Against The Gods

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Pre 1200: Beginnings

  • Probability and risk was borne out of gambling

  • It begun in Greece, when their philosophers were at the forefront of intellectual discussion

  • Counting and numbers were needed before probability could be known

  • Fibonacci and his series

  • The golden ratio

  • The abacus

  • The number system was developed by hindus

  • The centrepeice of the hindu number system was the invention of the number 0

1200 – 1700: A Thousand Outstanding Facts

The Renaissance Man

  • Girolamo Cardano

    • Extracted the first ideas of probability from gambling

    • Was also a gambling addict

    • Did a lot of work on combinations of numbers

  • Luca Paccioli

    • Came up with the “problem of Balla”, in which two players are playing a game of balla and it is cut short.

    • The question is, how do you divide the pot among the two players?

    • Evenly? But what about the player who is clearly winning?

    • How much more should you give the winning player?

The French Connection

  • Blaise Pascal & Pierre de Fermat

  • Spoke about Paccioli’s problem of Balla

  • How should the pot be split?

  • Very famous sets of letters were echanged between them

  • Pascals triangle

  • Pascals wager

    • If hell is as bad as it is described and heaven as good, then no matter how small the probability of it being real, you should beleive just in case

    • This is a probabilistic view of religion

The Remarkable Notions of the Remarkable Notions Man

  • Invariance

  • Demographic data

  • John Graunt’s “observations”

    • Compiled insurance data

    • Aggregated the first “statistics”

  • Edmund Halley’s “Life tables”

    • Predicted the occurence of a comet (Halley’s comet)

    • Created an age distribution of the population

  • Edward Lloyd’s coffee house -> Lloyds of london

1700 – 1900: Measurement Unlimited

Considering the nature of man

  • Daniel Bernoulli (Jacob’s nephew)

  • Utility theory (thinking of utility as a function of value)

  • St Petersberg paradox

  • Human Capital

  • Loss aversion

  • Differing levels of risk aversion

  • “Exposition of a new theory of the measurement of risk”

The Search for Moral Certainty

  • Jacob Bernoulli

  • Abraham de Moivre (first observed and documented the bell curve)

  • Thomas Bayes

  • Moral certainty = Statistical Significance

  • Inference & Bayes’ theorem

  • Assumes that events happening in the future will follow the same pattern (distribution) as in the past

  • Law of large numbers (Jacob Bernoulli)

The Supreme Law of Unreason

  • Carl Freidrich Gauss

    • Built on de Moivres observations of the bell curve

  • Marquis Laplace

  • Bell curve

  • Stock market randomness

  • Independence <–> Normal distirbution

The Man with the Sprained Brain

  • Francis Galton

    • Obsessed with measurement

  • Lambert Quetelet

  • The “average man” (L’homme moyen)

  • Regression to the mean

  • Average (“standard”) deviations

  • Correlation

Peapods and Perils

  • Regression to the mean

  • Stock market overrreaction

  • Dangers of expecting regression to the mean all the time

  • What mean should be regressed to?

    • At what point has normal shifted to a new location?

The Fabric of Felicity

  • Utility

  • Which risks should be taken?

  • Preferences and tradeoffs

  • Daniel Bernoulli -> Jeremy Bentham -> William Jevons

    • Bernoulli built the groundwork

    • Bentham invented utility theory

    • Jevons built on it

1900 -> 1960: Clouds of Vagueness and the Demand for Precision

The Measure of our Ignorance

  • Louis Bachalier: The theory of speculation

  • Acceptance of uncertainty

  • Birth of risk management

  • Kenneth Arrow

  • Practicality is introduced

  • Risk management becomes more pragmatic

  • There is so much randomness that nothing can be that precise

    • The gravitational pull of an electron in the milky way can affect a game of billiards on earth

The radically distant notion

  • Frank Knight

  • John Maynard Keynes

  • Moving away from probablity theory and toward practical applications and risk

  • Historical evidence cannot predict the future

  • Keynes: Intervention from government removes uncertainty

The Man who counted everything except calories

  • John von Neuman

  • Game theory

  • Oskar Morgenstern

  • Rationality

  • Other’s decisions as the cause of uncertainty

The Strange Case of the Anonymous Stockbroker

  • Harry Markowitz: Optimal portfolio selection

  • William Sharpe: CAPM model

  • Max return sub to risk

  • Min risk sub to return

  • Variance may not be a good proxy for risk

Degrees of Beleif: Exporing Uncertainty

The failure of invariance

  • Kahnemen and Tversky

  • Prospect theory

  • Behavioural biases: Humans dont always act rationally

  • Loss aversion

  • Ambiguity aversion

  • Paradox of choice

  • Experimental economics

The Theory Police

  • Behavioural biases

    • Decision regret

    • Loss aversion

    • Risk aversion

    • Endowment effect

  • Market rationality

  • Market efficiency

  • Risk management in the 1970s

  • DeBondt & Thaler

The Fantastic System of Side Bets

  • Derivatives (financial options) reallocate risk

  • Black Scholes Merton model

  • Volatiliy & risk vs direction

  • 1987 portfolio insurance crash

    • Aimed to replicate a put option

    • Sold stock on way down

    • Bought as it came back up

    • Problem was too many people were doing in, so as stock prices began to go down they crashed really fast

  • 1990s companies speculating in derivatives

    • P & G

Awaiting the wildness

  • The future of risk management

  • Models of the future

    • Chaos theory

    • Neural networks

    • Genetic algorithms

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