- 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.
August 2008 