'My Life as a Quant: Reflections on Physics & Finance'(3)
D: What I mean is that many people who enter the financial world think that it runs on models, and they start companies to sell the model and most of those companies die. A model isn’t enough, and inexperienced people put too much weight on it. A model in physics is a way of divining the future. A model in finance is a useful tool in thinking about the world, not a prescription for predicting the future. It’s a method of ordering complex securities on a linear simplified scale so you can say which are better and which are worse. Price alone doesn’t let you do that. Useful models are P/E for stocks, for a simple example. It lets you compare, crudely, many different stocks.
So you can’t just sell a raw model, you have to sell a system for using it and thinking about it and calibrating it and using common sense to modify it to be practically useful. KMV is a great example of how a sophisticated model can be turned into something really useful. The model is by no means right in the scientific sense, it’s a simplification really, but it’s valuable in thinking and quantifying the world. And it usefully, but simplistically, rates all companies on a metric involving the ‘distance to default.’ A little naïve, but so useful.
Z: Last few questions. I am sure you met a lot of ambitious Chinese young people in Wall Street. What’s your general impression of them?
D: Very very smart and well trained and they take to the world of markets very quickly.
Z: Any closing thoughts you would like to share with our Chinese readers?
D: I’m very happy to have my book available to them. It was a great pleasure writing the book, and in my physics career I’ve learned much from Chinese professors and Chinese collaborators, and so I’m thrilled that my book is now available in their native language.
Z: Dr. Derman, I really enjoy talking with you.
