Against the Gods: The Remarkable Story of Risk (2 page)
Read Against the Gods: The Remarkable Story of Risk Online
Authors: Peter L. Bernstein
18. The Fantastic System of Side Bets
304
Notes
339
Bibliography
353
Name Index
365
The suggestion that I write a book about risk came from the late Erwin
Glickes, then president of The Free Press. Erwin was a man who projected copious amounts of power, persuasiveness, and charm. Although
he considered my long experience as a professional investor to be sufficient qualification for the task he had in mind, I soon discovered, as I
had feared, that risk does not begin and end on the floor of the New
York Stock Exchange.
The vastness of the subject matter is daunting. Risk touches on the
most profound aspects of psychology, mathematics, statistics, and history. The literature is monumental, and each day's headlines bring
many new items of interest. Consequently, I have had to be selective.
I believe, however, that the omission of any important material was the
result of a decision on my part rather than an act of oversight.
For this project, I have been far more dependent on other people
than I had been in my earlier forays into writing books. Old friends as
well as many complete strangers from a wide variety of disciplines have
provided invaluable assistance combined with criticisms and creative
suggestions. In this case, increasing the number of cooks was a clear
benefit. My gratitude to them is boundless. There would have been no
book at all without them.
Convention dictates that expressions of appreciation to spouses and
editors should come at the end of the list of acknowledgments, but on
this occasion I choose to mention my wife and my editor first. That is
where they belong.
Barbara, my wife as well as my business partner, provided countless
creative ideas, conceptual contributions, and positive criticisms, all of
them essential to the task; there is barely a page that does not reflect her
influence. In addition, her success in arranging our lives to accommodate
this whole project made all the difference between progress and chaos.
Myles Thompson of John Wiley has been critically important to
the project. I have been privileged to have his expert editorial suggestions, to enjoy his enthusiastic leadership, and to benefit from his professional management. Myles's colleagues at Wiley have cooperated
with me in every way possible from start to finish. Everett Sims's copyediting helped me to make sense where there was confusion, while his
masterful use of the scalpel exorcised a great deal of fluff in the manuscript without harm to the content below.
A few people rendered assistance far beyond the call of duty. I owe
a special debt to Peter Dougherty for his countless inestimable comments and suggestions. Mark Kritzman was a tireless pilot through the
shoals of mathematical and statistical treatments. Richard Rogalski and
his associates at the Baker Library at Dartmouth saved me untold hours
by making their facilities available to me at long distance; Rich's good
humor and eagerness to help added to the joy of having his generous
assistance. Martin Leibowitz bestowed a gift of immensely valuable
material that has enriched the content of the book. Richard and Edith
Sylla were indefatigable investigators at points where the going was the
roughest. Stanley Kogelman furnished me with a priceless tutorial in
probability analysis. Leora Klapper served as an ideal research assistant:
indefatigable, enthusiastic, thorough, and prompt.
Molly Baker, Peter Brodsky, Robert Ferguson, Richard Geist, and
William Lee were good enough to read segments of early versions of
the manuscript. They gave me the running start I needed in order to
transform rough drafts into a finished material.
The following people also made significant contributions to my
work and warrant my deepest appreciation: Kenneth Arrow, Gilbert
Bassett, William Baumol, Zalmon Bernstein, Doris Bullard, Paul
Davidson, Donald Dewey, David Durand, Barbara Fotinatos, James
Fraser, Greg Hayt, Roger Hertog, Victor Howe, Bertrand Jacquillat,
Daniel Kahneman, Mary Kentouris, Mario Laserna, Dean LeBaron,
Michelle Lee, Harry Markowitz, Morton Meyers, James Norris, Todd
Petzel, Paul Samuelson, Robert Shiller, Charles Smithson, Robert
Solow, Meir Statman, Marta Steele, Richard Thaler, James Tinsley, Frank Trainer, Amos Tversky,*
and Marina von N. Whitman.
Eight people generously undertook to read the manuscript in its
entirety and to give me the benefit of their expert criticisms and suggestions. Each of them, in his own way, deserves major credit for the
quality of the content and style of the book, without bearing any
responsibility for the shortcomings it contains. Here they are: Theodore
Aronson, Peter Brodsky, Jay Eliasberg, Robert Heilbroner, Peter
Kinder, Charles Kindleberger, Mark Kritzman, and Stephen Stigler.
I end with a note of thanks to my late parents, Allen M. Bernstein
and Irma L. Davis, who inspired much of the enthusiasm that went into
the creation of this book.
PETER L. BERNSTEIN
AGAINST
THE GODS
hat is it that distinguishes the thousands of years of history
from what we think of as modern times? The answer goes
way beyond the progress of science, technology, capitalism,
and democracy.
The distant past was studded with brilliant scientists, mathematicians, inventors, technologists, and political philosophers. Hundreds of
years before the birth of Christ, the skies had been mapped, the great
library of Alexandria built, and Euclid's geometry taught. Demand for
technological innovation in warfare was as insatiable then as it is today.
Coal, oil, iron, and copper have been at the service of human beings for
millennia, and travel and communication mark the very beginnings of
recorded civilization.
The revolutionary idea that defines the boundary between modern
times and the past is the mastery of risk: the notion that the future is
more than a whim of the gods and that men and women are not passive before nature. Until human beings discovered a way across that
boundary, the future was a mirror of the past or the murky domain of
oracles and soothsayers who held a monopoly over knowledge of anticipated events.
This book tells 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 modem Western society. Like Prometheus, they defied
the gods and probed the darkness in search of the light that converted
the future from an enemy into an opportunity. The transformation in
attitudes toward risk management unleashed by their achievements has
channeled the human passion for games and wagering into economic
growth, improved quality of life, and technological progress.
By defining a rational process of risk-taking, these innovators provided the missing ingredient that has propelled science and enterprise into the world of speed, power, instant communication, and sophisticated finance that marks our own age. Their discoveries about the nature of risk, and the art and science of choice, lie at the core of our modern market economy that nations around the world are hastening to join. Given all its problems and pitfalls, the free economy, with choice at its center, has brought humanity unparalleled access to the good things of life.
The ability to define what may happen in the future and to choose among alternatives lies at the heart of contemporary societies. Risk management guides us over a vast range of decision-making, from allocating wealth to safeguarding public health, from waging war to planning a family, from paying insurance premiums to wearing a seatbelt, from planting corn to marketing cornflakes.
In the old days, the tools of farming, manufacture, business management, and communication were simple. Breakdowns were frequent, but repairs could be made without calling the plumber, the electrician, the computer scientist-or the accountants and the investment advisers. Failure in one area seldom had direct impact on another. Today, the tools we use are complex, and breakdowns can be catastrophic, with farreaching consequences. We must be constantly aware of the likelihood of malfunctions and errors. Without a command of probability theory and other instruments of risk management, engineers could never have designed the great bridges that span our widest rivers, homes would still be heated by fireplaces or parlor stoves, electric power utilities would not exist, polio would still be maiming children, no airplanes would fly, and space travel would be just a dream.*
Without insurance in its many varieties, the death of the breadwinner would reduce young families to starvation or charity, even more people would be denied health care, and only the wealthiest could afford to own a home. If farmers were unable to sell their crops at a price fixed before harvest, they would produce far less food than they do.
If we had no liquid capital markets that enable savers to diversify
their risks, if investors were limited to owning just one stock (as they
were in the early days of capitalism), the great innovative enterprises
that define our age-companies like Microsoft, Merck, DuPont, Alcoa,
Boeing, and McDonald's-might never have come into being. The
capacity to manage risk, and with it the appetite to take risk and make
forward-looking choices, are key elements of the energy that drives the
economic system forward.
The modern conception of risk is rooted in the Hindu-Arabic
numbering system that reached the West seven to eight hundred years
ago. But the serious study of risk began during the Renaissance, when
people broke loose from the constraints of the past and subjected longheld beliefs to open challenge. This was a time when much of the
world was to be discovered and its resources exploited. It was a time of
religious turmoil, nascent capitalism, and a vigorous approach to science and the future.
In 1654, a time when the Renaissance was in full flower, the
Chevalier de Mere, a French nobleman with a taste for both gambling
and mathematics, challenged the famed French mathematician Blaise
Pascal to solve a puzzle. The question was how to divide the stakes of an
unfinished game of chance between two players when one of them is
ahead. The puzzle had confounded mathematicians since it was posed
some two hundred years earlier by the monk Luca Paccioli. This was the
man who brought double-entry bookkeeping to the attention of the
business managers of his day-and tutored Leonardo da Vinci in the
multiplication tables. Pascal turned for help to Pierre de Fermat, a lawyer
who was also a brilliant mathematician. The outcome of their collaboration was intellectual dynamite. What might appear to have been a seventeenth-century version of the game of Trivial Pursuit led to the
discovery of the theory of probability, the mathematical heart of the concept of risk.