[EMANUEL DERMAN:] One of the things I've been thinking about a lot, both in relation to the financial crisis and in relation to the way people understand the world in general, is the role of models in the world. There are a variety of different approaches to trying to understand the world, in all its facets, from the physical sciences to the social sciences and even one's personal life. I've categorized them in two ways: I like to distinguish what are called “theories” from “models”. Theories, in my view, really try to capture the essence of the world, as in physics in one short equation, or in other fields, in one short schema.
It seems to me you can't really act in the world without having some kind of model or theory of how the world is going to behave in the future.
Models are simpler to describe in that they are similar to metaphors or analogies: you try to understand something that is difficult to comprehend in terms of something else you already comprehend. You try to understand the brain, for example, and you say, well, the brain is a lot like a computer. Or you try to understand a computer, and you assume people understand the brain and then say a computer is a lot like a brain.
In the same way in finance one says stock prices behave a lot like smoke diffusing off the tip of a cigarette . These are models or metaphorical ways of describing the world that add insight but you can't really rely on them very substantially in the long run. I'll give some examples in a little while.
The other extreme is to use theories, which are really ways of directly apprehending the way the world or the universe works: examples are Freud, Einstein and Newton. Of course, theories can be right or wrong, but theories are different from models.