What a physicist can teach us about investing

(MoneyWatch) James Weatherall, physicist and mathematician, has written a fascinating account of how physicists have been instrumental in advancing the science of investing. His book "The Physics of Wall Street," is beautifully written, providing clarity to even the most difficult of subjects. It's also a thoroughly entertaining read. I would highly recommend this book to anyone interested in learning how markets really work and how scientists have helped to advance our understanding of them.

Weatherall tells the fascinating tales of people like French economist Louis Bachelier and Edward Thorp. Bachelier is the founding father of the efficient markets hypothesis and other economic theories (although he rarely receives credit). Thorp is a mathematician who specialized in quantum physics, used those skills to beat the casinos at blackjack and roulette, and then put the same skills to work to run a highly successful hedge fund, exploiting mispricings in options. (Thorp's blackjack book "Beat the Dealer" was a New York Times bestseller.)

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Perhaps most fascinating is how the physicists applied their knowledge to seemingly intractable finance problems and finding the flaws in existing models. Weatherall notes: "If physicists have been successful at improving our understanding of finance, it is because they have approached problems in a novel way, using methodological insights that are commonplace in physics (and engineering) and that are useful in studying virtually anything."

Through his stories he does such a great job of showing the methodology in action, "using simplifying assumptions to make a problem tractable and solve it." He also notes that no model is perfect. The assumptions that models rely on need to be challenged, double-checked and played around with. He states: "Sometimes you realize that your original solution is no good, because it depends too heavily on assumptions that never really apply; other times, you discover that the solution is pretty good, but can be improved in simple ways; and other times still, you realize that your solution is great under certain circumstances, but you need to think about what to do when those circumstances don't apply."

Weatherall concludes: "We should never mistake a good model for the 'truth' about financial markets. The most important reason is that markets are themselves evolving, in response to changing economic realities, new regulations, and perhaps most importantly, innovations. ... As sociologist Donald MacKenzie has observed, financial models are as much the engine behind markets as they are a camera capable of describing them. This means that the markets financial models are trying to capture are a moving target."

This is one of the best finance books I've read. And it's a great read. I look forward to reading more of his work.

Image courtesy of  Flickr user katerha.