Book Review 353: Against the Gods

AGAINST THE GODS: THE REMARKABLE STORY OF RISK, By Peter L. Bernstein. 383 pages. Wiley paperback, $18.95.

When “Against the Gods” was published in 1996, it was taken seriously. Parts of it still can be, but subsequent events have turned Peter Bernstein’s thesis into a bad joke.

His idea is that over a period of around 800 years, men (no women) thinking about mathematical descriptions of events figured out how to manage risk for the good of all of us.

Only in the past generation, though, did they really nail it. Prior to that time, humans considered themselves at the mercy of fate or capricious deities — hence the title. These mathematicians showed how there are regularities and constraints that we can use to guide our planning. Good for them.

It began with gamblers trying to understand their chances. These chances are now very well understood, at least by those who understand them. The casinos are full of people who do not.

In the 19th century, the mathematicians began to try to understand far more complex systems, including those in which humans can make choices. The villain here was Francis Galton, who wildly overinterpreted some apparent regularities that appear across unrelated systems.

This is the reversion to the mean, and here is where Bernstein starts becoming ridiculous.  Especially as it is applied to markets, which was Bernstein’s job. He had a company that advised fund managers.

If you think about it, it is really hard to find examples of any system that reverts to its mean. Physical systems have to come to equilibrium, and the example of a balloon obeying the ideal gas laws is probably the favorite example.

But it is hard to find an example of a real physical system reverting to a mean; or even to define such a mean. Did the atmospheres of the Moon and Venus revert to a mean? Is a black hole a reversion to a mean?

The temperature of the Earth, which has not varied too much from its current value for nearly 4 billion years, is the only example I can think of.

Anyway, when it comes to stocks and other investments, Bernstein is downright comical. The price of tulip bulbs, for example. They went way up in the 17th century and then came down, which Bernstein says should not have surprised investors who got in late. But today I can buy a tulip bulb for a fraction of a fraction of a fraction of a penny of the 17th century price; the price is so low that it cannot be computed in terms that would mean anything to a resident of Amsterdam 400 years ago.

So what mean was that reverting to?

As Bernstein finished “Against the Gods,” two of the book’s heroes, Merton and Scholes, were advising a hedge fund, Long Term Capital Management, how to manage risk. By the time the paperback edition came out, LTCM was broke and, far from reducing overall risk, it was so big that it had manufactured global systemic risk that had not existed before.
In his summation, Bernstein does recognize the joker in the deck, although he fails to assign it its proper weight.

By the ‘90s, the people who thought they understood how to manage risk — and were paid immense amounts to do so — were in love with derivatives. Handicapping the first wave of disastrous derivatives in the early ‘90s, Bernstein opined:

“There is no inherent reason why a hedging instrument should wreak havoc on its owner. . . . 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 (once they noticed that hedges, which are a zero-sum game, sometimes yielded big gains).”

But nothing is more predictable than that managers in a free market system will do so. They have to, and everything in their ideology tells them they are right to do so.

Bernstein’s final pages are odd. After spending 300 pages telling us that risk has become scientifically manageable, for the benefit of all of us, he then describes how it hasn’t.

Long before the Bush Crash, the mortgage crisis in derivatives was brewing — it had nothing whatever to do with the Community Reinvestment Act — and here Bernstein did almost anticipate risk correctly. Though only in a footnote, he warned: “these mortgage-backed securities are complex, volatile, and much too risky for amateur investors to play around with.”

Too risky for the pros, too. I wonder what Peter L. Bernstein Inc. was advising its clients about mortgage-backed securities in 2006-7 or thereabouts. 

(I just realized that this Bernstein is the same idiot who wrote “Wedding of the Waters,” a ridiculous book about the Erie Canal. I wish I had connected the names sooner and not wasted my time on this silly book. On the other hand, Bernstein was in his time an influential popularizer of theories of investment, so it was useful to learn what doofus ideas Wall Street will buy.)