Against the Gods

Got the book by Peter Bernstein as one of farewell gifts when leaving the employer in late July. I pledge it has taken me a while to read it from cover to cover. The book, although worthwhile, is not actually immensely gripping and anything but breath-taking, albeit I realise I might not be the perfect target reader.

The content of the book revolves around manifold dimensions of risk and its presence in humans’ lives. Uncertainty regarding what the future holds has kept humans company since origins of the mankind, however centuries passed by before this uncertainty was quantified and gave rise to the concept of risk.

Uncertainty of future outcomes is an indispensable part of life, however sources of it are a matter judgement. You can put down future events to luck, fate, God’s hands or to mathematical probability. Depending on how you approach uncertainty, you may handle it in several ways. If you believe what lies ahead can only hinge upon luck, fate or God, you can only sit on your hands and wait for what future brings. However, if you put faith in existence of any rational root, presence of likelihood, you can harness tools to manage risks you come across. The concepts of risk management evolved with time, as people began to give credence that they need not to solely rely or luck, faith and Gods. Thanks to this risk could be quantified and thus ready to be handled…

The book, among many concepts highlights some that are pivotal in understanding economics on every-day level and deserve to be mentioned here…

1. Insurance is the price to pay for taking away uncertainty. Insurance premium as a matter of principle must be higher than probability of adverse event against you insure taking place. It is not only about an insurer’s profit. The case is that a humans are usually risk-averse and prefer a small, but certain loss (insurance premium) to a small probability of a big loss.

2. The bigger the sample, the more likely it is to reflect reality. The nature generally follows normal distribution. The two sentences above are clichés, however they can be employed to manage population. As the author argues, in the past there were concepts that birth regulation should ensure that only most intelligent, clever, beautiful people should proliferate to make the society in next generations more valuable… In practice, without any regulations, it works the other way round, namely the underclass have more children…

3. Volatility and uncertainty are highly correlated. Oddly enough, markets are placid when risk tolerance is high, but when market participants turn risk-averse, price fluctuations intensify…

4. Derivatives itself are not evil, but they are one of useful in risk management. It has to be noted the book was written long before 2008…

5. Although the concept that decision-makers act rationally underlies many economic theories, practice reveals the perfect world does not exist; the prospect theory justifies why this happens. In effect, people’s choices can easily be affected by their perception of the situation, which in turn can be easily manipulated…

6. Carrot, contrary to many theorem, works better than stick. Truth be told, I forgot why exactly, but maybe if this thread is left unsaid, it will prompt somebody to reach for the book…

If I were to recommend the book for reading, I would be in two minds. It definitely deserves credit for interdisciplinary character. It makes several references to religion, psychology, sociology, philosophy, mathematics, statistic and history. It actually is a handbook of risk management history, putting stuff risk managers deal with every day into historical perspective. It rather broadens horizons than introduces new concepts.

The book can be, however, an excellent read for economic laymen. It is written in a clear language and might help one familiarise with concepts I dwelled on during my studies. It should be much more interesting for somebody coming across some economic theories for the first time than to me… As for the drawback, I see one evident – it was written long before the onset of the 2008 - ??? financial crisis (its author died in June 2009, aged 90) and fails to incorporate lesson to economic reasoning learnt from the crisis in terms of risk management.

Next week’s break from blogging will be sponsored by my ‘duty’ to be off for most of the weekend…