Models.Behaving.Badly. Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

Now in paperback, "a compelling, accessible, and provocative piece of work that forces us to question many of our assumptions" (Gillian Tett, author of Fool's Gold). Emanuel Derman was one of the financial engineers whose mathematical models became crucial for Wall Street. The reliance investors put on such quantitative analysis was catastrophic for the economy, setting off the ongoing string of financial crises that began with the mortgage market in 2007 and continues today. Here Derman looks at why peoplebankers in particularstill put so much faith in these models, and why it's a terrible mistake to do so. Though financial models imitate the style of physics and employ the language of mathematics, ultimately they deal with human beings. In physics, theories aim for a description of reality; in finance, at best, models can shoot only for a simplistic and very limited approximation to it. Physicists and economists have been too enthusiastic to acknowledge the limits of their equations in the sphere of human behaviorwhich of course is what economics is all about. Describing the collapse of the subprime mortgage CDO market in 2007, Derman urges us to stop the naÏve reliance on these models, and offers suggestions for mending them. This is a fascinating, lyrical, and very human look behind the curtain at the intersection between mathematics and human nature.

Emanuel Derman is a professor at Columbia University, director of the university's program in financial engineering, and a principal at Prisma Capital Partners. He was formerly a quant and managing director at Goldman Sachs, and is the author of many widely used financial models. He lives in New York City.