Against the Gods: The Remarkable Story of Risk (1996)

Excellent overview of probability and the development of financial markets. I take issue with a few points- prospect theory does not obviate the benefits of statistical analysis, for example- but overall a fantastic read.

#6: Risk and its history.

Interesting so far, a little heavy going in the early chapters for those deficient in math skills but fascinating in the details. Amazed to find that Da Vinci had only 3rd grade math skills.

A fantastic, well written survey of the history of understanding and mitigating financial and market risks. Should be required ready for every legislator or regulator dealing with financial markets. If you want to put the financial crisis in perspective, read this now! ( )

Nature tends "to repeat itself, but only imperfectly”

In his somewhat dated Against the Gods, Peter Bernstein claims that the understanding risk as one of the key features of human progress. He follows that growing understanding mainly through the history of statistics, economics, and investment. At the same time he shows how integrated our understanding of economics and investment is with the general philosophy of an era.

Taking risk is a human trait, as is a certain overestimation of an individual's good fortune:

When the Soviets tried to administer uncertainty out of existence through government fiat and planning, they choked off social and economic progress

Strangely (page 16), the Greeks never developed probability theory. The modern conception of risk is rooted in the Hindu-Arabic numbering system that reached the West seven to eight hundred years ago. Leonardo Pisano (Fibonacci) popularised Arabic numbers after he learned about them in the Algerian city of Bugia where his father was Pisan consul. Fibonacci expanded his knowledge with mathematics, commercial bookkeeping, conversions and interest calculations. The serious study of risk began during the Renaissance, a time of religious turmoil, nascent capitalism and a vigorous approach to science and the future.

The concepts of thrift and abstinence that characterise the Protestant ethic evidenced the growing importance of the future relative to the present.

As an answer to questions related to gambling, Fermat and Pascal developed probability theory. All the tools for modern risk management stem from developments that took place in Europe between 1654 and 1760. The Englishman John Graunt discovered the merits of using samples for describing the population of London. Edmund Halley improved this, helping the establishment of the insurance industry.

Bernouilli introduced the understanding that individuals have a different appreciation of risk as well as utility, the underpinning for the law of supply and demand. With that Bernouilli set the standard for defining human economic rationality. His boldest innovation was the notion that each of us has a unique set of values and will respond accordingly. Our decisions have a predictable and systematic nature (page 112).

Limited data are a problem for managing risk. Three requisites define risk management: full information, independent trials, and the relevance of quantitative valuation. The Law of Large Numbers states that the average of a large number of throws will be closer to the true average than the average of a small number of throws. It was the basis of De Moivre's discovery of the normal distribution and the standard deviation. Laplace and Gauss developed predictions on its basis.

The normal distribution, requiring independent observations, is at the basis of most systems of risk management. The stock market follows the normal distribution, albeit with an average greater than zero, and downside outliers. Francis Galton, one of the fathers of eugenetics, postulated that human beings were also mostly mediocre as future generations reversed to the mean. The stock market tends to reverse to the mean, although lately not as quickly as Mr. Bernstein states in this book. Disruptions of this reversal occur when more fundamental changes occur.

Earlier statisticians like Laplace and Bernouilli did not believe in chance and uncertainty, but in cause and effect. That changed only at the end of the 19th century. At the same time came the realisation that reality is almost always too complex to create certainty. Frank Knight was the first to deal with decision making under conditions of uncertainty. Keynes condemmed as "flimsily based [and] disastrously mistaken" the assumption of classical economists that human nature is reasonable. He alluded to "deeper and blinder passions" and to the "insane and irrational springs of wickedness in most men". Keynes did not distinguish categorically between risk and uncertainty, but between definable and indefinable: the peapod analogy was irrelevant to human beings. Past events are only a modest part of the input. And "perception of probability, weight, and risk are all highly dependent on judgement". Interest is not a reward for refrained consumption, but for refrained financial liquidity, necessary in uncertain circumstances. And when we make decisions we do change the world. After Keynes came game theory which said that the true source of uncertainty lies in the intentions of others. Every decision is the result of a series of negotiations in which we try to reduce uncertainty by trading off what others want against what we want. The highest pay off usually comes from the riskiest alternative.

As economics is all about quantities, mathematics can describe it.

The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.

Investment management developed into engineering investment risk. Only recently with the Modern Portfolio Theory is stock market risk defined with a number. It used statistical variance based upon the normal distribution. Diversification is the best weapon to reduce risk.

This rationalism was countered by the rise of behavioral finance that stressed "the inconsistencies, myopia, and other forms of distortion" of decision-making. Human actions tend to regress to the mean also. Emotion destroys self-control and people experience lack of complete understanding. Man is loss averse, rather than seeking to gain. Investors hate taking losses, as it is an acknowledgement of error. People tend to analyse in pieces rather than in the aggregate, and they overrate recent information, leading stock prices to overshoot.

The book stops at the time derivatives that became more sophisticated. As it was first published in the 1990’s, Against the Gods does not cover the concept of Value at Risk and Black Swans. ( )