When risk gives way to superstition

By Giles Fraser
October 12, 2009

Back in 1996, the economic his­torian Peter Bernstein published Against the Gods: The remarkable story of risk (Wiley & Sons). It won a heap of prizes and sold more than half a million copies — no mean feat for a book about mathematical history.

Its cover shows a ship being tossed by the waves. The message was simple: whereas once we used to be superstitious and pray for a success­ful outcome to risky ventures, now we can predict and mitigate risk with appropriate mathematical modell­ing — hence, against the gods.

How differently this book reads today. Just over a year ago, Wall Street’s oldest bank, Lehman Brothers, collapsed, having leveraged itself 40 times over in the search for massive profits. The story can be told in many different ways. For some, it is a simple tale of greed and hubris. For some, it is about the failure of the regulatory system. But it is also a story of misplaced faith in math­ematical modelling.

Bernstein’s book tells the story of how mathematicians set about un­der­standing games of chance, work­ing out probabilities, and eventually developing strategies to offset risk. In the 1970s, mathematicians at the University of Chicago applied their work to the stock market, showing how one risk could be offset against others.

Computers throughout the finan­cial world came to operate a math­ematical model known as VaR (value at risk), which balances risk across a port­folio, thus apparently control­ling and minimising risk.

With this sense of mathematical insurance, traders pitched into the casino with even greater enthusiasm. They felt untouch­able. They had calculations to underwrite their punter’s instincts. The unknown mysteries of the market had been tamed.

But then it all crashed. The hedge-fund manager (and world-class poker-player) David Einhorn called it right when he described VaR as “an airbag that works all the time, except when you have a car accident”. Mr Einhorn began to short sell Lehman Brothers stock months before it collapsed. He made a fortune.

This side of the Lehman collapse, Bernstein’s faith in mathematical modelling looks little more than hubris. The unknown cannot be so easily tamed. Any half-decent theo­logian could have told him that.

Yet, as the sneering title of his book indicates, he believed that faith in numbers could replace the theo­logian’s respect for the unknown.

It all seems so obvious now. But greed can easily blind people to common sense. The unknown cannot be made predictable by a sprinkling of math­ematical abracadabras.

Indeed, there is a word for that: superstition.


(c) Giles Fraser is Canon Chancellor of St Paul’s Cathedral. This article is adapted from his regular Church Times column, with acknowledgments.

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