Risk Management Learned from Against the Gods by Peter Bernstein

The history and basics of risk management

This book covers the history of risk management from ancient times until the 1980s. It is written for people interested in the history of risk management and is a great introduction to the subject.

It is a well researched book about how financial institutions managed risks throughout history. It is about how we got into trouble and what we can do to avoid similar problems in the future.

Peter L. Bernstein is one of America’s most distinguished historians. His books include "Capitalism, Socialism, and Democracy," "Power, Politics, and Business," and "Against the Gods." When he was alive, he was mentioned as "the greatest living American historian."

This book has a rich history of the origins of risk, all the way back to ancient farmers in Greece and Rome. He explains how insurance companies were invented to protect against the risk of crop failure and other disasters.

He also discusses the invention of modern finance and its relationship with government regulation. He talks about the development of the stock market and the role that it plays in our economy today.

The author describes the rise of the insurance industry and how they became so powerful that they could dictate policy.

Origins of Risk

Risk management is about understanding the probabilities of different outcomes and taking action accordingly.

The book starts in the 1300s when Italian and French mathematici­ans explored probability through the problems in gambling, including card games, dice games, and lotteries. They were interested in finding patterns in numbers and probabilities. Fermat brought new ideas of algebra, Pascals had geometry, and Bernstein's related their correspondences and their breakthroughs.

Then the tale takes a more realistic turn and Bernstein introduces the very first elements of modern economics that we'd recognize today. In England, John Graunt applied statistical sampling to a question of financial security. Natural and Political Observatsons Made upon the Bills of Mortality was published in 1660, and compiles the birth and deaths, along with the cause of each. Graunt recognised that the most dreaded cause of mortality were not actually the most likely cause of mortality. Edmund Halley followed up on Graunt's work with statistics collected in Breslau (now Wroclaw), Germany. He calculated the odds of a persons age being dead in a given year; thus creating the very first actuarial table, and the base for the entire insurances industry.

Measuring Uncertainty

But not everyone measures risk in the same way... In 1738, Daniel Bernoulli wrote, “The value of an item must not be based on its price, but rather on the utility that it yields.” Bernoulli was 38 years old at the time when he defined the term "utility." 

Utility was a new concept at the time. And explained how people would act irrationally in different situations. People will act with different levels of conservativism or greed in different situations. It's all about the nature of risk.

Someone may bet heavily in games of chance. They'll get greedy. But they may have a different risk tolerance when it comes to physical events. Though the chances of being hit by lightning are low, someone afraid of lightning would place a very high valuation on protection against it - perhaps greater than the odds would warrant. And they may not even venture outside to their gambling venue if it looks like storm clouds are a brewing. 

He also introduced the concept of diminishing marginal utility. This is the notion that if one already owns something, the don't care as much about acquiring more.

On a hot day, if I've been outside for hour in the sun, I may pay $20 for a bottle of water. But if I'm fully hydrated, I wouldn't pay anything for a bottle of water. 

It's ideas like this helped further the understanding of risk. It's important to keep these ideas in mind... And remember that the future is the playing field. And it is always uncertain. But understanding the motivations of others playing the game will help us succeed. 

Behavioral Finance

Humans are fickle creatures. And it's important to keep human nature in mind when playing the markets. When we experience adverse events in the financial markets, people tend to act irrationally. 

This is a trap for logicians. They believe people will act in their best interests... And that the best interests of all people are the same. This is not true. 

The behavioral finance movement began in the 1970s. Great economists like Daniel Kahneman, Amos Tversky and Richard Thaler became the godfathers of new field in economics, behavioral economics.

They found evidence that investors behaved differently depending upon whether they had just won or lost money. They also tend to be less willing to take risks when they feel like they are losing money.

In addition, people often fail to appreciate the long term consequences of their actions. For example, they tend to underestimate future losses and overestimate future gains. This makes it difficult for them to budget effectively and plan ahead.

Financial risk

This built on the concept of Harry Markowitz's portfolio theory. In 1952 Markowitz, a graduate student in economics, released is 14-page paper titled "Portfolio Selection."

In the late 1950s, many people began focus on portfolio theory and diversification. And by combining different, uncorrelated assets we can increase returns while reducing risk. And that is the dream of investing. 

While there is no such combination of assets that guarantee against loss, this can help maximize our returns while keeping invested in our plans. 

Markowitz showed that there were two main ways to measure risk: variance and standard deviation. Variance measures how much an investment fluctuates over time. Standard deviation measures volatility.

And this is the essence of risk management in modern portfolios. Markowitz covers many more concepts in the book such as game theory, prospect theory, regressions to the mean, etc... And how derivatives fit into the mix. But that's more than we're going to cover here. 

Every investor, needs to understand risk and risk management. This is a great book that covers the basics of managing risk. And how to not fall trap to our biases. We talked more about biases here in our review of Thinking Fast and Slow by Daniel Kahneman. 

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