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Against the Gods: The Remarkable Story of…

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

by Peter L. Bernstein

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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.
  BrianFannin | May 31, 2013 |
#6: Risk and its history.
  SoliDeoGloria | Mar 31, 2013 |
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.
  velvetink | Mar 31, 2013 |
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! ( )
  beaurichly | Feb 25, 2012 |
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. ( )
1 vote mercure | Nov 15, 2011 |
Showing 1-5 of 14 (next | show all)
Against the Gods sets up an ambitious premise and then delivers on it. This is a lively, panoramic book that includes tales of everyone from Omar Khayyam to Florence Nightingale to Daniel Ellsberg. Khayyam, the poet, was also a mathematician. Nightingale, the nurse, once offered to fund a chair in applied statistics at Oxford University. And Ellsberg, the Defense Dept. analyst who leaked the Pentagon Papers, specialized in the behavioral psychology of risk-taking.
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Amazon.com Amazon.com Review (ISBN 0471295639, Paperback)

With the stock market breaking records almost daily, leaving longtime market analysts shaking their heads and revising their forecasts, a study of the concept of risk seems quite timely. Peter Bernstein has written a comprehensive history of man's efforts to understand risk and probability, beginning with early gamblers in ancient Greece, continuing through the 17th-century French mathematicians Pascal and Fermat and up to modern chaos theory. Along the way he demonstrates that understanding risk underlies everything from game theory to bridge-building to winemaking.

(retrieved from Amazon Mon, 30 Sep 2013 13:23:35 -0400)

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People constantly make choices, arrive at decisions, and take risks. Savers buy stocks, doctors perform operations, poker players figure the odds, and business managers launch new products. Without the instruments of risk management, such decisions would be impossible, because no one could figure out the likelihood of success. Yet the idea that we need not listen to soothsayers for advice is less than five hundred years old. This book blends biography with history and science to show how famous thinkers like Pascal, Bernoulli, Bayes, Keynes, Markowitz, Arrow and von Neumann paved the way from superstition to the supercomputer. But Bernstein tells of others as well, less known but equally important in developing the theory and practice of risk management. The book also explains significant concepts including probability, uncertainty, the distinction between chance and skill, the interactions between gambling and investing, and rational versus irrational decision-making.--From publisher description.… (more)

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