WARNING: Physics Envy May Be Hazardous To Your Wealth

The quantitative aspirations of economists and financial analysts have for many years beenbased on the belief that it should be possible to build models of economic systems—andfinancial markets in particular—that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, “physics envy” hasalso created a false sense of mathematical precision in some cases. We speculate on the originsof physics envy, and then describe an alternate perspective of economic behavior basedon a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with twoconcrete examples: the classical harmonic oscillator with some new twists that make physicslook more like economics, and a quantitative equity market-neutral strategy. We concludeby offering a new interpretation of tail events, proposing an “uncertainty checklist” withwhich our taxonomy can be implemented, and considering the role that quants played in thecurrent financial crisis.