Equity Valuation and Portfolio Management

THE RISE OF ECONOPHYSICS

Before outlining a general framework for quantitative equity research, let's briefly compare the discovery process in the physical sciences and in economics. The classical view of scientific discovery (albeit grossly oversimplified) is one of empirical observations plus human genius. Vast amounts of data are collected and then a theoretical synthesis is made. The end result is a mathematical model that explains the data and allows accurate predictions. In modern science, this process forces us to make model revisions when even very small discrepancies occur between prediction and observation.

Let's mention a few points that have become pivotal to modern scientific methodology and that are important as well to economics:

1. “Observation” is far from being an obvious term. Any observation presupposes some theory. In the parlance of the modern philosophy of science, we say that observations are “theory laden.” Thus we see a stratification of science, where advanced theories live on the back of simpler theories. For example, the so called “stylized facts” are an example of first level theories. They are empirical observations that presuppose a significant amount of theory.
2. There is an ongoing debate as to whether science actually “describes” an objective reality or simply provides recipes for predicting the outcome of observations without any descriptive pretension. In economics, the latter point of view was forcefully made by Milton Friedman.⁴
3. In general, different ...