Against the Gods: The Remarkable Story of Risk

Chapter 11

The Fabric of Felicity

Up 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 ...