Facing the Consequences

Business Economics, Jan, 2000 by Peter L. Bernstein

RISK IS MORE ABOUT HOW WE MAKE BUSINESS DECISIONS AND OUR BASIC VISIONS OF THE WORLD THAN IT IS ABOUT MATH.

Although the achievements over the past three hundred and fifty years in the measurement of risk are extraordinary intellectual leaps, these mathematical innovations are merely instruments. Risk is about how we make decisions and only incidentally about the math we employ to reach those decisions. The consequences of our decisions must always dominate the probabilities. Leibniz taught us that no model has an [R.sup.2] of 1.00--so beware of those who tell us we know more about the long run than the short run. And finally, the way we make decisions reflects our most basic philosophical assumptions of what life is all about.

As this is the third anniversary of the publication of Against the Gods, I thought it might be an appropriate moment to look back at the history of risk and all those brilliant ideas from the perspective of the intensely risk-conscious world of today. There can be no doubt that the subject is alive and well. Risk is a much hotter topic than it was when I first began my research in this area some seven years ago.

My sense of what was most important in this story has changed with the passage of time. When I wrote the book, I was fascinated with the mathematical discoveries--probability, the normal curve, sampling, regression to the mean, and mean/variance, among others. I found myself mesmerized by the way that these remarkable innovations seemed to bubble up almost out of nowhere in the minds of strange and often very neurotic people to form the foundation of today's science of risk management. Their achievements were extraordinary intellectual leaps that transformed the way we see the world and the way we respond to it.

On the other hand, these mathematical innovations are only tools, mere instruments to be employed in the search for a much more exciting objective. Risk is about how we make decisions, and only incidentally about the math that we employ to reach those decisions. Knowing how it works is just the beginning. Knowing how to use these tools is the introduction to wisdom. And that is no easy task.

At its roots, risk is about mystery. It focuses on the unknown, for there would be no such thing as risk if everything were known. Pascal himself, the father of probability, touched the heart of the matter in his wager: God is or God is not. "Which way should we incline?" Pascal asks. And then he puts the clincher on the matter when he states: "Reason cannot answer." That is what life is all about: dealing with problems to which there is no certain solution and where any kind of rational decision is often impossible to define.

Today's obsession with risk management focuses too intently on the instruments of the management and measurement of risk. The more we stare at the jumble of equations and models the more we lose sight of the mystery of life. All too often, reason cannot answer. Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.

The theme that I want to emphasize here is the dominance of decision making over the analysis of probability. I am going to explore these matters from three points of view: Pascal's wager as the ideal model for making decisions, the impact of time on decisions, and an exploration into the sources of uncertainty, which lead us to philosophical and moral issues that illuminate the same theme.

The purpose of Pascal's examination of the question of whether God exists was to reveal the dominating importance of decision making. Pascal differentiates between decision and belief. You cannot wake up one morning and decide, "Today I will believe in God," or "Today I will decide not to believe in God." You believe or you do not believe--that is in your gut, not your head. How you behave in life, however, is a decision that you can make. You can act as though God is or act as though God is not, no matter how you believe.

The issue is what happens if your choice is wrong. Suppose you act as though God is and lead a life of virtue and abstinence when in fact there is no God. You will have passed up some pleasant goodies in life, but there will be rewards as well. On the other hand, suppose you act as though God is not and lead a licentious and hedonistic life when in fact God is. You may have had lots of fun during the relatively brief duration of your lifetime, but you will spend eternity in Hell. If you care about consequences, you must decide to act as though God is, whether you believe it or not. By the time we find out whether God is or God is not, it will be too late. The risk of deciding that God is not has consequences that are intolerable.

Even when we know the probabilities of an outcome, that knowledge is insufficient. Try reassuring a nervous flier by reciting the tiny probability of an airplane crash. Or try to use the laws of probability to dissuade a gambler from betting all his chips on double-zero. The expected utility of an outcome seldom equals the mathematical expectation of that outcome.