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Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

by Emanuel Derman

Pub Date: Oct. 25th, 2011
ISBN: 978-1-4391-6498-3
Publisher: Free Press

A fascinating cross-disciplinary exploration of how and why financial and scientific models fail.

Derman (Financial Engineering/Columbia Univ.; My Life as a Quant, 2004) is a former theoretical physicist turned Wall Street financial engineer, or quantitative analyst (“quant”). Having previously written about the world of quantitative finance, he now sets out to discover why existing financial models failed to predict the economic crisis of 2007-08. Quants use mathematics and physics to create their predictions of how markets work; Derman argues that these models fail to account for the human element, or what John Maynard Keynes called “animal sprits.” Drawing on his experience as a child in Apartheid South Africa, the author exposes the failure of models and theories when applied to politics. By incorporating philosophy, physics, social theory and economics, he presents an eclectic, multidisciplinary discussion about what happens when models are taken too seriously and the human factor is ignored. “The greatest conceptual danger is idolatry; believing that someone can write down a theory that encapsulates human behavior and thereby free you of the obligation to think for yourself,” he writes. Derman draws intriguing connections between the language of physics and economics, and while the material may be complex for nonphysicists, the author’s prose writing is fluid and makes many of these complicated theories accessible.

A unique examination of the limits of models and theories in understanding and predicting human behavior, and a nice rejoinder to the equations-can-solve-or-explain-everything crowd.