Against the Gods, P. Bernstein: book review

Against the Gods by Peter Bernstein

I thoroughly enjoyed this book. It is a history of risk management from ancient Greek thought, through Bernoulli, to modern quants innovators such as Markowitz and behavioural finance analysts such as Khaneman and Tversky. The style is very easy with no mathematics. Its an outline of the problems in risk management and the people involved.

Bernstein argues that many of the risk management innovations are essential to our development. “The central theme of this whole story is that the quantitative achievements … shaped the trajectory of progress over the past 450 years”. Nevertheless he gives the following warning regarding modern practice (p.336):

Nothing is more soothing or more persuasive than the computer screen, with its imposing arrays of numbers, glowing colors, and elegantly structured graphs. 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. Those who live only by the numbers may find that the computer has simply replaced the oracles to whom people resorted in ancient times for guidance in risk management and decision-making.

One common assumption is in using past data to build models:

We cannot enter data about the future into the computer because such data are inaccessible to us. So we pour in data from the past to fuel the decision-making mechanisms created by our models … past data from real life constitute a sequence of events rather than a set of independent observations, which is what the law of probability demands.

This is not to suggest we should not do this, but that we are careful when we do and that we ensure our models are robust. As Bernstein concludes

At the same time, we must avoid rejecting numbers when they show more promise of accuracy than intuition and hunch.

Ultimately, without risk management methods we would not have the tools to manage our increasingly complex financial decisions.