Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein
Given what has been happening in the economy recently, this book (written ten years ago) provides an excellent foundation for understanding how we ended up here. In telling the story of risk, Bernstein focuses on how much people believe the past determines the future. The more we believe we understand the past, the more certain we are of what will happen in the future. Quantifying the past helps enormously in bringing certainty to the future. But risk lurks in the shadows surrounding certainty and underestimating it because of our blind faith in numbers and computers can lead, he says, to disaster. But what makes this book a wonderful read is that it really does tell a story stretching back millennia and is populated with exotic places and interesting characters. For someone interested in this topic it is time well spent.
Bernstein divides the story of risk into four time periods. The first one stretches till 1200 AD and starts with the ancient Greeks and an explanation of the difference between games of chance and games of skill. The first substantial foundation stone for understanding risk was laid by Leonardo Pisano the author of the Liber Abachi (The Book of Abacus), known more famously as Fibonacci (literally blockhead!). While the book had explanations for many interesting and useful things (such as bookkeeping and calculations of interest payments), its longest lasting contribution related, innocently enough, to how many rabbits will be born in the course of a year if they reproduced in a specified way. This led to what is known as the Fibonacci series (where each successive number is the sum of the two preceding numbers) and ultimately to the discovery of a remarkable number, 1.618. This number known as the golden mean, is seen everywhere from the proportions of man-made structures like the Parthenon and credit cards to phenomena of nature such as flower patterns and ratios of human body parts. Fibonacci helped put us on the path to mathematically understanding risk.
The second part of the book takes us through the years 1200 to 1700. It starts with the work of a contemporary of Da Vinci and Galileo, Girolamo Cardono, whose book Ars Magna (The Great Art), laid the foundations of probability theory. By inquiring into how the stakes of an unfinished game should be divided he started the process of probabilitistically thinking about the future. The systematic and theoretical foundations for measuring probability were laid by two famous Frenchmen, Blaise Pascal and Pierre de Fermat. They brought us to the doorway of economic forecasting. This part of the book concludes with the work of two remarkable Englishmen - John Graunt who developed the idea of statistical sampling and the astronomer Edmund Halley who figured out how to calculate life expectancies, thus giving birth to the idea of annuities.
The next part of the book (1700-1900) starts with the work of a Swiss mathematician, Daniel Bernoulli, who Bernstein describes as having written one of the most profound documents ever and in the process laid out the idea of utility and its subjective nature. That is, the idea that any decision related to risk depends on both the objective facts and the subjective value associated with the facts. This ultimately led to the idea that "the utility resulting from any increase in wealth will be inversely proportional to the quantity of goods previously possessed". Essentially, Bernoulli explains how much a person desires something depends inversely on how much he already has. This great insight lays the foundation for studying how people make decisions in every aspect of life. As an aside, while the name Bernoulli may sound familiar, it turns out that there were actually eight Bernoullis in this remarkable family who were famous mathematicians!
The last part of the book runs from 1900 onwards. It starts with the development of game theory by the renowned physicist John Von Neumann and explains the origins of portfolio selection. It concludes with the modern day work of two Israeli psychologists who have conducted the most influential research into how people manage risk - Amos Tversky and Daniel Kahneman. Their work has spawned the area of behavioral economics which studies the irrationality in the decisions made by supposedly rational economic beings. Many of the articles and ideas discussed in this blog have come from this interesting stream of work. Tversky passed away a few years after this book was published, but Kahneman went on to win the Nobel Prize for their work.
Peter Bernstein is an economic consultant and the author several of books including The Power of Gold.