Bernstein on Risk Management

This week, I discovered Peter L. Bernstein, the author of Against the Gods: The Remarkable Story of Risk. He passed away on June 5th at 90. Bernstein, like Peter Drucker, who also passed away in his nineties about a year ago, is from a generation of thinkers with a breadth and depth of perception and comprehension in their thinking that amazes me. Coming from the old school, they never forgot their humanity and that of others, recognizing the limits to how mechanical and mathematical models can measure or direct the actions of men. Their thinking is more relevant today than ever in the light of the global financial crisis we are facing.

I’ve taken the opportunity to put into words portions of the McKinsey Quarterly video where Bernstein discusses the “meaning of risk and explains why sophisticated mathematical models to control it sometimes go awry, ” Do listen to Bernstein as he talks about the history of risk and how it works in real-world markets and in our lives. Some very big ideas here.

What is risk?

When you think about risk, it essentially says we don’t know what is going to happen. Risk means more things can happen and will happen. It’s a range of outcomes and we don’t know where it’s going to fall within that range. Often we don’t even know what the range is.

It’s an interesting thought when you realy sit down and think about it. First of all it means good things can happen as well as bad things. Instinct says we are in danger, it doesn’t. It just means we are in this unknown, this uncertainty.

I believe with a passion this statement that we don’t know what the future holds. It’s easy to say, a lot of people give it lip service but they go on acting as if they do know. I think this is such a big overwhelming idea about life that we walk every moment into the unknown.

If things happen differently from the way we expected, the way we anticipated or plan that doesn’t mean you are a fool, that’s in the nature of life. if you don’t know what’s going to happen, you don’t know what’s going to happen, so mistakes are an inevitable part of the process.

What risk management really means things are going to be different from what we expect from time to time and how well prepared are we to deal when it’s different.

Foundations of Modern RM
Starting in the post war years, after world war two people began to think in a more sophisticated fashion about risk. Something more than probability. You can begin to think of risk as a set of scenarios, that if you try to put some kind of handle on the different outcomes that might happen with the recognition that you never get a 100% of it, you begin to think in a more systematic fashion, just in the sense of the normal curve, where events might fall. It give a big leg up on if you are wrong, how far wrong are you going to be and what the consequences are.

Harry Markowitz, who won the first noble prize in finance, in 1952, used finance as a framework in thinking about trade-offs. He said in investing you have to think about risk as well as return. To me this is a thunderbolt of a statement. People in Wall Street didn’t like to be told this. They didn’t like mathematical models. They don’t like to think about equilibrium or efficiency because they believed they know so much that it is easy to beat the market. Intellectually, it was repulsion rather than acceptance.

After the experience of the 1970s, everybody turned out to be wrong, from the president of the US to head of the Federal Reserves. It was much more humility. Only in very recent years in finance, things have become more formalized, less seat in the pants. Resistance to thinking about risk in a more systematic manner will diminish. I just think it’s in the nature of the process. Sometimes these things are helped by a crisis. The !970s certainly changed everybody’s view about the financial markets. 99% of the people were wrong.

I’ve been fascinated why was probability was developed in the 1640s, and then it set the world on fire. But in the 1640s people were beginning to understand that human beings could control their outcomes. Although God was up there, we had some degree of free will. If I have free will how do I exercise this. Exposure to financial instruments of all kinds also gives a sense that there were a lot of different opportunities that I can use but how do I use them, how do I begin to apply them.

Options and the Price of Waiting
An option gives you the right but not the obligation to respond to a change in the scene. It’s very helpful as a hedge for a modest cost. You have an opportunity but you don;t have to take it. At the heart of options is waiting.

Suppose I have decided to wait, and I can afford to wait, what is worth to me to have the additional information, more opportunity to think it through, can I do it better. This is a big idea. Business people intuitively done that for a long time but this a way using option pricing, which is essentially is the function of the degree of uncertainty in the outcome, using that to put a value on waiting, this is a stupendous idea. The kind of option we talk about in the business world is contrasted to the option in the financial world called a real option because it involves real decisions. This is my passion, is still cutting edge stuff. A lot of people not using this framework who could use it are because it helps you make big decisions, irreversible decisions in the face of uncertainty. So want all the tools that you can bring to irreversible decisions.

Risk in Everyday Life
The cockroach has a course risk management system. At the first sight of danger it runs like hell. Clearly there are things where course decision making process is more important than a model or something that has been tested under data. There is a large area of stuff that we don’t know and we will never will know. We do our best. The interesting question is not how you are going to find out what that is and you can’t by definition, but how you deal with it when it happens.

The Limits of Risk Models.
Long Term Capital Management (LTCM) which was probably the primary example of high powered mathematical modeling by people who were geniuses in the bond market, they developed very elegant models for taking risk in the bond market and every kind of risk management thing you can think of. The only thing that they forgot was that all of those models were based on a world that LTCM did not exist… Too much dependence on the math, you lose sight of the dynamics, you lose sight of the world that we move and it’s a complex system.

Video interview with Peter L. Bernstein on risk management by McKinsey Quarterly .


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