
THE CLOSEST THING TO A CRYSTAL BALL
AGAINST THE GODS Against the Gods sets up an ambitious premise and then delivers on it. This is a lively, panoramic book that includes tales of everyone from Omar Khayyam to Florence Nightingale to Daniel Ellsberg. Khayyam, the poet, was also a mathematician. Nightingale, the nurse, once offered to fund a chair in applied statistics at Oxford University. And Ellsberg, the Defense Dept. analyst who leaked the Pentagon Papers, specialized in the behavioral psychology of risktaking. Bernstein argues that the mastery of risk is what divides modern from ancient times. The ancient Greeks, for example, adept as they were with numbers, regarded mathematics as belonging to a higher plane, unsuited for the messiness of daily life. Amazingly, Bernstein says of dicerolling: ``Though people played these games with insatiable enthusiasm, no one appears to have sat down to figure the odds.'' Anyone who did would have cleaned up. Someone who did try to clean up is Bernstein's first hero, Girolamo Cardano, a Milanese born around 1500 who was not only a famous physician but a compulsive gambler. His vice led to his greatest achievement: publishing the first serious work to lay out the statistical principles of probability. From then on, things happened quickly. Over the years, the field of risk attracted such giants as Galileo, Pascal, Newton, Gauss, Poincare, von Neumann, and Keynes. All of them come alive here. Blaise Pascal, for instance, is remembered as a religious philosopher. But as a youthful mathematician, he teamed up with Pierre de Fermatfamed for the mathematical puzzle known as Fermat's last theoremon a solution to an old conundrum: how to divide the stakes of an uncompleted gambling game. With its implications for prediction in other fields, Bernstein says, Pascal and Fermat's solution became ``the cornerstone of modern insurance and other forms of risk management.'' Confidence in probability and statistics reached a highwater mark in the Victorian era. By the 20th century, confidence waned a bit. Longrun averages aren't always helpful, John Maynard Keynes famously observed, because ``in the long run, we are all dead.'' Next to take a crack at risk were game theorists, led by John von Neumann, the midcentury genius of bombmaking and computing. Game theory presented life as a contest in which people seek to maximize rewards and minimize riskswhile others do the same, often with conflicting objectives. Many game theorists repeated a mistake of the Victorians, by having too much faith that human behavior could be modeled mathematically. Still, their insight paved the way for modern portfolio theory, which says diversification reduces risk. Harry Markowitz put forth the theory at age 25 in a 1952 paper in the Journal of Finance. Bernstein brings Against the Gods up to the present with an account of how some skeptical researchersbeginning with the Israeliborn psychologists Amos Tversky and Daniel Kahneman in the 1950strashed the classical model of rationality by exploring how people actually behave in risky situations. The bottom line: People behave irrationally, even when they know they are doing so. Bernstein relates an anecdote about a distinguished Soviet professor of statistics who showed up at an airraid shelter during a German bombardment. Until then, he had scoffed at the prospect of being hit. What changed his mind? ``Look,'' he explained. ``There are 7 million people in Moscow and one elephant. Last night, they got the elephant.'' Like Girolamo Cardano, Bernstein himself is a Renaissance man. He's not only an authorAgainst the Gods is his sixth bookbut a working Wall Street economist who consults for institutional investors and companies. Against the Gods is loaded with tidbits of modern economic research and war stories from Bernstein's 40year career, which makes for an enchanting blend of history and investment advice. Bernstein clearly relishes this stuff. In a chapter on derivatives, he devotes two pages to describing an intricate ``cotton loan'' issued in 1863 by the Confederacy. Then, he launches into the principles behind the model for the proper pricing of options that was developed in the 1960s by Fischer Black, Myron Scholes, and Robert C. Merton. After the early chapters, there's not much here outside of finance, which is clearly Bernstein's main interest. Even within finance, Bernstein gives short shrift to important topics such as Monte Carlo analysis, which uses computergenerated random numbers to solve intractable problems. But that's O.K. Bernstein covers plenty of ground as it is. And he does so with the verve of someone who has lived his subject.
By Peter Coy

Updated June 14, 1997 by bwwebmaster
Copyright 1996, Bloomberg L.P.
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