Interview with New Scientist
POSTED — March 21, 2015 — In The Press
You used to be a physicist. Are there laws of financial markets in the same way there are laws of physics?
In my opinion, absolutely not. In physics you have absolute values. If you want to shoot a rocket to the moon, you can use Newton's laws and the gravitational constant. In finance you can't make absolute predictions. You try to figure out the value of something by relating it to the value of something more simple. If you tell me the price of a one-bedroom apartment, for example, I can give you a guesstimate for a 14-bedroom apartment. Most financial modelling is a more sophisticated version of that.
Is there any predictive model of markets that investors can rely on?
There is, but only for short periods of time. The world keeps changing. People change their behaviour and then markets behave differently. I don't think there is one absolute law or statistical distribution that describes stock prices or interest rates. The probability of a stock market crash in New York, for example, depends on all kinds of detailed political and geographical information. It's not like flipping coins: if a coin came up heads yesterday it doesn't affect the way it will come up today.
How do you explain that behaviour?
Markets are affected by people and people are prone to all sorts of behaviour. They make decisions in complicated ways: they are influenced by what's going on around them and by their prejudices and thinking. It's a kind of idolatry to think you can write down one equation that will describe accurately the way collections of people behave. I'm not saying prediction is a waste of time. I'm just saying that you have to look over your shoulder all the time and understand that it works for a small range of market behaviour in the area you're currently in. At some point things are going to change and then all bets are off about your model.
What does it feel like to work in that world of uncertainty?
I've been doing it for 25 years, so I'm kind of used to it. I like to maintain a high degree of scepticism. What bothers me a lot is that people teach finance as if it were a branch of pure mathematics, not a practical field. Economics too has an unpleasant flavour of pure mathematics to it. That's dangerous. You need to know the mathematics, but you need to keep a certain scepticism and be able to walk a middle line. People who use models to make a living don't take them as seriously as academics think they do.
Have we learned the lessons of the recent financial crisis?
I don't think we have, and that makes me fearful. There are even bigger banks now, and they're more consolidated. If you look at the oscillations in the markets over recent decades, they're bigger and bigger in terms of the losses and crises. Maybe such risks are intrinsic to capitalism. I don't know what the right solution is. A part of me thinks that if you want the upside, then when you get the downside you have to swallow it.
Profile: Emanuel Derman is a professor at Columbia University