Extract

Models in Finance

There are no genuine theories in finance. Financial models are always models of comparison, of relative value. They are metaphors. The efficient market model assumes stock prices behave like smoke diffusing through a room. These are comparisons that have some reasonableness, but they’re not even remotely fact. Newton’s laws and Maxwell’s equations are. There is almost no gap between the object and their description. You can say that stock prices behave like smoke.

You cannot say that light behaves like Maxwell’s equations. Light is Maxwell’s equations. All concepts, perhaps all things, are mental. But there are no genuine theories in finance because finance is concerned with value, an even more subjective concept than heat or pressure. Furthermore, it is very difficult to find the scientific laws or even regularities governing the behavior of economies: there are very few isolated economic machines, and so one cannot carry out the repeated experiments that science requires. History is important in economics. Credit markets tomorrow won't behave like credit markets last year because we have learned what happened last year, and cannot get back to the initial conditions of a year ago. Human beings and societies learn; physical systems by and large don't.

For an experiment to be approximately repeatable, history has to be unimportant. That requires that the system couple very weakly to the rest of the universe. A coin flip can be repeated ad infinitum under almost the same conditions, because external conditions affect its outcome hardly at all. That’s not the case in finance.