Saturday, March 01, 2008

Against the Gods

The image “http://ecx.images-amazon.com/images/I/51XK9BR459L.jpg” cannot be displayed, because it contains errors. This very interesting book is not really the complete "story of risk"--it's more the history of the measurement of risk. As such, it begins with a history of probability and statistics before it switches to economics and finally finance.

It starts off, interestingly, with discussions of the ancient Greeks and Romans and medieval Hindus and Arabs, questioning why they didn't discover the principles of probability. The author, Peter L. Bernstein, answers that while Greeks understood the idea that some future events were likely and some were unlikely, they were ill equipped to measure it because their number system made it next to impossible to do the necessary calculations. Indeed, it's amazing that the Greeks managed to accomplish so much in mathematics without a "zero." (When I was a sophomore in college, I wrote a computer program for a class that permitted the user to do addition, subtraction, multiplication, division, and order of operations with Roman numerals. Of course, my program converted them into decimal numbers to accomplish this.)

It's more of a puzzle why the Arabs and Hindus, who did have a modern, flexible numbering system, didn't discover the rules of probability, but Bernstein suggests the following:
The answer, I believe, has to do with their view of life. Who determines our future, the gods, or ourselves? The idea of risk management emerges only when people believe that they are to some degree free agents. Like the Greeks and the early Christians, the fatalistic Muslims were not yet ready to take the leap.
This strikes me as a bit too culturally determined. One reason I disagree is that one of the main tools of risk management, the forward contract, has existed since antiquity--at least since the ancient Greeks. Greek farmers were clearly worried about what would happen in the future and did something to control the outcomes. They didn't just depend on the whim of the gods to guarantee a certain price for their olive harvests.

I think that by the Renaissance, intellectual change was happening so rapidly that a sort of critical mass was reached that allowed thinkers to think some radically new thoughts. In other words, I think Renaissance mathematicians who first discovered the laws of probability were able to do so for the same reason that Kepler and Galileo made their great discoveries in astronomy and physics. That kind of discovery was simply in the air.

This is a minor disagreement, though. And Against the Gods is a thoroughly enjoyable book, one that makes me want to delve more deeply into some of the subjects Bernstein describes. Prospect Theory, in particular, shows how irrational people are when it comes to risk. In a nutshell, we want to avoid risk and lock in certain returns, which makes us seem risk-averse, but at the exact same time, we want to bet on losses rather than take a certain loss, which makes us seem risk-seeking. As trivial as it is to state this, it was kind of a revelation to read it. Needless to say, it makes me all the more interested in behavioral finance. Likewise, while I've always been interested in Keynes, after reading Against the Gods, I feel I just have to read The General Theory of Employment, Interest and Money.

This book was published in 1996, so it does detail one of the great failures of risk management, the crash of 1987, and the way that portfolio insurance programs exacerbated it. But Bernstein published too early to include some of the most spectacular recent meltdowns in derivatives trading, like Nick Leeson's destruction of Barings. Nor does Bernstein have anything about Value at Risk, which was still quite new while he was writing the book, and obviously he doesn't have anything about Jerome Kerviel and Societe Generale, where (if the bank is to be believed) Kerviel covered his losses in futures trading by manipulating Societe Generale's VaR protections. But Bernstein would say the same thing about Leeson and Kerviel--they were not managing risk, they were making bets. Hedging is the opposite of making a bet--which is ironic, because the tools of risk management came out of Renaissance gamblers wanting to know more about probability.

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