Against the Gods: The Remarkable Story of Risk

THE THE REMARKABLE STORY OF RISK

PETER 1. BERN STEIN

JOHN WILEY & SONS, [Ne. New York· Chichester. Weinheim • Brisbane· Singapore· Toronto

This text is printed on acid-free pape r_

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Copyright 0 1996, 19911 by Pe ter L. Benutein. All rights reserved _ Published by John Wiley & Sons, Inc. P\lblisned ~hn\lka.neQ\ltiy in CanaCanning Ot otheJWue, except as permitted \lnder Section 107 Ot 1011 ()fthe 1976 United SUtts Copyri ght Act, without dther the prior written permission of the Pu blishe r, or author_ iution th rough payment of the appropriate per-copy fee to th e Copyright Clearance Center, 222 Rosewood Drive , D anve rs, MA 0 1923, (978) 750-11400, f.tx (978) 7504744. R.equ ests to the Publisher for pumission should be ad dressed to the Pennissions Deputment,Jo hn W iley & Som, Inc., 605 T hird Avenue, New York, NY 10158-0012, (21 2) 1150-6011, fax (212) 850-60011, E-Mail: PERMREQ@ WlLEY .COM. This publicadon is designed to provide accunte and au thont:uive information in regird to me subject matter cove red. It is sold with the understanding that the publisher is not engaged in rendering professional serviceS. If professional advic e or other expert :usisrance is reqU ired, the services of a competent profes.siom.1 person should be sought.

Bernnein, Peter L. A8'in1! the gods: The remarkable story of risk/Perer L. Bernstein, p. cm. Indudes bibliographical references 1nd index. ISBN Ow471-29563 _9 (paper) 1. R isk Mam.gement. 2, DeCision-making. I. Title. HD61 . B~66b 19% 368--dc20 96-33861 Printed in the U nited States of America

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For Peter Brodsky

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Contents Acknowledgments

IX

1

Introduction

TO 1200: BEGINNINGS 1.

2.

The Winds of the Greeks and the Role of the Dice As Easy as I, n , III

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1200-1700: A THOUSAND OUTSTANDING FACTS 3. 4. 5.

The Renaissance Gambler The French Connection T he Remarkable Notions of the Remarkable Notions Man

39 57 73

1700-1900: MEASUREMENT UNLIMITED 6. 7. 8.

Considering the Nature of Man The Search for Moral Certainty The Supreme Law of Unreason

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99 116 135

Contents

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9. 10. 11.

The Man with the Sprained Brain Peapods and Perils The Fabric of Felicity

152 172 187

1900-1960, CLOUDS OF VAGUENESS AND THE DEMAND FOR PRECISION 12.

13. 14. 15.

The Measure of Our Ignorance The Radically Distinct Notion The Man Who Counted Everything Except Calories The Strange Case of the Anonymous Stockbroker

197 215 231 247

DEGREES OF BELIEF, EXPLORING UNCERTAINTY 16. 17. 18. 19.

The Failure of Invariance The Theory Police The Fantastic System of Side Bets Awaiting the Wildness

Notes Bibliography Name Index Subject Index

269 284 304 329 339 353 365 369

Acknowledgments 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 cask he had in mind, I soon discovered, as I had feared, that risk does not begin and end on the £loor 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, chat 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.

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Acknowledgments

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 crus whole project made aJJ 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 w ithout 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 bes(Qwed 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 [he 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 transfonn 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 H owe. Bertrand Jacquillat, Daniel Kahneman. Mary Kentouris, Mario Laserna, Dean LeBaron, Michelle Lee, Harry Markowitz, Morton Meyers,james Norris. Todd Petzel , Paul Samue1son, Robert Shiller. Charles Smithson, Robert

Acknowledgments

Solow, Meir Statrnan, Marta Steele. Richard Thaler, James Tinsley, Frank Trainer, Amos Tversky, * and Marina van N. Wbitman. 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, Robe« Heilbroner, Peter Kinder, Charles Kindleberger, Mark Kritzman, and Stephen Stigler. I end with a note of thanks to my late parents. AlIen M. Bemstein and Irma 1. Davis. who inspired much of the enthusiasm that went into the creation of this book. PETER

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BERNSTEIN

"Amo$ TVenky, who pb)'1 an important role in Chapten 16 and 17, died unexpectedly just as this book wu about to go into print.

AGAINST THE GODS

Introduction

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hat is it that distinguishes the thousands of years of history from what we think of as modem 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 conununication mark the very beginnings of recorded civilization. The revolutionary idea that defines the boundary between modem 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 soothsayer.; 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 modern 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 oflife, and technological progress.

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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 [0 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 whafmay 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 waglng 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 const:lntly 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 pador 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 fanners were unable to sell their crops at a price fixed before harvest, they would produce far less food than they do. 'The scientist who developed the Saturn 5 rocket that bunched the tint Apollo mi~ion to the moon put it this way: "You want a valve that doesll't leak and you try everything possible to develop one. But the real world provides you with a leaky valve. You have to detennine how much leaking you can tolente." (Obiwary of Arthur Rudolph, in The New York TimeJ, January 3, 1996.)

Introduction

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If we had no liquid capital markets that enable savers to diversift 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 modem 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 tunTIoil, 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 cla Vinci in the multiplication tables. Pascal turned for help to Pierre de Femut, 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 che discovery of the theory of probability, the mathematical heart of the concept of risk. Their solution to Paccioli's puzzle meant that people could for the first time make decisions and forecast the future with the help of numbers. In the medieval and ancient worlds, even in preliteI