Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman

Models.Behaving.Badly. is a novel written by Emanuel Derman, a renowned physicist and Professor of Professional Practice in Financial Engineering at Columbia University. The book is an entertaining exploration of the complexities of models in finance and other fields, as well as an exploration of the perils of false certainty.

In a broad sense, Models.Behaving.Badly. is an exploration of two fundamental concepts; namely, that models in any field are rarely perfect, and that even when they are, they can only take us so far. Throughout the book, Derman illustrates this point with examples from the world of finance, but his lessons apply to all areas of life. From physics, to politics, to decision-making, in life and in business, the potential for confusion between illusion and reality is ever-present.

The book begins by exploring two major factors that often lead to such confusion, namely our tendency to use a mix of models and intuition and our inclination to overestimate our ability to control or predict the future. Derman uses the example of financial modeling on Wall Street to illustrate these points, showing how even sophisticated models can ultimately be of limited use in predicting the stock market.

He goes on to discuss the concept of the “hard sell” - the tendency of some to exploit the chaos of the stock market to increase profits at the expense of investors. He argues that the mindless use of models and algorithms on Wall Street gives some investors an unfair advantage and exposes unsuspecting investors to great risk.

In the second half of the book, Derman focuses on the dangers of confusing illusion and reality. In particular, he emphasizes the importance of understanding the limitations of models, and of being aware of the potential dangers of relying too heavily on them. He provides compelling arguments as to why over-reliance on models can lead to disaster, both on Wall Street and in life. For example, in the case of Wall Street, badly constructed models can lead to risky and imprudent investments, as well as investment bubbles. Similarly, reliance on faulty models in our personal lives can lead to disappointment, bad decisions and even depression if expectations exceed reality.

Ultimately, Derman's main point is that no matter where models may be used, the key is to understand their true nature and use them for what they are - a useful guide to certain aspects of life, but not a replacement for thought and informed decision-making. By taking this approach, we can avoid and avoid the risks associated with confusing illusion and reality.

In conclusion, Models.Behaving.Badly. is an insightful look at how the abuse of models can lead to disaster on Wall Street and in life. In addition to exploring the potential pitfalls of overly confident predictions, Derman offers wise counsel on how to define the proper use of models and instincts to make sound decisions and avoid disaster. As Derman states in his conclusion, “none of us will ever know all of the answers, so none of us should ever be too certain of our predictions.”