Against the Gods by Peter L. Bernstein

Against the Gods by Peter L. Bernstein

Author:Peter L. Bernstein [Bernstein, Peter L.]
Language: eng
Format: epub
Published: 2011-05-23T21:50:00+00:00


'p to now, our story has focused on theories about probability and on ingenious ways of measuring it: Pascal's Triangle, Jacob Bernoulli's search for moral certainty in his jar of black and white balls, Bayes's billiard table, Gauss's bell curve, and Galton's Quincunx. Even Daniel Bernoulli, delving for perhaps the first time into the psychology of choice, was confident that what he called utility could be measured.

Now we turn to an exploration of a different sort: Which risks should we take, which risks should we hedge, what information is relevant? How confidently do we hold our beliefs about the future? In short, how do we introduce management into dealing with risk?

Under conditions of uncertainty, both rationality and measurement are essential to decision-making. Rational people process information objectively: whatever errors they make in forecasting the future are random errors rather than the result of a stubborn bias toward either optimism or pessimism. They respond to new information on the basis of a clearly defined set of preferences. They know what they want, and they use the information in ways that support their preferences.

Preference means liking one thing better than another: tradeoff is implicit in the concept. That is a useful idea, but a method of measuring preferences would make it more palpable.

That was what Daniel Bernoulli had in mind when he wrote his remarkable paper in 1738, boasting, "It would be wrong to neglect [his ideas] as abstractions resting upon precarious hypotheses." Bernoulli introduced utility as the unit for measuring preferences-for calculating how much we like one thing more than another. The world is full of desirable things, he said, but the amount that people are willing to pay for them differs from one person to another. And the more we have of something, the less we are willing to pay to get more.1

Bernoulli's concept of utility was an impressive innovation, but his handling of it was one-dimensional. Today, we recognize that the desire to keep up with the Joneses may lead us to want more and more even when, by any objective standard of measurement, we already have enough. Moreover, Bernoulli built his case on a game in which Paul wins the first time Peter's coin comes up heads, but Paul loses nothing when Peter's coin comes up tails. The word "loss" does not appear in Bernoulli's paper, nor did it appear in works on utility theory for another two hundred years. Once it had appeared, however, utility theory became the paradigm of choice in defining how much risk people will take in the hope of achieving some desired but uncertain gain.

Still, the power of Bernoulli's concept of utility is evident in the way his insights into "the nature of man" continue to resonate. Every advance in decision-making theory and in risk evaluation owes something to his efforts to provide definition, quantification, and guides to rational decisions.

One might expect, as a result, that the history of utility theory and decision-making would be dominated by Bernoullians, especially since Daniel Bernoulli was such a well-known scientist.



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