Physics Envy

POSTED — May 16, 2002 — Archives

SURVEY: INTERNATIONAL FINANCE Bubble trouble May 16th 2002 From The Economist print edition

Why do so many people cling so hard to the notion of efficient markets? Andrew Lo, an economist at MIT, suggests that they may be suffering from a “peculiar psychological disorder known as ‘physics envy'...We would love to have three laws that explain 99% of economic behaviour; instead, we have about 99 laws that explain maybe 3% of economic behaviour. Nevertheless, we like to talk as if we are dealing with physical phenomena.”

There may be some truth in this. In 1947 Paul Samuelson, later awarded the Nobel prize for economics, set out to apply the principles of thermodynamics to economics. More recently, Bill Sharpe, another Nobel-prize winner for his contribution to modern finance, wrote an interesting paper on “Nuclear Financial Economics”, drawing parallels with nuclear science. This work yielded some useful insights, but left a lot of question marks.

Emanuel Derman of Goldman Sachs, one of the growing number of former physicists working in investment banking, puts the financial world's physics envy into perspective. “There is no fundamental theory in finance. There are no laws.” In finance, he says, you are playing against people, who value assets on the basis of their feelings about the future. “These feelings are ephemeral, or at best unstable.”

The art (not science) of valuing shares may be getting harder because of changes in the nature of the economy, creating even greater scope for bubbles to form. When the bulk of a company's assets were physical and its markets were relatively stable, valuation was more straightforward. Now a growing proportion of a firm's assets—brands, ideas, human capital—are intangible and often hard to identify, let alone value. They are also less robust than a physical asset such as a factory. As Enron showed, a reputation for trustworthiness, and the market value resulting from it, can vanish in a moment. The dotcoms pushed this valuation challenge to extremes, often expecting investors to put a price on profits that would not be forthcoming for many years, and would be derived from business models and intangible assets such as brands that had not yet been created.

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