But the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, that there are not many jobs for physicist [sic] in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.Via a post in FT Alphaville.
Andrew Lo and Mark Meuller have has [sic] a recent paper that addresses the issue of physics envy. They focus on the applicability of the tools of physics as the type of uncertainty becomes more profound, pointing out that while physics can generate useful models if there is well-parameterized uncertainty, where we know the distribution of the randomness, it becomes less useful if the uncertainty is fuzzy and ill-defined, what is called Knightian uncertainty.
I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well.
In the Bruce Lee movie, Enter the Dragon, Lee faces his arch enemy in a fight. To intimidate Lee, his opponent holds up a board, and splits it in two with his fist. Lee watches passively and says, “Boards don’t hit back”. That gets to the reason physics does not work in finance: markets do hit back.
The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.
(The Lo and Meuller paper can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1563882)