Against the Gods: The Remarkable Story of Risk

Peter L. Bernstein
A Business Week, New York Times Business, and USA Today Bestseller"Ambitious and readable . . . an engaging introduction to the oddsmakers, whom Bernstein regards as true humanists helping to release mankind from the choke holds of superstition and fatalism." -The New York Times"An extraordinarily entertaining and informative book." -The Wall Street Journal"A lively panoramic book . . . Against the Gods sets up an ambitious premise and then delivers on it." -Business Week"Deserves to be, and surely will be, widely read." -The Economist"[A] challenging book, one that may change forever the way people think about the world." -Worth"No one else could have written a book of such central importance with so much charm and excitement." -Robert Heilbroner author, The Worldly Philosophers"With his wonderful knowledge of the history and current manifestations of risk, Peter Bernstein brings us Against the Gods. Nothing like it will come out of the financial world this year or ever. I speak carefully: no one should miss it." -John Kenneth Galbraith Professor of Economics Emeritus, Harvard UniversityIn this unique exploration of the role of risk in our society, Peter Bernstein argues that the notion of bringing risk under control is one of the central ideas that distinguishes modern times from the distant past. Against the Gods chronicles the remarkable intellectual adventure that liberated humanity from oracles and soothsayers by means of the powerful tools of risk management that are available to us today."An extremely readable history of risk." -Barron's"Fascinating . . . this challenging volume will help you understand the uncertainties that every investor must face." -Money"A singular achievement." -Times Literary Supplement"There's a growing market for savants who can render the recondite intelligibly-witness Stephen Jay Gould (natural history), Oliver Sacks (disease), Richard Dawkins (heredity), James Gleick (physics), Paul Krugman (economics)-and Bernstein would mingle well in their company." -The Australian


Reviewed: 2020-04-11

Peter Bernstein's latest book, Against the Gods The Remarkable Story of Risk, establishes his standing as America's preeminent scholar-practitioner in the field of finance. Together with his highly successful predecessor, Capital Ideas The Improbable Origins of Modern Wall Street (The Free Press, New York, 1992), Bernstein has laid out a remarkably insightful and entertaining history of the "science" of finance, including fascinating descriptions of the people who drove the development of modern financial economics.

Bernstein's earlier work, Ideas, emphasized the advances emerging from the notion that investors are rational and security markets are efficient It focused on modern portfolio theory and its implications for security prices, and on the development of new instruments, like equity options. Gods serves as a prequel. It searches out the roots of modern finance and provides an interpretation of the history of that "science." Throughout, Bernstein's subtext is an investigation of the meaning of rationality and of the limits of rationality in explaining our choices.

Gods begins with a sweeping proposition Modern thinking began when man abandoned the belief that events are due to the whim of the gods and embraced the notion that we are active, independent agents who can manage risks. Thus in the worldview of ancient Greece, a man's destiny swayed with the whim of the gods, logic prevailed over experimentation, and the use of letters for numbers inhibited man's ability to calculate. But by the thirteenth century, new mental tools were in place the Hindu-Arabic numbering system, algebra, accounting, and other necessary equipment for the first insights into the laws of chance.

Those insights came in the seventeenth century, in the analysis by Blaise Pascal, a dissolute who became a religious zealot, and Pierre de Fermat, a lawyer whose genius was in mathematics, of a gambling problem first proposed in the fifteenth century. The Pascal-Fermat contribution to probability theory, which helps us to analyze risk, was mixed in the next century with insights into the role risk plays in our choices arising from the work of Daniel Bernoulli, a Swiss mathematician whose father and uncles were confirmed eighteenth-century geniuses. The foundation for modern decision theory was laid. From that foundation, Bernstein sets off on a whirlwind tour of the development of modern decision theory.

In the last quarter of Gods, Bernstein focuses on the assumption that human choices are "rational," meaning that they are derived logically from a few axioms. In modern economics, one model of rational decision making is the expected utility hypothesis Decisions are made with the goal of maximizing one's expected satisfaction (back to Bernoulli again). Bernstein acquaints us with the many new ways of interpreting and measuring risk, and with the emerging field of behavioral finance, which recognizes and attempts to explain anomalies in finance, examples in which rational explanations fail. In this part of Gods Bernstein tips his hand, telling us that although the assumption of rational behavior is a useful starting point, it describes the real world only up to a point.

The most interesting part of this discussion is Bernstein's presentation of the path-breaking work of Daniel Kahneman and the late Amos Tversky; they were experimental psychologists whose work, called "prospect theory," is often used by students of behavioral finance to explain a variety of financial anomalies.

Among the human tendencies documented by Kahneman and Tversky are extrapolation from small and unreliable samples (I had a car accident at that intersection, therefore that intersection is more dangerous than others), giving greater weight to catastrophic outcomes than their low probabilities warrant (the Three Mile Island effect), loss aversion, and mental accounting. Loss aversion refers to our tendency, when faced with a choice between a sure loss and an uncertain gamble, to gamble unless the odds are strongly against us; embezzlers will recognize this, as will many investors who avoid selling at a loss in the hope that continuing the gamble will extricate them. Mental accounting refers to the tendency to sort decisions into compartments rather than to consider the overall position. Examples of mental accounting are Christmas saving clubs and other ways of segregating assets by intent; as Bernstein argues, this includes the practice of buying dividend-paying stocks so that one can avoid "dipping into capital" -- selling stock -- to pay for life's necessities.

By the end of the book, Bernstein has shown us how interpretations of rational behavior in the presence of risk have changed as the tools to understand decision making have changed. He almost gets us to move into the castle-in-the-air, the notion that we are, in fact, rational. But his good sense and long experience with security markets, supported by the work of behavioral economics, keeps him from entering the front door. Bernstein believes that "we are rational as far as it goes." To know what he means, read the book. That would be rational!

Peter Fortune rationally economizes for the Boston Fed. 


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