Against the Gods – Peter Bernstein


Against the Gods – The remarkable story of risk by Peter Bernstein in one of the best books I have ever read on markets/ risk management. 

One of the first questions that one comes across in Against the Gods is how to divide the stakes of an unfinished game of chance between two players when one of them is ahead.

This question gave rise to probability, which later developed in risk management.

Pascal and Fermat were the ones who did considerable amount of work in probability. Initial works in probability were inspired by gambling. Peter explains the significance of zero and the role it played in the growth of mathematics.

Cardano, one of my favorites in this book, wrote that the greatest advantage from gambling comes from not playing it at all. He said that a man is nothing but his mind; if that be out-of-order, all is a mess, and it that be well the rest is at ease.

Some of the concepts Peter cover in his book are normal distribution, bell curve, rationality, behavioral finance. He asks one question again and again; how much past data is useful in predicting the future? He goes on to say that risk management is valid if we believe that future is in our hands.

Peter attacks the common phrase we use in our lives ” on the average”. If we put head of a man in oven and feet in refrigerator, is the person on average normal?

Bernoulli is introduced in chapter 6 who emphasizes decision making rather than getting into the intricacies of probability theory. Bernoulli said that ” the utility resulting from any small increase in wealth will be inversely proportionate to the quality of goods previously processed.”

Although this was later attacked by Kahneman and Tversky who said that the valuation of a risky opportunity appears to depend far more on the reference point from which the possible gain or loss will occur than on the final value of the assets that would result. It is not how rich you are that motivates your decision but rather whether that decision will make you richer or poorer”.

Bernoulli said that everyone colors the information we have in our own fashion. So, are we rational? He said that everyday life is quite different than the games of chance.

Wealth as Bernoulli puts is “anything that can constitute to the adequate satisfaction of any sort of want…There is then nobody who can be said to posses nothing at all in this sense unless he starves to death”.

Bernoulli discussed the big assumptions in probability and hence in risk management models: full information (we don’t have full information and we will never have that); independent trials(we assume events are independent); relevance of quantitative valuation. Will an event lead to same result in future as occurred in past?

Bernoulli’s friend Leigniz said “nature has established patterns originating in the return of events, ” ” but only for the most part. New illnesses flood the human race, so that no matter how many experiments you have done on corpses, you have no thereby imposed a limit on the nature of events so that in the future they could not vary.” This was in response to Bernaulli’s question that we do not know the probability that a man of twenty will outlive a man of sixty and so might we not find the answer to this question by examining a large number of pairs of men of each age?

Then Peter goes to normal distribution and explains why it is the core of all risk management systems and insurance businesses. He explains that for stock prices to be in random as believed by many, changes in stock prices must form normal distribution and the fact is although  changes in stock prices are normal but problems occur at the extremes (normal curve would not have untidy bulges). Fortunes are created and destroyed at the extremes; more often destroyed!

Regression is another concept discussed in detail; good time are followed by bad times and vice versa. They say that in the long run prices will move towards mean. But what is the long run?

He explains that reducing uncertainty is a costly business and the number of risks that can be insured against is far smaller than the number of risks we take in the course of a lifetime.

Frank Knight had a dim view of people who took themselves too seriously and said that economics was not at all obscure or complicated but that most people had a vested interest in referring to recognize what was “insultingly obvious”.  “Oh well, if you cannot measure, measure anyhow”.

He considered reliance on the frequency of past occurrences extremely hazardous.

Then in the story comes the guru of diversification, Harry Markowitz. He considered investors as rational decision makers. Before he introduced the concept of diversification, portfolios were constructed without much thought on risk. Markowitz’s objective was to take into account variance of portfolio.

The problem with variance is that markets are not perfectly normal and hence variance can’t take 100 percent of uncertainty of the portfolio.

Peter now moves on to the development of behavioral finance, which says that answer depends on the way question is asked. When the question is asked about profits, we are risk-averse and when the question is about losses, we are risk-seekers. This behavior is against the assumption that investors are rational.

Kahneman and Tversky asked the following question:

Imagine that a rare disease is breaking out in some community and is expected to kill 600 people. Two different programs are available to deal with the threat. If program A is adopted, 200 people will be saved; if program B is adopted, there is 33% probability that everyone will be saved and a 67% probability that no one will be saved. Which program would you choose?

Daniel Kahneman points out that the failure of the rational model is not in its logic but in the human brain it requires. He goes on saying that who could design a brain that could perform the way this model mandates. He said that every single of us would have to know and understand everything completely and at once for this model to work.

Harry Markowitz said that we diversify to reduce risks but psychologists say that we diversify to find winners and hold on to them.

Richard Thaler came up with the concept of anomalous behavior; behavior that violated the predictions of standard rational theory. He says that so-called anomalous behavior is often normal behavior where as rational behavior, which most of the models assume, is an exception.

Point here is that rational behavior can be quantified whereas so-called anomalous behavior can not be quantified and hence markets which are based on anomalous behavior can never be predicted and can never be modeled.

Advertisements

About Danish Kapur

Danish Kapur is a writer, commentator and actively follows the global financial markets.

No comments yet... Be the first to leave a reply!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: