Monday, 19 November 2007

Book Review: Against the Gods (The Remarkable Story of Risk) by Peter Bernstein

This book is a popularized introduction to the long history of the development of the theory of risk. It is a welcome and useful entryway into a vast subject as Bernstein has taken care to provide footnotes and a substantial 12 page bibliography of original material. Bernstein manages quite a feat in effectively summarizing in plain language the findings and theories of so many highly mathematical and subtle ideas.

The author's attempt to make the book more entertaining is fairly successful. The meandering descriptions of the personal foibles of the men (why not even one woman among them?) who have advanced the theory of risk along with various anecdotes and trivia (e.g. the English national debt began on Dec.15, 1693) provides amusing distraction but the cutesy chapter titles (e.g. "The Man Who Counted Everything Except Calories") are an annoying artifact of our times.

The book is replete with bold sentences that make wonderful quotes (see below). I found many to be very thought-provoking.

  • At the extremes, the market is more likely to destroy fortunes than to create them. (p.150)
  • It is perilous in the extreme to assume that prosperity is just around the corner simply because it has always been just around the corner. (p.172)
  • We are in the business of managing and engineering financial investment risk. (quote of Charles Tschampion, manager of GM's pension fund; p.247); interesting because engineering only applies when the inputs and assumptions are accurate and as Bernstein states often, we cannot necessarily assume that the future will be like the past and all the assumptions are based on data about the past.
  • The capital markets are not accommodating machines that crank out wealth for everyone on demand. (p.251)
  • Investors diversify their investments because diversification is their best weapon against variance of return. (p.252)
  • Well-informed investors diversify because they do not believe that investing is a form of entertainment. (p.275)
  • It is hard to over-estimate the importance of house price trends for consumer psyches and behavior. ... Consumers view their home equity as a cushion or security blanket against the possibility of future hard times. (quote of former US Federal Reserve Chairman Alan Greenspan, p.290); given the current slide of house prices in the US, one has to wonder what the repercussions will be on consumer spending and economic activity.
  • ... investors had met the enemy and it was them(selves) ... (p.303)
  • ... if all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized. (quote of former US Federal Reserve Chairman Alan Greenspan, p.328)
  • ... in spite of all of our efforts, human beings do not enjoy complete knowledge of the laws that define the order of the objectively existing world. (p.330)
  • Uncertainty is a consequence of the irrationalities ... in human nature, ... (p.331)
  • Wars, depressions, stock market booms and crashes, and ethnic massacres come and go, but they always seem to arrive as surprises. (p.334)
  • ... diversification is not a guarantee against loss, only against losing everything at once. (p.336)

I wish Bernstein would more explicitly address the difference between the research or theory that is prescriptive or normative, i.e. which says what people should do, from that which is descriptive, i.e. what people actually do. There is a danger, manifested today in investing as rote acceptance of structuring a portfolio based on a person's "risk preference", to magically transform irrational, illogical behaviour into acceptable practise. Bernstein's example (p.105) of the varying degrees of fear displayed by passengers going through turbulence in an airplane illustrates the point. Why does he describe the varying reactions with "And that's a good thing"? The risk and the consequences to the passengers are the same and presumably none actually want to die so should the reaction not be the same for all despite the observed variety of emotional reactions, however understandable that reaction might be. In a later chapter describing other research on irrational behaviour (p. 273), Bernstein writes: "This behaviour, although understandable, is inconsistent with the assumptions of rational behaviour. The answer to a question should be the same regardless of the setting in which it is posed."

There are some fascinating statements which I wish had received more treatment - perhaps in another book? One statement is that the perceptions and behaviour of investors are shaped by their own times and experience (p. 54 and 301), especially nasty painful ones, like the Great Depression of the 1930s. So, how would Bernstein characterize today's generation? Another is the surprising result that despite all the irrationalities displayed by people/investors the market for all practical purposes - the phrase he uses, borrowed from John Maynard Keynes, is "when it really counts" - operates as though rationality prevailed. In investment terms it means that it is very difficult to exploit mis-pricing, over- and under-valuation in any systematic, profitable way. A third such statement is that the advances in risk management techniques have encouraged greater risk taking. Everyday life, including especially investment management that is dominated by the professionals who supposedly practise risk management in the most extensive and sophisticated way, fall down in the most spectacular fashion. Witness the unfolding sub-prime mortgage lending credit crash and the world's biggest banks who are getting hammered, with the economic debris already starting to fall upon the heads of ordinary people.

The book is somewhat schizophrenic in that it presents the thesis of mastery and a confident answer on the one hand, but on the other hand it asks a key question to which no answer is given: "But to what degree should we rely on the patterns of the past to tell us what the future will be like?" Suppose there is no mean to revert to in the stock market, or suppose the mean has or will shift? In that case, investing theory is a house built on sand.

For the practical-minded individual investor, a quote (p.49) by 18th century gambler and mathematician Girolamo Cardano in the book gives a neat summary of the book's value: "... these facts contribute a great deal to understanding but hardly anything to practical play."

PS a small note to Mr. Bernstein, please find synonyms for the word remarkable; it is a tad over-used in this book.

Overall, a thought-provoking read, succeeds in the story-telling but leaves one confused about how to tell quantifiable risk from unknowable uncertainty and in doubt that such a goal is even achievable. Useful to individual investors to heighten their sense of the need for caution. 4 out of 5 stars.

1 comment:

Y HAT said...

I thought this was a great book. After reading its accounts of Pascal, the Chevaliere de Mere, Dalton, etc. all my undergraduate statistics courses finally started making sense.

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