Physics Envy and the Taxonomy of Uncertainty
What is Physics Envy and who has it?
Physics Envy is what Economists and Financial analysts get when they find out what physicists can do. Physicists have a model, a collection of mathematical formulas and, with a set of initial conditions, they can (essentially) predict the future. At least predict the future to a level of practical utility, certainty, and repeatability that they can land a man on the Moon and get some rovers to Mars.
Wow! Even though Econ and Finance folks have models and they can crank a lot of math they can’t do that in their discipline. When Econ and Finance people turn the crank on their models they don’t get much of anything – at least anything for the predictability of financial markets at the level of certainty that would be the analogue of getting a man on the moon, a rover to Mars, landing an Intercontinental Ballistic Missile to within a 1/2 mile of target from the other side of the globe launched from an underwater submarine, or predicting an eclipse of the sun a millennium into the future to an accuracy of about 1 minute. Why? Why can’t Econ and finance folks crank this level of certainty?
Overconfidence in models for financial markets
Not that economists and finance folks have not tried to do what physicists have accomplished. In fact, they have tried. And they believe in the model and the math. But the results predicted by the model don’t always fit the facts (Reality is a bummer). You might want to ponder if the financial crises of the past, present, and perhaps into the future are caused by an overconfidence on the part of economists, finance folks, and those that push the great levers of federal and global financial policy who believe in these models and that they can predict the future or know the future in the same way as Classical Newtonian Physics.
To cite just one example, the Efficient Market Hypothesis.
Those who defend quants insist that markets are efficient and the actions of arbitrageurs impose certain mathematical relationships among prices that can be modeled, measured, and managed. Is finance a science or an art?
Richard Feynman knows
So, here is the rub, from Nobel Prize winning Physicist Richard Feynman
Imagine how much harder physics would be if electrons had feelings!
– Richard Feynman, speaking at a Caltech graduation ceremony
That’s exactly to the point. Economics and finance are about people – not the laws of nature. People have feelings, make mistakes, are driven by emotions, and are fallible.. They are not predictable as are billiard balls or planets. This is why models in finance or economics will never reach the level of certainty of Physics. Thus, Physics Envy. To skin these cats ( all deference to Schrödinger’s cat ) requires a careful and rigorous understanding of uncertainty.
Taxonomy of Uncertainty
All of this cames from (or at least the first I heard of it) was a lecture delivered at the MIT Innovations in Management Conference back in 2007. I recently found that a new draft (March 2010) of a paper on this subject is now available ( link at the end of this posting)
This paper is long (74) pages but it is a good read especially if you can remember some high school physics on Hooke’s Law for springs and simple harmonic motion. The authors use this simple physics example (block of mass M on a frictionless 1-D surface connected to a spring attached to a wall with the system obeying Hooke’s Law – a fully deterministic system) to demonstrate how adding “noise” (unknowns) into the system can take a model that is capable of predicting to complete certainty down to nothing. What is the “noise” in the system? Take it as Feynman’s “electrons with feelings” – people and this idea of (see below) “Reflexivity”.
Taxonomy of Uncertainty
1: Complete Certainty
2: Risk without Uncertainty
3: Fully Reducible Uncertainty
4: Partially Reducible Uncertainty
5: Irreducible Uncertainty
∞: Zen Uncertainty
Here is a little more meat from the paper
The distinctions between the various types of uncertainty are, in fact, central to the differences between economics and physics.
Level 1: Complete Certainty
This is the realm of classical physics, an idealized deterministic world governed by Newton’s laws of motion. All past and future states of the system are determined exactly if initial conditions are fixed and known—nothing is uncertain…
Level 2: Risk without Uncertainty
This level of randomness is Knight’s (1921) definition of risk: randomness governed by a known probability distribution for a completely known set of outcomes. At this level, probability theory is a useful analytical framework for risk analysis.
Level 3: Fully Reducible Uncertainty
This is risk with a degree of uncertainty, an uncertainty due to unknown probabilities for a fully enumerated set of outcomes that we presume are still completely known. At this level, classical (frequentist) statistical inference must be added to probability theory as an appropriate tool for analysis. By “fully reducible uncertainty”, we are referring to situations in which randomness can be rendered arbitrarily close to Level-2 uncertainty with sufficiently large amounts of data using the tools of statistical analysis.
Level 4: Partially Reducible Uncertainty
Continuing our descent into the depths of the unknown, we reach a level of uncertainty that now begins to separate the physical and social sciences, both in philosophy and model building objectives. By Level-4 or “partially reducible” uncertainty, we are referring to situations in which there is a limit to what we can deduce about the underlying phenomena generating the data.
Level 5: Irreducible Uncertainty
Irreducible uncertainty is the polite term for a state of total ignorance; ignorance that cannot be remedied by collecting more data, using more sophisticated methods of statistical inference or more powerful computers, or thinking harder and smarter. Such uncertainty is beyond the reach of probabilistic reasoning, statistical inference, and any meaningful quantification. This type of uncertainty is the domain of philosophers and religious leaders, who focus on not only the unknown, but the unknowable.
3.6 Level 8: Zen Uncertainty
Attempts to understand uncertainty are mere illusions; there is only suffering.
Finally, the authors make this interesting mapping of disciples to levels of uncertainty
Most certain to least certain:
- Mathematics and Physics(classical)
- Economics and Psychology
I sort of have a feeling that Theologians would disagree that Religion is ranked on the bottom as least certain.
To be truly effective in any discipline one needs to understand the level of certainty that is endemic to the discipline itself. Not understanding this along with the over reliance on models where they do not fit ( Feynman – “Imagine how much harder physics would be if electrons had feelings! ) will lead to catastrophe. This could partially explain the financial crises of the past and be a harbinger of the future crisis if we do not learn from past mistakes.
Mens minds are different. And perhaps the reason why successful Wall Street Analysts and financial guru’s are so scarce and are paid so much money is simply that those minds can effectively and intuitively deal with radical uncertainty. This sort of mind is far different from the mind of a Physicist (or at least Physics in general) that still holds on to the ideal of a “Natural Law” that can be known in some sort of closed form leading to an elegant and beautiful Theory of Everything.
Not so in economics and finance.
Here is the theory of Reflexivity from George Soros ( The Alchemy of Finance: Reading the mind of the Market (1987))
… Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.
Flanagan (Psychology, progress, and the problem of reflexivity: a study in the epistemological foundations of psychology) and others have argued that reflexivity complicates all three of the traditional roles that are typically played by a classical science: explanation, prediction and control.
The fact that individuals and social collectivities are capable of self-inquiry and adaptation is a key characteristic of real-world social systems, differentiating the social sciences from the physical sciences.
Reflexivity, therefore, raises real issues regarding the extent to which the social sciences may ever be viewed as ‘hard’ sciences analogous to classical physics, and raises questions about the nature of the social sciences.
So, is there Physics Envy out there? – Yes, very much so! Take a read of the paper below for the details.
The paper from the MIT Laboratory for Financial Engineering –
WARNING: Physics Envy May Be Hazardous To Your Wealth
This is a book with a catchy title but is long, boring, and repetitious with an unrelenting barrage of criticism of “know nothing” business schools and business school professors. You see, the author is a successful “street fighter” (a trader) and has no need for fancy-pants academics and their models. In fact, the author thinks that over reliance on model is what has caused just about every modern financial crisis. The author is a Bird and he has no need of any lectures on flying from business schools, professors, or financial model makers. A good read and will accelerate your journey to the arms of Morpheus.
Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?
Read about more people with Physics Envy – those that have Wicked Problems