A Ph.D. in Economics and former senior risk manager for Bridgewater Associates, Richard Bookstaber argues that while human judgment along with quantitative modeling can lead to better results than either alone, “when humans put blind faith in quantitative models, that’s dangerous.” This according to Jason Zweig in this month’s Wall Street Journal.
The article discusses Bookstaber’s new book, The End of Theory, in which the author argues that computers and mathematical models perform well when drawing from historical data on the assumption that “variables will behave in the future the way they did in the past.” However, Zweig writes, “a financial market doesn’t consist only of digitized streams of information. A market is made of human beings. Some are patient and prudent; others trade as if the world will end in the next half-hour.”
Bookstaber’s stance is founded in his argument that individuals act differently in a group than they do alone. “Think of how a throng moving toward a door can suddenly start—or stop—shoving to get in or out,” explains Zweig, adding, “Financial markets do that, too.”
According to Zweig, Bookstaber believes that the “very act of identifying a source of extra return in the financial markets can often end up reducing or erasing it,” and quotes the author: “If you can model it, you’re wrong.”
Zweig advises investors to beware of quantitative models that draw “floods of new money chasing recent performance. Sooner or later,” writes Zweig, “the influx of capital will drive up prices to unsustainable levels—at which point a selling panic may ensue.”