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Sunday, August 24, 2008

Reading List: Against the Gods

Bernstein, Peter L. Against the Gods. New York: John Wiley & Sons, [1996] 1998. ISBN 978-0-471-29563-1.
I do not use the work “masterpiece” lightly, but this is what we have here. What distinguishes the modern epoch from all of the centuries during which humans identical to us trod this Earth? The author, a distinguished and erudite analyst and participant in the securities markets over his long career, argues that one essential invention of the modern era, enabling the vast expansion of economic activity and production of wealth in Western civilisation, is the ability to comprehend, quantify, and ultimately mitigate risk, either by commingling independent risks (as does insurance), or by laying risk off from those who would otherwise bear it onto speculators willing to assume it in the interest of financial gains (for example, futures, options, and other financial derivatives). If, as in the classical world, everyone bears the entire risk of any undertaking, then all market players will be risk-averse for fear of ruin. But if risk can be shared, then the society as a whole will be willing to run more risks, and it is risks voluntarily assumed which ultimately lead (after the inevitable losses) to net gain for all.

So curious and counterintuitive are the notions associated with risk that understanding them took centuries. The ancients, who made such progress in geometry and other difficult fields of mathematics, were, while avid players of games of chance, inclined to attribute the outcome to the will of the Gods. It was not until the Enlightenment that thinkers such as Pascal, Cardano, the many Bernoullis, and others worked out the laws of probability, bringing the inherent randomness of games of chance into a framework which predicted the outcome, not of any given event—that was unknowable in principle, but the result of a large number of plays with arbitrary precision as the number of trials increased. Next was the understanding of the importance of uncertainty in decision making. It's one thing not to know whether a coin will come up heads or tails. It's entirely another to invest in a stock and realise that however accurate your estimation of the probabilistic unknowns affecting its future (for example, the cost of raw materials), it's the “unknown unknowns” (say, overnight bankruptcy due to a rogue trader in an office half way around the world) that can really sink your investment. Finally, classical economics always assumed that participants in the market behave rationally, but they don't. Anybody who thinks their fellow humans are rational need only visit a casino or watch them purchasing lottery tickets; they are sure in the long term to lose, and yet they still line up to make the sucker bet.

Somehow, I'd gotten it into my head that this was a “history of insurance”, and as a result this book sat on my shelf quite some time before I read it. It is much, much more than that. If you have any interest at all in investing, risk management in business ventures, or in the history of probability, statistics, game theory, and investigations of human behaviour in decision making, this is an essential book. Chapter 18 is one of the clearest expositions for its length that I've read of financial derivatives and both the benefits they have for prudent investors as well as the risks they pose to the global financial system. The writing is delightful, and sources are well documented in end notes and an extensive bibliography.

Posted at August 24, 2008 23:57