Against the Gods. Bernstein Peter L.

techniques for quantifying risk. Eight years later, Daniel Bernoulli, Jacob’s nephew and an equally distinguished mathematician and scientist, first defined the systematic process by which most people make choices and reach decisions. Even more important, he propounded the idea that the satisfaction resulting from any small increase in wealth “will be inversely proportionate to the quantity of goods previously possessed.” With that innocent-sounding assertion, Bernoulli explained why King Midas was an unhappy man, why people tend to be risk-averse, and why prices must fall if customers are to be persuaded to buy more. Bernoulli’s statement stood as the dominant paradigm of rational behavior for the next 250 years and laid the groundwork for modern principles of investment management.

      Almost exactly one hundred years after the collaboration between Pascal and Fermat, a dissident English minister named Thomas Bayes made a striking advance in statistics by demonstrating how to make better-informed decisions by mathematically blending new information into old information. Bayes’s theorem focuses on the frequent occasions when we have sound intuitive judgments about the probability of some event and want to understand how to alter those judgments as actual events unfold.

      All the tools we use today in risk management and in the analysis of decisions and choice, from the strict rationality of game theory to the challenges of chaos theory, stem from the developments that took place between 1654 and 1760, with only two exceptions:

      In 1875, Francis Galton, an amateur mathematician who was Charles Darwin’s first cousin, discovered regression to the mean, which explains why pride goeth before a fall and why clouds tend to have silver linings. Whenever we make any decision based on the expectation that matters will return to “normal,” we are employing the notion of regression to the mean.

      In 1952, Nobel Laureate Harry Markowitz, then a young graduate student studying operations research at the University of Chicago, demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or business manager can ever come to a free lunch. That revelation touched off the intellectual movement that revolutionized Wall Street, corporate finance, and business decisions around the world; its effects are still being felt today.

      The story that I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future. This is a controversy that has never been resolved.

      The issue boils down to one’s view about the extent to which the past determines the future. We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on the patterns of the past to tell us what the future will be like? Which matters more when facing a risk, the facts as we see them or our subjective belief in what lies hidden in the void of time? Is risk management a science or an art? Can we even tell for certain precisely where the dividing line between the two approaches lies?

      It is one thing to set up a mathematical model that appears to explain everything. But when we face the struggle of daily life, of constant trial and error, the ambiguity of the facts as well as the power of the human heartbeat can obliterate the model in short order. The late Fischer Black, a pioneering theoretician of modern finance who moved from M.I.T. to Wall Street, said, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.”5

      Over time, the controversy between quantification based on observations of the past and subjective degrees of belief has taken on a deeper significance. The mathematically driven apparatus of modern risk management contains the seeds of a dehumanizing and self-destructive technology. Nobel laureate Kenneth Arrow has warned, “[O]ur knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.”6 In the process of breaking free from the past we may have become slaves of a new religion, a creed that is just as implacable, confining, and arbitrary as the old.

      Our lives teem with numbers, but we sometimes forget that numbers are only tools. They have no soul; they may indeed become fetishes. Many of our most critical decisions are made by computers, contraptions that devour numbers like voracious monsters and insist on being nourished with ever-greater quantities of digits to crunch, digest, and spew back.

      To judge the extent to which today’s methods of dealing with risk are either a benefit or a threat, we must know the whole story, from its very beginnings. We must know why people of past times did – or did not – try to tame risk, how they approached the task, what modes of thinking and language emerged from their experience, and how their activities interacted with other events, large and small, to change the course of culture. Such a perspective will bring us to a deeper understanding of where we stand, and where we may be heading.

      Along the way, we shall refer often to games of chance, which have applications that extend far beyond the spin of the roulette wheel. Many of the most sophisticated ideas about managing risk and making decisions have developed from the analysis of the most childish of games. One does not have to be a gambler or even an investor to recognize what gambling and investing reveal about risk.

      The dice and the roulette wheel, along with the stock market and the bond market, are natural laboratories for the study of risk because they lend themselves so readily to quantification; their language is the language of numbers. They also reveal a great deal about ourselves. When we hold our breath watching the little white ball bounce about on the spinning roulette wheel, and when we call our broker to buy or sell some shares of stock, our heart is beating along with the numbers. So, too, with all important outcomes that depend on chance.

      The word “risk” derives from the early Italian risicare, which means “to dare.” In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being.

      TO 1200: BEGINNINGS

      Chapter 1

      The Winds of the Greeks and the Role of the Dice

      Why is the mastery of risk such a uniquely modern concept? Why did humanity wait the many thousands of years leading up to the Renaissance before breaking down the barriers that stood in the way of measuring and controlling risk?

      These questions defy easy answers. But we begin with a clue. Since the beginning of recorded history, gambling – the very essence of risk-taking – has been a popular pastime and often an addiction. It was a game of chance that inspired Pascal and Fermat’s revolutionary breakthrough into the laws of probability, not some profound question about the nature of capitalism or visions of the future. Yet until that moment, throughout history, people had wagered and played games without using any system of odds that determines winnings and losings today. The act of risk-taking floated free, untrammeled by the theory of risk management.

      Human beings have always been infatuated with gambling because it puts us head-to-head against the fates, with no holds barred. We enter this daunting battle because we are convinced that we have a powerful ally: Lady Luck will interpose herself between us and the fates (or the odds) to bring victory to our side. Adam Smith, a masterful student of human nature, defined the motivation: “The overweening conceit which the greater part of men have of their own abilities [and] their absurd presumption in their own good fortune.”7 Although Smith was keenly aware that the human propensity to take risk propelled economic progress, he feared that society would suffer when that propensity ran amuck. So he was careful to balance moral sentiments against the benefits of a free market. A hundred and sixty years later, another great English economist, John Maynard Keynes, agreed: “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.”

5

Personal conversation.

6

Arrow, 1992, p. 46.

7

Quoted in Ignatin and Smith, 1976, p. 80. The quotation is from Book I, Chapter X, of The Wealth of Nations.