Difference between revisions of "Essay On: Against the Gods"

Revision as of 08:52, 30 July 2006

An Essay On: Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

by Christoph Champ, 25-May-1999; EC201

Introduction

In a narrative that reads like a novel and on a time-line from the Greek philosophers to today's computer generation, Bernstein takes us on a detailed, knowledgeable and thoroughly enjoyable journey through the key periods of history, in which he details Man's changing perception to risk, plotting it against the often restrictive influences of culture and religion. The very concept of risk is held it up to the light, showing its role in and its impact on the world we live in.

Bernstein shows how the idea of risk and, gradually, the idea that risk can be controlled has been instrumental in the evolution of the world we live in today.

Computing power has further increased our ability to control risk, and as we enter the information age, craps players to fund managers will no doubt be using the most sophisticated systems around to calculate the odds in their favor. The question this book asks is, will this liberate us from the hand of Fate?

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.

The first two-thirds of the book is history, the latter part talks about how history evolved to some of the investment management ideas in place today.

I have divided my summary or essay on Against the Gods into chapters or subdivisions to follow some sort of chronology of the book and for an easier read. These subdivisions follow: The History, The Risk At Hand, The Assurance of Insurance, Market Analysis, and The Conclusion.

The History

The concept of risk and probability wasn't developed during ancient times, though the need was certainly there.

When economic activity consists of agriculture, hunting and fishing, the great unknown is the weather. You can insure against the weather; certainly ships were insured as far back as we know. Agricultural crops were to some extent insured by sharing. (We'll help you out if you have a drought if you'll help us out when we have a drought.) Crude forms of insurance did exist, but even today we understand so little about the weather.

In the 17th century, commerce took a more sophisticated form and the unknowns became different. In a way, the weather became secondary relative to other risks. (Think of the risks of the steam engine and early cotton mill, for instance.)

It is amazing that so much of the theory was developed in such a short period of time. Apparently conditions were just right, both intellectually and commercially.

That may be one reason why insurance could not effectively develop in ancient times -- the opportunities for diversification weren't there. You either had the flood or you didn't. If you had the flood, it would wipe out the property in your area. You didn't have the opportunity to balance the risks, which we have today. One way to improve diversification is to be more global, and the investment markets are certainly becoming global.

The Risk At Hand

Life has always involved risk. Yet, as Mr Bernstein points out, there was no systematic method for managing it until the 17th century. Without the revolutionary ideas of brilliant scientists and mathematicians, our society would not have command of probability theory and other instruments of risk management that lie at the core of our modern market economy.

Risk is at the core of all decisions, but how often do we contemplate its origins, its significance, and what life would be like without those who put order around it?

Once there was the idea of mean variance – the idea that there's a systematic relationship between risk and return – the essence of risk management and investment management became clear. But first we had to see that there's a systematic relationship. The sense that inflation was in the system and out of control was very scary. People began looking for ways to deal with risk. That was the turning point.

The more people learn to deal with risks the more risks they'll take. And the more risks we take the more vital our economy will be.

Nevertheless, all of these risk-management instruments ultimately require exit strategies. It depends on somebody at the other end doing something to bail you out – counter-party risk. Between what can happen to counter-party risk and what can happen to the co-variances, you can have a lot of surprises in risk management. When there are surprises, responses are unpredictable.

If we can continue to live in a world of moderate inflation, things go a lot better. When the price level is uncertain, a lot of things get out of whack.

Transition to Insurance

I think one of the most interesting ‘thoughts’ in the book was Pascal's wager, which asks, "God is, or he is not. Which way should we incline? Reason cannot answer."

If you act as though God is and lead a virtuous life and there is no God, so you gave up some goodies in your lifetime. But if you act as though there's not a God and you lead a sinful life and there is a God, you're going to have eternal damnation. When you think about a problem in those terms, the probabilities almost don't matter. The risk of betting that God is not is too great. So in making decisions and choices, it's the consequences in the end that are the determining factor. The probability may be low; maybe it's a very small probability that there is a God. But if there is, the consequences are so huge that I don't care what the probabilities are, I've got to lead a virtuous life.

Apply that thinking to a consideration of whether the stock market is or is not efficient. If you act as though it is efficient and therefore index and it's not efficient, you're still going to do OK; you're not going to feel like a fool. But if you act as though the market is not efficient and make big, active bets and it is efficient, you're going to suffer ‘eternal damnation.’

This is the reason people buy insurance. The probability that I'm going to die prematurely is very small, so why should I buy an insurance policy? But if I don't buy the insurance policy and I'm wrong and I die prematurely . . . It's a wonderful structure when you don't even know what the probabilities are and you're trying to make a decision.

There are people who don't insure because they say the probability is so small that they can self-insure. They don't understand that if they're wrong, the consequences can be much bigger than they realize.

The human imagination is not unlimited: If we always understood what the future holds, we wouldn't need insurance. Insurance is an expression that we don't know. Even insurance people can't know all of the risks that will develop.

The Assurance of Insurance

You can't think about risk without thinking about insurance.

After reading the book I realized how old the idea of insurance is and how urgent the need for it was. That it began in the 17th century was interesting to me; I hadn't really thought about that before.

For the first time, wealth was being accumulated. Prior to that, most people got richer by taking from somebody else. Now people could get richer by creating something new, finding something new or taking from some country across the seas. The number of things to worry about losing was becoming more varied. People began to think about sharing risk in order to avoid catastrophes. Risk has had to be safeguarded against in order to deal with an unknown future and the worst consequences.

Insurance products that safeguard against the worst outcomes enable people to feel freer, willing to take more risks, which result in a better society.

Transition to Markets

One of many areas where the insurance world and the world of finance overlap is with markets. It's reasonable to model events that happen frequently, but when you get to low-probability events there's no model to fall back on. What's the probability of a major earthquake in California? Who knows? You can approach it statistically, but there's not much to fall back on. You can approach it from a scientific study, which is helpful too, but there's still a huge amount of judgment involved.

Market Analysis

The real nightmare is the foreign exchange market, in part because the players are not under one roof and it's not a market that responds well to intrinsic values. The movement of foreign exchange changes the value of every contract. It is a pervasive and overwhelmingly important variable in the system.

If somebody looked at this country rationally, we could be considered bankrupt because the outstanding obligations to foreigners are so enormous and essentially in demand form. The ingredients for a big crisis are there all the time. If something does happen that will trigger a crisis it would probably be in those foreign markets. Even more important is the stock market: Changes in the foreign exchange rate alter the value of every contract.

The worst happens (considering stock markets) because people don't know how they're going to behave when the news is bad: The less familiar the bad news, the less we understand how we're going to act.

Markets have been crashing since they were invented. What you need is for expectations to be shocked. The crashes that have persisted developed out of maladjustments in the financial system somewhere. Maladjustments don't have to start in the market; they can start in the banking system. They can start in the foreign exchange markets. They can start in the halls of the Federal Reserve System.

Something outside the stock markets tend to be the trigger. The big risk, I think, in our present environment is the sense that in the long run everything is going to be lovely, and it doesn't matter what happens in the short run.

Conclusion

The conclusion of the book and my personal conclusion is one of questions: What will happen when this “thing” (our International Economic System) explodes? — As it may some day.

There are complicated questions like: Do we really know how to measure the risk? How well does volatility serve the purpose? At least the theoretical understanding has reached the point where we can ask the right questions. This doesn't mean that the answers are going to be easy to find, but I can't think of any questions we should be asking that we, society, are not currently asking.