Risk As I See It

What is it that distinguishes the thousands of years of history from what we think of as modern times?  The answer goes way beyond the progress of science, technology, capitalism, and democracy.

The distant past was studded with brilliant scientists, mathematicians, inventors, technologists, and political philosophers.  Hundreds of years before the birth of Christ, the skies had been mapped, the great library of Alexandria built, and Euclid’s geometry taught.  Demand for technological innovation in warfare was as insatiable then as it is today.  Coal, oil, iron, and copper have been at the service of human beings for millennia, and travel and communication mark the very beginnings of recorded civilization.

The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk:  the notion that the future is more than a whim of the gods and that men and women are not passive before nature.  Until human beings discovered a way across that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events.

The ability to define what may happen in the future and to choose among alternatives lies at the hart of contemporary societies.  Risk management guides us over a vast range of decision-making, from allocating wealth to safeguarding public health, from waging war to planning a family, from paying insurance premiums to wearing a seatbelt, from planting corn to marketing cornflakes.

In the old days, the tools of farming, manufacture, business management, and communication were simple.  Breakdowns were frequent, but repairs could be made without calling the plumber, the electrician, the computer scientist or the accountants and the investment advisers.  Failure in one area seldom had direct impact on another.  Today, the tools we use are complex, and breakdowns can be catastrophic, with far-reaching consequences.  We must be constantly aware of the likelihood of malfunctions and errors.  Without a command of probability theory and other instruments of risk management, engineers could never have designed the great bridges that span our widest rivers, homes will still be heated by fireplaces or parlor stoves, electric power utilities would not exist, polio would still be maiming children, no airplanes would fly, and space travel would be just a dream.  Without insurance in its many varieties, the death of the breadwinner would reduce young families to starvation or charity, even more people would be denied health care, and only the wealthiest could afford to own a home.  If farmers were unable to sell their crops at a price fixed before harvest, they would produce far less food than they do.

If we had no other investment products than those bound to capital markets that enable savers to diversify their risks, if investors were limited to owning just one stock (as they were in the early days of capitalism), the great innovative enterprises that define our age; companies like Apple, Microsoft, Merck, DuPont, Alcoa, Boeing, and McDonald’s, might never have come into being. The capacity to manage risk, and with it the appetite to take risk and make forward-looking choices, are key elements of the energy that drives the economic system forward.

All the tools we use today in risk management and in the analysis of decisions and choice, from the strict rationality of game theory to the challenges of chaos theory, stem from the developments that took place between 1654 and 1760, with only two exceptions:

In 1875, Francis Galton, an amateur mathematician who was Charles Darwin’s first cousin, discovered regression to the mean, which explains why pride goeth before a fall and why clouds tend to have silver linings.  Whenever we make any decision based on the expectation that matters will return to “normal,” we are employing the notion of regression to the mean.

In 1952, Nobel Laureate Harry Markowitz, then a young graduate student studying operations research at the University of Chicago, demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or business manager can ever come to a free lunch.  That revelation touched off the intellectual movement that revolutionized Wall Street, corporate finance, and business decisions around the world; its effects are still being felt today.

The story of risk is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who based their decisions on more subjective degrees of belief about the uncertain future.  This is a controversy that has never been resolved.

The issue boils down to one’s view about the extent to which the past determines the future.  We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past.  But to what degree should we rely on the patterns of the past to tell us what the future will be like?  Which matters more when facing a risk, the facts as we see them or our subjective belief in what lies hidden in the void of time?  Is risk management a science or an art?  Can we even tell for certain precisely where the dividing line between the two approaches lies?

It is one thing to set up a mathematical model that appears to explain everything. But when we face the struggle of daily life, of constant trial and error, the ambiguity of the facts as well as the power of the human heartbeat can obliterate the model in short order.  The late Fischer Black, a pioneering theoretician of modern finance who moved from M.I.T. to Wall Street, said, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.”

Over time, the controversy between quantification based on observations of the past and subjective degrees of belief has taken on a deeper significance.  The mathematically driven apparatus of modern risk management contains the seeds of a dehumanizing and self-destructive technology.  Nobel laureate Kenneth Arrow has warned, “[O] ur knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness.  Vast ills have followed a belief in certainty.”  In the process of breaking free from the past we may have become slaves of a new religion, a creed that is just as implacable, confining, and arbitrary as the old.

Our lives teem with numbers, but we sometimes forget that numbers are only tools.  They have no soul; they may indeed become fetishes.  Many of our most critical decisions are made by computers, contraptions that devour numbers like voracious monsters and insist on being nourished with ever-greater quantities of digits to crunch, digest, and spew back.

The word “risk” derives from the early Italian risicare, which means “to dare.”  In this sense, risk is a choice rather than a fate.  The actions we dare to take, which depend on how free we are to make choices, are what risk is all about.  And that helps to define what it means to be a human being.

Antonio De Falco
Co-Chairman of DENU Realty Group