and discussion of risk management ideas, it is not particularly insightful if one has knowledge of these fields though.
11 of 12 people found the following review helpful
2.0 out of 5 stars Save your money. glad i borrowed it from the library. 31 Jan 2012
By Shawn Riley - Published on
only the last quarter of the book deals w/ financial models that caused the economic crisis. the rest is the author's life in south africa, basic physics, philosophy etc that have little to do w/ economics. odd book considering the author's impressive background.
39 of 50 people found the following review helpful
1.0 out of 5 stars Don't do this 13 Dec 2011
By Ignacio Chapela - Published on
Format:Hardcover|Verified Purchase
Don't do what I did: if you are interested in any of the following, don't waste your money -and worse still, your time- with Derman's book:

What happened in 2008; how models lead people astray; what models are actually used in the financial world; "why confusing illusion with reality can lead to disaster on wall street and in life"; "the modeller's manifesto"; "the modeller's Hippocratic Oath".

I was. I also read, like you did, some internet review or comment on the book. I, like many of us who deal with science, also feel the urge to restore (or establish for the first time?) the ethical and moral keel to the listing ship of the Enlightment. I ordered the book.

What I got was promising: A well-bound book with generous paper and type-font. Nice, clean dust-jacket in bright off-white promised a measured, even conservative take on what should be a revolutionary or at the very least revealing statement of a book. I cracked it open and soon realized that I would have to go through some personal mythologizing by the author talking about his life among the white South African middle class: nothing to be scared by, it is always nice to learn where a revolutionary comes from.

Page after page, trouble crept upon me more like the subconscious realization of the fourth-tier "investor" in a pyramid scheme as he realizes that there may be no exit from it. By now I was more informed about the poorly archived memoir notes of a mediocre bean-counter (flashily described as a "quant", for "quantitave analyst") than I ever wanted to be, well past the middle of the book and still not at the beginning of any of my questions.

There are some interesting explanatory sections (again, badly collated among diversions on the author's warped descritpions of some models in physics) on the making of a financial model, and then, towards the end, some moralizing about things we all learned more clearly than here in any of the many movies about the financial meltdowns of our times. These good bits could have easily fitted in a short pamphlet. Just to crown the elephantine self-aggrandizing bore, we are treated to a grand-finale of the author's mixed-up confusions between college physics, cliff notes of his fave philosophers (Spinoza reigns supreme, which is not bad), and his own adolescence and adolescent professional life.

So, if you want to hear about those questions, like me, and if you must, just go for chapters 5 and 6, which really entails 200-139 = 61 skimpy pages of large font.

But I hope this comment will spare you the time and money. Don't do what I did.
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