Peter Bernstein: Against the Gods

Peter Bernstein's Against the Gods: The Remarkable Story of Risk (1996) is a fine read. It is a book that helps us better understand the games of chance and gain we play in capitalist economies. We also learn about key historical figures who have devoted their lives to better understanding these games. Bernstein continues his study in two latter books that I have not yet read, Capital Ideas and Capital Ideas Evolving (forthcoming). Finally, he gives us some insight into the problems with our new-found love affair (and/or "hate affair") with derivatives, hedge funds, risk concentration, and possible governmental regulation of such.

In the introduction Bernstein lets us know exactly why investment decision-making is both art and science:

…[T]he story I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future. This is a controversy that has never been resolved.

The issue boils down to one's view about the extent to which the past determines the future. We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on patterns of the past to tell us what the future will be like? Which matters more when facing a risk, the facts as we see them or our subjective belief in what lies hidden in the void of time? Is risk management a science or an art? Can we even tell for certain precisely where the dividing line between the two approaches lies? …

Our lives teem with numbers, but we sometimes forget that numbers are only tools. They have no soul; they may indeed become fetishes. Many of our most critical decisions are made by computers, contraptions that devour numbers like voracious monsters and insist on being nourished with ever-greater quantities of digits to crunch, digest, and spew back. …

Near the end of the book, Bernstein revisits his introduction: Here are a few highlights, (pp. 300-336):

Capital markets have always been volatile, because they trade in nothing more than bets on the future, which is full of surprises. … [E]veryone is as the mercy of everyone's else's expectations and buying power.

Such an environment provides a perfect setting for nonrational behavior; uncertainty is scary. If the nonrational actors in the drama overwhelm the rational actors in numbers and in wealth, asset prices are likely to depart far from equilibrium levels and to remain there for extended periods of time. Those periods are often long enough to exhaust the patience of the most rational of investors. …

[E]xplicit attention to invesment risk and to the tradeoff between risk and return is a relatively young notion. Harry Markowitz laid out the basic idea for the first time only in 1952 …. Academic interest speeded up during the 1960s, but it was only after 1974 that practitioners sat up and took notice. … [R]isk management became the biggest game in town. First came a major emphasis on diversification, not only in stock holdings, but across the entire portfolio, ranging from stocks to bonds to cash assets. … [T]he 1970s and 1980s gave rise to new uncertainties that had never been encountered by people whose world view had been shaped by the benign experiences of the postwar era. Calamities struck, including the explosion of oil prices, ….

Along with financial deregulation and a wild inflationary sleighride, the environment generated volatility in interest rates, foreign exchange rates, and commodity prices that would have been unthinkable during the preceding three decades. Conventional forms of risk management were incapable of dealing with a world so new, so unstable, and frightening. …

Fortuitously perhaps, impressive technological innovation coincided with the urgent demand for novel methods of risk control. Computers were introduced into investment management just as concerns about risk were escalating. Their novelty and extraordinary power added to the sense of alienation, but at the same time computers greatly expanded the capacity to manipulate data and to execute complex strategies. … [A] new age of risk management was about to open….

The Fantastic System of Side Bets

Derivatives are the most sophisticated of financial instruments, the most intricate, the most arcane, even the most risky. Very 1990s, and to many people a dirty word. …

Despite the mystery that has grown up about these instruments in recent years, there is nothing particularly modern about them. Derivative go back so far in time that they have no identifiable inventors. …

Combined with the risk-reducing features of diversification, the ingenuity of the financial markets has transformed the patterns of volatility in the modern age into risks that are far more manageable for business corporations than would have been the case [without derivatives and other recent innovations].

In 1994, a few of these apparently sound, sane, rational, and efficient risk-management arrangements suddenly blew up, causing enormous losses among the customers that the risk-management dealers were supposedly sheltering from disaster. …

There is no inherent reason why a hedging instrument should wreak havoc on its owner. On the contrary, significant losses on a hedge should mean that the company's primary bet is simultaneously providing a big payoff. …

These disasters in derivative deals among big-name companies occurred for the simple reason that corporate executives ended up adding to their exposure to volatility rather than limiting it. They turned the company's treasury into a profit center. They treated low probability events as being impossible. When given a choice between a certain loss and a gamble, they chose the gamble. They ignored the most fundamental principle of investment theory: you cannot expect to make large profits without taking the risk of large losses.

What are we to make of all this? Are derivatives a suicidal invention of the devil or the last word in risk management? Bad enough that fine companies … can get into trouble, but is the entire financial system at risk because so many people are trying to shed risks and slough them off onto someone else? How well can the someone else manage that responsibility? In a more fundamental sense, as the twentieth century draws to a close, what does the immense popularity of derivatives tell us about society's view of risk and the uncertain future that lies ahead? …

Awaiting the Wildness

…The past seldom obliges by revealing to us when wildness will break out in the future. … After the fact, however, when we study the history of what happened, the source of the wildness appears to be so obvious to us that we have a hard time understanding how people on the scene were oblivious to what lay in wait for them.

Surprise is endemic above all else in the world of finance. … [If events are] unpredictable, how can we expect the elaborate quantitative devices of risk-management to predict them? How can we program into the computer concepts that we cannot program into ourselves, that are even beyond our imagination? …

Finally, the science of risk management sometimes creates new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks that we would not otherwise take. On most counts that is beneficial, but we must be wary of adding to the amount of risk in the system.

And add systemic risk we have! Bernstein is only one of many who have so noted, and continue to warn: beware! See, in particular: Markowitz Bites Back: The Failure of CAPM, Compression of Risky Asset Spreads and Paths Back to Normalcy, by Vineer Bhansali, January 2007.