The Physics of Wall Street: Book Review

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The Physics of Wall Street

Let me admit my bias at the start.  Physics is the wrong model for financial markets and economics.  The better models are ecological or biological, because people adapt to conditions that change.  Perhaps we are predictable on average, but there is a wide variation in specific behaviors.

Economics and ecology deal with scarcity and plenty.  Physics does not.  Physics is exact, aside from the quantum and universal scales.  Economics and ecology are never exact, and prediction is fraught with error.

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But what of financial instruments where the math of physics might have application?  Perhaps physics has some application there?

Okay, sort of.  Even something as pervasive as option modeling does not truly have a simple model, but implied volatility has to be re-estimated regularly for the Black-Scholes Model.  A true model does not require re-estimation of a parameter, particularly when it varies by time and strike price.

What I liked  about the book

I liked reading about the mathematicians who applied analogies from physics to economics. Even though the models had their flaws, they improved the explanatory power.

I also appreciated how the author kept explanations simple.  He could have gone into a lot more detail, and a lot more math, and he would have lost most of his audience.

He also explained the life circumstances of the men he wrote about.  That adds depth, because science does not occur in a vacuum.  It is a social activity.   Few men think purely abstractly, and those that do ride the edge of genius/insanity.

There are two motives for understanding  how men approach markets — to explain, and to make money.  The book has both sorts, and it is a strength to see one validate another.

Quibbles

Already given

Who would benefit from this book: If you want to learn about men who shaped the market by their knowledge of math, you will like this book.  If you want a book that explains the markets, this is not it.  If you want to, you can buy it here: The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

Full disclosure: I received a free copy from the publisher.

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By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.