Bernstein - Risk: The Hottest Four-Letter Word in Financial...

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10 x SEPTEMBER 2006 ©2006, CFA Institute x cfa pubs .org Risk: The Hottest Four-Letter Word in Financial Markets Peter L. Bernstein President Peter L. Bernstein, Incorporated New York City nvesting is unlike many other fields of endeavor because uncertainty is lodged in its heart. When we think we know the future, we are setting ourselves up for trouble. Trends are not destiny. We are no more able to extend smooth lines into the future than a sailor can observe what lies ahead on a choppy sea. The safest risk management system is to view uncer- tainty as a constant rather than a variable and to take those variables out of the measurement system. Bill Sharpe recently said that, in general, it is dangerous to think of risk as a number. The problem we all face is that many scenarios can unfold in the future. Elroy Dimson defined risk in a way that I like: More things can happen than will happen. It is a profound, thoughtful, and helpful definition. When you add it all up, it really means that we do not know what will happen, but this definition frames risk in a way that is useful for thinking about the problem. The Known and Unknown I am increasingly concerned with how the risk man- agement business today focuses so intently on the tools of risk measurement—probability, normal curve sampling, regression to the mean, mean–variance. To me, risk management is not about measurement at all. It is about how we make decisions and only inciden- tally about the math we use in making those deci- sions. If we stare at just the models and equations, we lose sight of the mystery of life—we lose sight of the unknown. There would be no such thing as risk if everything were known. If only a finite number of things could happen, risk would not exist. Even the most brilliant mathematical genius will never be able to tell us what the future holds. What matters in think- ing about risk is the quality of the decisions we make in the face of uncertainty . Pascal’s wager offers the ideal model for making decisions. Blaise Pascal, the celebrated 17th century French mathematician and philosopher, was the first person to develop the idea of probability, so the genesis of risk management begins with Pascal. He spent half his time leading an unsavory life and half the time being very ascetic. In the end, he came to the conclusion that he must give up the sinful life and retire to a monastery. While in the monastery, he asked himself the following question: “God is, or God is not?” He said that reason cannot answer this question—an important statement to come from a mathematician. He said belief in God is not a deci- sion. I cannot wake up one day and say, “Today I will believe in God,” or “Today I will not believe in God.” It does not work like that. The answer to Pascal’s question comes from within, but you can decide how you will live your life. You can act as though there is a God, or you can act as though there is not a God. This is your choice. If you act as though there is a God,
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This note was uploaded on 12/10/2011 for the course FNBU 3432 taught by Professor Yang during the Spring '10 term at Bentley.

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Bernstein - Risk: The Hottest Four-Letter Word in Financial...

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