Do Formulas Apply Outside of Physics?


Thanks to the ongoing recession, it’s easy to find people today who say that formulas (and the associated maths) don’t work in finance. I don’t know if that’s becoming the widespread belief in finance today, but if it is, it would make it hard for the quants (the guys who apply the maths to finance and come up with the formulas) to find jobs.

Then again, the same feeling persisted more than a decade back when a huge hedge fund, LTCM, failed and threatened to take down the system with it. Even back then, there was a comment in the book, When Genius Failed, by a guy who thought that quants picked a physics formula to “jam into finance”!

Another quote which I liked questioned the accuracy of formulas in a very funny way: this one by Max Bublitz, a former investment banker:
“You take Monica Lewinsky, who walks into Clinton’s office with a pizza. You have no idea where that’s going to go. Yet if you apply math to it, you come up with a thirty-eight percent chance she’s going to go down on him. It looks great, but it’s all a guess”.

Emanuel Derman wrote a book titled My Life as a Quant: Reflections on Physics and Finance and stated that
“In physics there may one day be a Theory of Everything; in finance and the social sciences, you’re lucky if there is a useable theory of anything.”
Is Derman taking it too far? Do formulas and theories ever work in fields involving people? Look no further than the Brad Pitt movie, Moneyball where a baseball team manager uses statistical analysis to pick the best possible baseball team given his budgetary constraints. So how does his team perform on the field? (Remember, the movie was based on real life, so this isn’t just a thought experiment).  After a bad start, they picked up steam and went on to win more consecutive games than any other team in history. And then they get knocked out before the finals.

Of course, one season of a baseball team doesn’t prove anything. And so the debate will continue. I think we feel psychologically more confident to do things based on maths, formulas and the associated alphas, betas and gammas. The risk with that approach, to quote yet another former investment banker, is that “you can overintellectualize these Greek letters”!

Comments

  1. KumarMarch 21, 2012 at 12:08 PM

    That mathematical formulation works most effectively in physics is often a point of discussion. Since physics is very successful in explaining inert physical nature, it gives that science a peculiar advantage. Those who are into physics sometimes fell many subjects are hardly science!

    The Western world has shown nevertheless that biology is science, not non-science, even if physicists delight, mathematics has little place in that science. So they would like use adjectives like "more exact" or "less exact" with sciences. Mathematics naturally is the most exact science and all others slowing move away from "exactness". Etc.

    Is psychology science? Is economics science? Is there a thing called 'political science"? Is geography science? Can history be any close to being scientific, in the sense it reflects truth, not points of view? And such questions keep rising.

    We are moving towards better understanding in many "non-exact" sciences too. If we avoid the usage of the word 'science' and instead evaluate "better understanding" then the undue advantage that we give to physics will change.

    I recall the irony of Rutherford the physicist who stated, "Physics is the only science. All others are stamp collection (hobbies)!" And he was awarded the Nobel prize for 'Chemistry' for his work which he thought was physics. It is not known if he changed his mind about "Chemistry being stamp-collection"! :-)

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