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FROM THE BOOKSHELF
ANDREW RUPPEL,
Feature
Editor, McIntire School of Commerce,
Do Dice Play God?by Mark White, McIntire School of Commerce, University of Virginia
Peter Bernstein's newest book is
an immensely enjoyable romp through the origins and history of risk
management techniques. Perhaps no topic is more central to decision
sciences than uncertainty, and Mr. Bernstein has done an
outstanding job chronicling and describing the work of scholars in
mathematics, statistics, economics and finance to resolve, or at
least mitigate, unfortunate outcomes. He knows whereof he speaks;
an historian and accomplished investor, Bernstein founded the
Journal of Portfolio Management and made the best seller lists with
his previous book, Capital Ideas: The Improbable Origins of
Modern Wall Street.
In the Introduction, Bernstein asserts that the single most
important factor differentiating modern times from our historical
past is mastery of risk. Chance and fate have given way to
probability and statistics; the Black-Scholes option pricing model
has replaced the Oracle of Delphi. In five chronologically distinct
sections, Bernstein traces developments in the measurement and
mastery of risk from the invention of the zero to the development
of neural networks and genetic algorithms.
In Section One, Bernstein acknowledges the historical prevalence of
games of chance and man's early reliance on fate as a guiding
force. The discovery of numbers serves as the cornerstone for what
is to come -- "Without numbers, risk is wholly a matter of gut."
Leonardo Pisano, aka Fibonacci, presents myriad practical
applications of the new tools in his Liber Abaci.
The first attempt to quantify risk is described in Section Two,
covering the period 1200 to 1700. Luis Paccioli, the "father of
accounting," asks how one should divide the winnings of an
unfinished game of chance. Fellow Italian and inveterate gambler
Girolamo Cardano expands on this question, developing rudimentary
laws of probability along the way. These are refined further by
mathematical geniuses Blaise Pascal and Pierre de Fermat during the
latter half of the fifteenth century. Meanwhile, John Graunt, a
well-to-do English merchant, is analyzing records of births and
deaths in London with the goal of determining average life
expectancies. Graunt's work, and that of Edmund Halley (of comet
fame) provided the beginnings for actuarial science and the
insurance industry.
The years 1700 - 1900, chronicled in Section Three, were an
exciting time in the history of risk. Three members of the
venerated Bernoulli familyþDaniel, Jacob and Nicolaus -- made
important contributions. Daniel realized that everyone does not
value risk the same way. In other words, people maximize expected
utility, not expected value, and the utility one receives from a
particular outcome is inherently subjective. Daniel's uncle Jacob
developed the Law of Large Numbers as a result of his focus on the
quality of information available to a person making uncertain
decisions. Jacob's ideas were expanded upon by his nephew Nicolaus,
Abraham de Moivre and Thomas Bayes, among others. De Moivre is
credited with discovering the bell curve; Bayes developed a system
of inference useful for revising old information in light of new.
Bernstein then introduces readers to the work of Carl Friedrich
Gauss (the normal distribution) and Francis Galton (regression to
the mean), along with a fascinating digression on the latter
concept's application to the stock market. As the 19th century
draws to a close, risk management follows rationally from risk
measurement, and quantification is all that is needed. English
economist William Stanley Jevons is able to remark, "Value depends
entirely upon utility."
Section Four (1900-1960) concentrates on the major controversy
facing risk managers todayþreliance on past patterns of events vs.
subjective beliefs about the future. Economists Frank Knight and
John Maynard Keynes emphasize the role of uncertainty in
decision-making. In Bernstein's words, "we are not prisoners of an
inevitable future. Uncertainty makes us free." The quest for
rationality in decision making was furthered by John von Neumann
and Oskar Morgenstern's development of game theory and Harry
Markowitz's elaboration of portfolio selection theory. The former
provides tools for analyzing the role of other persons' actions in
creating uncertainty, while the latter describes the benefits of a
diversified investment strategy.
The book's final section should appeal to readers familiar with the
advances described earlier. Two major topics are discussed:
departures from the rational model and the application of risk
management techniques to the financial markets in the form of
derivative instruments. Prospect theory, developed by Daniel
Kahneman and Amos Tversky, argues that humans are powerfully driven
to avoid losses, and that risk valuation depends on strongly upon
one's reference position. Additional work by Richard Thaler, Meir
Statman and others has reinforced these findings. Their work has
spawned a new discipline ("behavioral finance") aimed at discerning
what's really motivating investors.
The central role of volatility in the creation of new financial
instruments is captured by Bernstein's colorful descriptions of the
options, futures, portfolio insurance and swap markets. He
concludes that while derivative instruments certainly have
increased systemic financial risk, they have also provided
unparalleled opportunities for financial and corporate innovation.
Against the Gods is peppered with amusing anecdotes and
interesting side comments. We learn, for instance, that the word
algorithm derives from the name of the great Arabic mathematician
al-Khowrizm. To emphasize the critical role of numbers in the
measurement of risk, Chapter Two is paginated in roman numerals.
Francis Galton, whose obsessive measurements led to his discovery
of reversion to the mean, also fathered the field of eugenics.
During the War Between the States, the Confederate government
drastically reduced its cost of borrowing via a clever
option-linked bond issue tied to the price of cotton and the
fortunes of the Confederacy.
Peter Bernstein's lively and accessible writing style, engaging
command of history, and fascinating applications make this book a
sure winner for academics, practitioners, and students alike. A
thoughtful bibliography (highlighting especially useful references)
is provided for those wishing to explore certain topics in greater
depth. The well-organized and thorough index aid the reader's
inevitable desire to look up and share particularly interesting
anecdotes.
The book's sole weakness is its focus on Western traditions of risk
measurement and management. Significant differences exist between
the American-European view of risk and that of other (particularly
Asian) cultures. For the most part, however, these issues are
beyond the scope of this book; their inclusion would significantly
increase the book's already substantial (380 pages) length.
Against the Gods is well-written, informative and
stimulating. It joins Malkiel's A Random Walk Down Wall
Street and Bernstein's earlier work, Capital Origins, on
my "Favorite Recommended Reading" list.
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