Book Review: Models. Behaving. Badly

Emanuel Derman has written a terrific book for explaining the difference between models, theories, and intuition.The author grew up in Cape Town, South Africa, when apartheid was at its peak in the 1950s and 1960s, came to the US in the mid-60s, worked as a theoretical physicist, then as a "quant" at Goldman Sachs.I can quibble with some of his political and economic views, such as the claim that the extreme left and right are equivalent, which is nonsense. I'd rather live under a Italian fascist than a communist. And his contention that capitalism is not capable of self-regulation, Wall Street overshoots in its greed, etc. Not once does he mention government failure when discussing the financial meltdown of 2008.These quibbles aside, his dissection of the differences between a model and theory is fascinating, one that I wish I had read a lot sooner. This will be a very abbreviated review, just to summarize the major differences between theories and models, which I believe will be incredibly useful in our work.The author's major purpose in the book is to explain the three ways of understanding the world: theories, models, and intuition.Humans worry about what's ahead, and models and theories are a way of foretelling the future, and controlling it. We need theories and models because of time (the world is not stationary, and we must plan for the future).Theories attempt to discover the principles that drive the world; they need confirmation, but no justification for their existence. They must stand on their own two feet. A theory can become a fact; it is deep; whereas a model is shallower. A theory doesn't simplify, it becomes indistinguishable from the object itself.We advance by mounting new theories atop previous facts. If those theories prove correct, they become facts too.This is why the author loves what Goethe wrote in Maxims and Reflections:

The ultimate goal would be: to grasp that everything in the realm of fact is already theory.

And:

There is nothing so terrible as activity without insight.

Models stand on someone else's feet. They are metaphors. They simplify, and can only capture partial truths, not entireties (the model is not the object; think of a model airplane vs. a real one; a model is a toy!).Models always describe one thing relative to something else (think of the VeraSage Adaptive Capacity Model of the Boeing 777 airplane as a firm).While theories tell you what something is, models tell you merely what something is like. Models fail and theories are never perfect (always subject to falsification). Models save mental labor—they are a little language.A model grounded in a theory can have more power than either alone.Intuition is more comprehensive; it unifies the subject, and plays a major role in the discovery of nature's truths. It also requires common sense and ethical principles.Einstein called intuition "a sympathetic understanding of experience."The author spent 17 years extending the Black-Scholes model, the most celebrated model in economics:

Our knowledge about the behavior of stock markets is much sparser than our knowledge about how egg whites turn fluffy. Fluids and egg protein don't care what people think about them. Markets and stock prices do. This makes models usable but simultaneously limits their usefulness.

He states that financial modeling is not the physics of markets, which is absolutely true. This is why Austrians wanted to study human behavior first (Ludwig von Mises called it Praxeology), then work up to macroeconomic principles.What's interesting is his contention that

Economists for the most part have never seen a genuine theory...for people have proved difficult to theorize about. Economists falsely believe that rigor can replace fact and intuition.

Economists are said to have "physics envy," a joke I believe this author would agree with.He calls the Efficient Market Hypothesis a model, not a hypothesis. Austrian economists don't subscribe to the EMH, but rather, as Rory Sutherland says, the Cool Market Hypothesis—markets just do things that are cool.I'm not sure what the author's opinion would be on the subjective theory of value? Is that a theory, or intuition, or both? He does write:

Value is determined by people, and people change their minds.

The movements of stock prices are more like the movements of humans than of molecules. It is irresponsible to pretend otherwise. There are no genuine theories in finance. Financial models are always metaphors.

I also love this advice:

Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister's foot into Cinderella's pretty glass slipper. It doesn't fit without cutting off some essential parts. You must start with models but then overlay them with common sense and experience.

And:

To confuse a model with a theory is to believe that humans obey mathematical rules, and so to invite future disaster.

Here's a list that distinguishes the characteristics of models with theoriesModelsAre madeRequire a modelerFailSimplifyShallow—a little languagePartial truthsStands on other's feetMetaphor—what something is likeSave mental laborStaticTheoriesAre discoveredNo theorizer neededNeed confirmationIndistinguishable from objectDeepEntiretiesStands on its ownWhat something isSubject to falsification—never perfectCumulative—new theories atop factsI'm trying to figure out if The Firm of the Future is a theory or a model? Probably a model, but maybe both?