At The University of Chicago i was an economics major. My early economics courses were in things like indifference curves and other mathematical ways to represent human behavior.I went through a number of courses on using quantitative methods in a number of areas in economics-econometrics, statistics, and a course on commodity markets with Lester Telser. In the course of my studies, I developedskepticism about the ability of quantitative methods to accurately answer economic problems.

It started with the fact that economists spend so much of their time saying “ceteris parabus”; Latin for “with other things the same”. It is a method to solve a problem by keeping all but one of the variables in an equation fixed, so you’re not trying to solve a multivariate equation.This may be fine in academia, but real world problems don’t work that way.The idea that if you model things correctly, you’ll be able to forecast what you hope to predict, seems unlikely when looking at problems like the optimal rate of economic growth or trying to predict interest rate movements.

The core issue, as I see it, is that economics is a social science, not a physical science.Economics problems don’t have immutable facts that can be used to reduce the number of variables to be plugged in.More importantly, as a social science, economics is really the study of human behavior, and as such, we aren’t yet at the point that many human behaviors can be quantified.This is why so many economic models fail; the pricing of mortgage securities is a monumental example of this.(Yes, there were many other factors involved, but many of these stem from the failure of the models to predict foreclosure rates).

My skepiticsm has colored my opinion of the use of quantitiative models for trading.Don’t get me wrong,I use plenty of qunatitative methods to analyze the markets, but to me, indicators and systems are tools for me to improve my decision making, not things to be used for mechanical trading (maybe I’ve never tortured the numbers enough to come up with something).

I think we will see a movement in economics (and trading maybe?) to move to a more behavioral and psychological basis. Gregor Macdonald wrote a blog post about it HERE (I haven’t watched the video yet, so I can’t comment on the speaker).

I don’t write this to get you to take all your indicators off your charts, but I do think that many traders would do better to focus on themselves, rather than coming up with the Holy Grail of mechanical trading.I also think that developing methods to capture and analyze human behavior in trading is fertile ground for research. A (r)Evolution in Economics?

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