The odds and the gods: the origins of risk management

Posted by TEBI on January 25, 2022

The odds and the gods: the origins of risk management

 

 

The idea of humans seeking to manage risk was once seen as blasphemous. The view in medieval times was that only God could determine our fate and that any attempt to master risk was to interfere with the forces of the universe. The distance we have travelled since those days is mapped out in Peter L. Bernstein’s classic work Against the Gods: The Remarkable Story of Risk.

 

Without the insights of probability many of the advances we take for granted today would not exist. Engineers could not have designed the world’s great bridges, polio would still be maiming children, insurance would be unheard of and farmers could not sell their crops at fixed prices before harvest.

In fact, without the capacity to manage and take risk, we would not have many of the great financial innovations of today – including highly diversified managed funds that allow individual investors to get broad access to capital markets.

The fascinating history of risk management is told in vivid terms by the late financial historian, economist and educator Peter L. Bernstein in his now classic 1996 work Against the Gods: The Remarkable Story of Risk.

 

The breakthrough

For most of human history, the outcome of something even as basic as the flip of a coin was seen as belonging to the realm of unknowable chance. But in the seventeenth century, French mathematicians Pascal and Fermat laid the foundations of probability theory, which changed our understanding of risk and uncertainty.

Prompted by a simple question about how to divide the stakes of an unfinished game of chance between two players when one of them is ahead, the work done by Pascal and Fermat led centuries later to the science of quantitative techniques of risk management employed in highly complex financial derivatives. 

As Bernstein wrote, by defining a rational process of risk-taking, these two scholars provided the missing ingredient that has propelled science and business into today’s world of speed, instant communication, and sophisticated finance.

But the scientific measurement of risk is not just about high finance. It extends into just about every facet of our lives today.

“Risk management guides us over a vast range of decision-making,” Bernstein wrote, “from allocating wealth to safeguarding public health, from waging war to planning a family, from paying insurance premiums to wearing a seatbelt, from planting corn to marketing cornflakes.”

 

Not only numbers

Unfortunately, the risk management story is also one of hubris. Financial crises such as the Long-Term Capital Management collapse of the late 1990s and the global crisis of 2008-09 had their roots in a naïve belief in risk management models and a lack of understanding by key players in the highly complex tools they were using to defray risk.

While Bernstein’s book predated both those crises, he was one of the first to identify the perennial tension between those who believe the best decisions are based on quantification and numbers, built on past patterns, and those who look more to subjective degrees of belief about an uncertain future.

“The issue boils down to one’s view about the extent to which the past determines the future,” he wrote. “It is one thing to set up a mathematical model that appears to explain everything. But when we face the struggle of daily life, of constant trial and error, the ambiguity of the facts as well as the power of the human heartbeat can obliterate the model in short order.”

We have to remember, Bernstein wrote, that numbers are only tools. Computers can crunch billions of bits of data, but managing risk is as much about human judgement as it is about a mathematical equation.

“Past data from real life constitute a sequence of events rather than a set of independent observations, which is what the laws of probability demand. It is in those outliers and imperfections that the wildness lurks.”

 

A renaissance man

Bernstein, who died in 2009, was a rare renaissance man in the often arid field of economics. His writing is redolent with allusions to philosophy and art and literature. His interest firstly is in humanity. As such, his writing on risk brings vividly to life what could have been a dry and technical tome.

In fact, the respected Wall Street Journal personal finance writer and columnist Jason Zweig once called Against the Gods the best and most interesting high-level book on investing and one that every serious investor should read at some point.

We can only agree.

 

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