I came to Wall Street in 1982 as a computer consultant and went for an MBA in finance at night. That is where I first encountered the finance-as-physics mentality of my professors. I bought into it. By the time I graduated in 1986, it seemed likely that the old-timers who understood only markets would not survive because they could not do physics.
By 1987, the hottest innovation to come from finance theory was something marketed as “portfolio insurance.” The idea was that as markets went up, you could increase your exposure, and when they went down, you could decrease it and protect your gains.
In October of 1987, stock markets experienced the worst crash on record. Believers in portfolio insurance discovered that they could not decrease their exposure fast enough, and as they sold, the crash snowballed.
After the crash, I stopped listening to people who understood physics but not markets and went back to doing what I do best: trying to understand things through direct observation and applying my tools to solving the problems at hand.
The theoreticians dusted themselves off and went back to what they do best. They invented exotic financial instruments that nobody can price properly—not even them—and designed complex, misguided risk models that triumphed over common sense. Markets are now so complex and move so fast that humans cannot participate without assistance from supercomputers—programmed, incidentally, to quality standards so low they would shock engineers responsible for things such as airline safety.
Physicists (and most other “quants”) on Wall Street will tell you over a beer that they know that finance is not a science, but they act as if it is. I think the reasons are that: 1) once you are trained to be a scientist it is hard not to act like one, and 2) management and clients want to believe you are one.
There is also something more insidious going on.