Tuesday, February 14, 2012

Mathematical Models, Financial Markets, and Herd Instinct

Ian Stewart has a fabulous article in this morning's The Guardian explaining that existing mathematical models of financial markets, including the non-infamous Black-Scholes equation, are based on woefully simplistic assumptions that fail to account adequately for perturbations and the ways humans respond to such perturbations. Here is his conclusion:
Despite its supposed expertise, the financial sector performs no better than random guesswork. The stock market has spent 20 years going nowhere. The system is too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don't represent reality adequately. The entire system is poorly understood and dangerously unstable. The world economy desperately needs a radical overhaul and that requires more mathematics, not less. It may be rocket science, but magic it's not.

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