Against the Gods: The Remarkable Story of Risk

Against the Gods: The Remarkable Story of Risk
Peter L. Bernstein
John Wiley and Sons, New York, 1996
ISBN: 978-0-471-29563-9

Reviewed by Ramya Rajajagadeesan Aroul

Peter L Bernstein’s Against the Gods brilliantly presents centuries of mankind’s encounters with risk and uncertainty. This book enlightens the readers with the tale of thinkers and scholars whose astounding vision revealed how to put the future at the service of the present. The author in his pursuit for the understanding of the evolution of risk travels across various time periods and different continents and civilizations. It is definitely worth mentioning that this book is a comprehensive coverage of the history of risk. Another attraction of the book is the obvious passion with which Bernstein describes the many interesting people and alluring mysteries so peculiar to the mathematics of chance.

Bernstein concentrates on the history of numbers with fascinating insight. Bernstein walks that course through the laws of probability, decision theory, sampling, and utility theory and makes the entire exercise as enjoyable as a stroll in the woods. That stroll ends in the world of the stock market, forecasting, derivatives and chaos. The author’s approach is mostly historical and biographical. The five sections of the book cover the periods before 1200, 1200–1700, 1700–1900, 1900–1960, and 1960 to the present. The chapters in each part contain a series of one or more important contributors to the subject. The author not only provides an insightful history of the “science” of finance but also includes enthralling stories of people who drove the advance of modern finance. Many well-known names emerge—Cardano, Pascal, Fermat, Graunt, the Bernoullis, De Moivre, Bayes, Laplace, Galton, Keynes, and von Neumann.

Peter L Bernstein brings an extraordinary and novel perspective to his historical survey of the development of the mathematics of probability and uncertainty. In his journey of telling the tale of risk, the author also touches upon the persistent tension and unresolved controversy between the quantitative and subjective schools of thought. This aspect that the author deals with is of significant importance to researchers in understanding how much of the future can be predicted from the past patterns using mathematical modeling.

It comes to our surprise that the ancient Greek had little to do with the conception and advancement of the theory of risk. The author clearly provides nuances of the Greek era, their contributions and the reasons why they did not advance to the concept of risk. Modern thinking began when man discarded the idea that events are due to the whim of the gods and accepted the view that we are independent agents who can manage risks. In the case of ancient Greeks, they believed in the former view and to add to that they had an alphabet based numeric system that curtailed them from enabling more complicated calculations both of these did not let them venture into this area of risk management. Moreover, Greeks had little interest in experimentation; theory and proof are all that mattered to them. The modern conception of risk is rooted in the Hindu Arabic numeric system that reached the western world few hundred years ago. But the actual study of risk began during Renaissance as this was the time of vigorous approach to science and the future.

The 1654 correspondence between Blaise Pascal, a dissolute who became a religious advocate, and Pierre de Fermat, a lawyer whose genius was in mathematics signaled a very important event in the history of mathematics and the theory of probability. They constructed a systematic method for analyzing future outcomes. This definitely embarked the beginning of the theory of decision making. Decision theory is the theory of deciding what to do when the outcomes are uncertain and making that decision is the first step in the efforts of managing risk.

Foundations of modern decision theory were laid with the works of Daniel Bernoulli, a Swiss mathematician whose father and uncles were confirmed eighteenth-century geniuses. Bernoulli not only applied measurement to risk that cannot be counted for the first time in history but also defined the concept of utility intuitively. It was Bernoulli who identified every human being is different and has different risk aptitude which is one of the most pioneering breakthroughs in the theory of risk. Jacob Bernoulli, Daniel Bernoulli’s uncle was the first person to consider the relationship between probability and the quality of information through his Law of Large Numbers. He also draws the crucial difference between the reality and abstraction in applying the laws of probability.

DeMoivre came up with the new perspective of considering risk as a chance of loss and his greatest contribution of the introduction of normal distribution, mean and standard deviation to the field of risk management and statistics. Thomas Bayes extended Jacob Bernoulli’s Law of large Numbers further to come u with the concept of conditional probability. Thus Jacob Bernoulli, Abraham de Moivre, and Thomas Bayes showed how to infer previously unknown probabilities or uncertainties from the empirical facts of reality. Despite his lack of interest in risk management, Gauss’s achievements especially the Bell curve are at the heart of modern techniques of risk control. Galton’s innovation of analysis that led to the concept of correlation ultimately paved way for the emergence of today’s complex instruments for the measurement and control of risk in both business and finance.

Bernstein's last few chapters focus on the modern era of risk management including a complete review of the most important philosophers of the field. It makes immense meaning when the author while defining risk management states that “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome”. Bernstein touches upon Chaos theory which is a more recent development based on the premise that much of what looks like chaos is actually a product of an underlying order. I would have preferred a more in depth analysis about chaos theory considering the importance of this theory especially after the advent of electronic computer.

It is in these few chapters that Bernstein focuses primarily on the stock markets. Bernstein interestingly notes that though Markowitz’s methodology in his famous 1952 Journal of Finance article on Portfolio Selection is a synthesis of ideas of Pascal, de Moivre, Bayes, Laplace, Gauss, Galton, Daniel Bernoulli, Jevons and von Newmann, he had failed to credit his intellectual forebears. It is rather probing to note that Markowitz himself had stated that he knew the ideas but not the authors. But what we as young researchers should take from Markowitz is the fact that he neatly draws on earlier theories like probability theory, sampling , bell curve, dispersion around the mean, regression to the mean and on utility theory to come up with a novel theory, the theory of portfolio selection. This is one such paradigm change that Thomas Kuhn talks about in his “The Structure of Scientific Revolutions”.

Bernstein familiarizes us with the many novel ways of inferring and measuring risk, and with the emerging field of behavioral finance, which recognizes and attempts to explain anomalies in finance, examples in which rational explanations fail. In this part Bernstein inclines himself to the fact that the assumption of rational behavior is a useful starting point, but it describes the real world only up to a point. "As civilization has pushed forward, nature's vagaries have mattered less and the decisions of people have mattered more," concludes Bernstein. The most attention-grabbing part of this discussion is Bernstein's presentation of the path-breaking work of Daniel Kahneman and the late Amos Tversky; they were experimental psychologists whose scholarly work, called "prospect theory," is often used by students of behavioral finance to explain a variety of financial irregularities.

With his appealing literary style, Bernstein explains the concepts of probability, sampling, regression to the mean, game theory, and rational versus irrational decision making. The final sections of the book hoist vital questions about the role of the computer, the relationship between facts and subjective beliefs, the impact of chaos theory, the role of the burgeoning markets for derivatives, and the looming dominance of numbers. The fact that the author clearly captures the various stages of the scientific revolution that was staged in the pursuit of risk management and control techniques is indeed the primary reason for me to state that this is one of finest books of this century. I could witness the paradigm shifts in the process of the evolution of various theories over the centuries. I could understand the art of theory building by just travelling with the author’s biographical nuances. Above all, as a young scholar I realize that I have to stand on the shoulders of other researchers to create new scholarly work and contribute to both the world of academicians and practitioners.

If I got to say about the book in one line, I would say that, Against the Gods: The Remarkable Story of Risk is an extraordinary book that turns the most scholarly and philosophical issues of our time into pure reading pleasure.