The driving force called risk

Peter Bernstein takes us through an intriguing journey about risk, through his book, Against the Gods: The Remarkable Story of Risk. He uses anecdotes from the past to hint that risk is the driving force behind modern thought and action. The introduction points out the importance of risk analysis, especially quantitative, to the development of modern civilisation. This explains the emphasis on milestones in the evolution of mathematics.

Bernstein begins with the proposition that modern thinking began when man abandoned the belief that events are due to the whims of gods and embraced the notion that we are active, independent agents who can manage risks. In ancient Greece, the logic “a man’s destiny sways with the whims of gods,” prevailed over experimentation, and the use of letters for numbers inhibited man’s ability to calculate.

But by the 13th century, new mental tools were in place: the Hindu-Arabic numbering system, algebra, accounting, and other necessary equipment for the first insights into the laws of chance.

Bernstein introduces Pascal, Graunt, Halley, Statuaria studies, and Lloyd’s of London, which are the first steps towards economics, a subjective look at the concept of utility, the law of large numbers (increased confidence in analysis with increased instances), Gauss (and although the point is obvious, Gaussian distribution, we never quite get there), and Galton and normal distribution. He’s at his best while talking about promotional realms, looking at the short- and long-term activities of stock markets, taking a brief detour of the Victorian studies of economics, statistics and reliability, comparing Knight and Keynes, and game theory as applied to chance, stock portfolios, psychological factors in risk choice, the irrationality of investors, and derivative financial instruments.

Title : Against The Gods: The Remarkable Story of Risk Author : Peter L Bernstein Publisher : John Wiley & Sons, Inc. Pages : 383 Price : Rs 800

Among the human tendencies documented by Kahneman and Tversky are extrapolation from small and unreliable samples, giving greater weight to catastrophic outcomes than their low probabilities warrant (the Three Mile Island effect), loss aversion, and mental accounting. Loss aversion refers to our tendency, when faced with an option between a certain loss and an uncertain gamble, to gamble unless the odds are strongly against us; embezzlers will recognise this, as will many investors who avoid selling at a loss in the hope that continuing the gamble will extricate them. Mental accounting refers to the tendency to sort decisions into compartments rather than consider the overall position. Bernstein gives an example of mental accounting, in which, he remarks that the practice of buying dividend-paying stocks so that one can avoid “dipping into capital”— selling stock—to pay for life’s necessities.

The Pascal-Fermat contribution to probability theory, which helps us to analyse risk, was mixed with insights into the role risk plays in our choices arising from the work of Daniel Bernoulli, a Swiss mathematician, whose father and uncles were confirmed 18th-century geniuses. The foundation for modern decision theory was laid. From that foundation, Bernstein sets off on a whirlwind tour of the development of modern decision theory.

Bernoulli had put forth his revolutionary idea that “the utility (satisfaction) resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.” Bernstein believes that in the final analysis “gut rules the measurement.”

Through this book, Bernstein has tried to imply the importance of risk and the urge to implement it as an essential element in the fields of economics, management and healthcare.

—Varun Aggarwal