Against the Gods: the remarkable story of risk. – Peter L Bernstein
Since so much of the last four years has been an argument about risk – why the banks were allowed to assume so much, why subprime mortgage lending was a good idea, why governments thought they could borrow more than their GDP – revisiting this classic is worth taking onto your next long haul flight. Written in 1996 by Peter Bernstein, its purpose is to
“...tell the story of a group of thinkers whose remarkable vision revealed how to put the future at the service of the present. By showing the world how to understand risk, measure it, and weigh its consequences, they converted risk-taking into one of the prime catalysts that drives modern Western society...”
The story of mankind’s battle with risk could hardly be more relevant today, 15 years after the publication of the book. As Bernstein puts it in his introduction
“The issue boils down to one’s view about the extent to which the past determines the future. We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on the patterns of the past to tell us what the future will be like?”
So much for the philosophy. What’s really valuable about the book –a work of historical synthesis rather than original thinking – is its interesting and anecdote-packed run through risk-taking through the ages, providing a historical perspective that our current gamblers seems to have completely forgotten (assuming they ever know).
There’s plenty of maths made easy here, with standard deviation, probability theory and The Law of Large Numbers explained in simple terms, along with the answers to questions such as “What is an option worth?” The puzzles are fun as well: Pascal’s Wager, Fermat’s Last Theorem and The Petersburg Paradox...
Against the Gods examines many previous financial debacles, and has warnings which, obviously, were ignored
“... the science of risk management sometimes creates new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks we would not otherwise take. On most counts, that is beneficial, but we must be wary of adding to the amount of risk in the system.... Research reveals that seatbelts encourage drivers to drive more aggressively. Consequently the number of accidents rises even though the seriousness of injury in one accident declines. Derivative financial instruments designed as hedges have tempted investors to transform them into speculative vehicles with sleigh-rides for payoffs and involving risks that no corporate risk manager should contemplate.”
This was in 1996, before Credit Default Swops were invented, but since one of the principal causes of the financial crisis was that vast amounts of money were lent on sub-prime mortgages which should never have been lent, primarily so the debts could be repackaged and sold on, often with credit ratings far above their actual value, it is instructive. There was little data to support these valuations – because sub-prime mortgage lending had never occurred on this scale before – and so the ratings were wrong. When the market inevitably corrected itself, the banks and various financial institutions were highly leveraged in debt and were inadequately capitalised, requiring bailouts from governments which helped tip us into recession. Bernstein quotes James Morgan, a columnist at the Financial Times
“A derivative is a like a razor. You can use it to shave yourself... Or you can use it to commit suicide.”
Bernstein seems to me to be very good at foreseeing the current financial crisis, far better than some he quotes, such as Alan Greenspan, Chairman of the Federal Reserve Board in 1994,
“There are some who would argue that the role of the bank supervisor is to minimise or even eliminate bank failure; but this view is mistaken, in my judgement. The willingness to take risk is essential to the growth of a free market economy.... [I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realised.”
The end of the book, however, has an air or retrospective sadness, it seems to me. The opening quote from the statistician Maurice Kendall seems to sum it up,
“Humanity did not take control of society out of the realm of Divine Providence... to put it at the mercy of the laws of chance.”
And Bernstein asks, “As we look forward to the new millennium, what are the prospects that we can finish that job, that we can hope to bring more risks under control and make progress at the same time?”
His answer is cautionary,
“Nothing is more soothing than the computer screen... As we stare at the passing show, we become so absorbed that we tend to forget that the computer only answers questions; it does not ask them. Whenever we ignore that truth, the computer supports us in our conceptual errors.”
It is that loss of perspective, reliance on modes and an ignorance of the real risks we were taking that caused the current financial crisis. History teaches us, however, that it’s unlikely any lasting lessons have been learned.
Tom Otley
Against the Gods: the remarkable story of risk. – Peter L Bernstein
Since so much of the last four years has been an argument about risk – why the banks were allowed to assume so much, why subprime mortgage lending was a good idea, why governments thought they could borrow more than their GDP – revisiting this classic is worth taking onto your next long haul flight. Written in 1996 by Peter Bernstein, its purpose is to
“...tell the story of a group of thinkers whose remarkable vision revealed how to put the future at the service of the present. By showing the world how to understand risk, measure it, and weigh its consequences, they converted risk-taking into one of the prime catalysts that drives modern Western society...”
The story of mankind’s battle with risk could hardly be more relevant today, 15 years after the publication of the book. As Bernstein puts it in his introduction
“The issue boils down to one’s view about the extent to which the past determines the future. We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on the patterns of the past to tell us what the future will be like?”
So much for the philosophy. What’s really valuable about the book –a work of historical synthesis rather than original thinking – is its interesting and anecdote-packed run through risk-taking through the ages, providing a historical perspective that our current gamblers seems to have completely forgotten (assuming they ever know).
There’s plenty of maths made easy here, with standard deviation, probability theory and The Law of Large Numbers explained in simple terms, along with the answers to questions such as “What is an option worth?” The puzzles are fun as well: Pascal’s Wager, Fermat’s Last Theorem and The Petersburg Paradox...
Against the Gods examines many previous financial debacles, and has warnings which, obviously, were ignored
“... the science of risk management sometimes creates new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks we would not otherwise take. On most counts, that is beneficial, but we must be wary of adding to the amount of risk in the system.... Research reveals that seatbelts encourage drivers to drive more aggressively. Consequently the number of accidents rises even though the seriousness of injury in one accident declines. Derivative financial instruments designed as hedges have tempted investors to transform them into speculative vehicles with sleigh-rides for payoffs and involving risks that no corporate risk manager should contemplate.”
This was in 1996, before Credit Default Swops were invented, but since one of the principal causes of the financial crisis was that vast amounts of money were lent on sub-prime mortgages which should never have been lent, primarily so the debts could be repackaged and sold on, often with credit ratings far above their actual value, it is instructive. There was little data to support these valuations – because sub-prime mortgage lending had never occurred on this scale before – and so the ratings were wrong. When the market inevitably corrected itself, the banks and various financial institutions were highly leveraged in debt and were inadequately capitalised, requiring bailouts from governments which helped tip us into recession. Bernstein quotes James Morgan, a columnist at the Financial Times
“A derivative is a like a razor. You can use it to shave yourself... Or you can use it to commit suicide.”
Bernstein seems to me to be very good at foreseeing the current financial crisis, far better than some he quotes, such as Alan Greenspan, Chairman of the Federal Reserve Board in 1994,
“There are some who would argue that the role of the bank supervisor is to minimise or even eliminate bank failure; but this view is mistaken, in my judgement. The willingness to take risk is essential to the growth of a free market economy.... [I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realised.”
The end of the book, however, has an air or retrospective sadness, it seems to me. The opening quote from the statistician Maurice Kendall seems to sum it up,
“Humanity did not take control of society out of the realm of Divine Providence... to put it at the mercy of the laws of chance.”
And Bernstein asks, “As we look forward to the new millennium, what are the prospects that we can finish that job, that we can hope to bring more risks under control and make progress at the same time?”
His answer is cautionary,
“Nothing is more soothing than the computer screen... As we stare at the passing show, we become so absorbed that we tend to forget that the computer only answers questions; it does not ask them. Whenever we ignore that truth, the computer supports us in our conceptual errors.”
It is that loss of perspective, reliance on modes and an ignorance of the real risks we were taking that caused the current financial crisis. History teaches us, however, that it’s unlikely any lasting lessons have been learned.
Tom Otley 
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