Against the Odds!

In last two instalments, primarily introductory, I tried to build up a block-by-block approach to the systematic understanding, and study, of Risk. As the subject is vast, and complex, having origination and spreading its tentacles in multiple sources/directions, it becomes imperative to have a structured point of beginning.

As we trace back human activities since modern men started building societies, a significant step forward from the days of the nomads, we see, almost always, a penchant to understand and manage risks. Risk is ‘in-built’ in human activities since time immemorial. Be it hunting, living in harsh natural, and weather conditions, raising a family and protecting them in seemingly insurmountable situations, human enterprises (so far only survival) and risk were intricately interwoven. Primitive living and survival were fraught with odds that seemed invincible. Well, those were soon to change!

As civilisations progressed, so did man’s thinking faculty. Great civilisations like the Indus Valley, Egypt, Persia/Mesopotamia and several others grew, and challenged mankind towards growth and progression. Human beings strived for a better life over mere survival strategies, that were the hallmarks for ‘life in caves’. From the subterranean, claustrophobic cavern existence, men sought light and rapid progression with available, and newly discovered, tools. As population grew there were needs for rapid urbanisation and town planning, building sewerage and drinking water facilities, cultivate lands to grow food, develop faster modes of communication, just to name a few. Technologies were deployed to create facilities. All these, needless to say, started risk generation of different nature. So, from the ‘risk from nature’, humans started considering the nature of risk. Risk begets risk! Indeed a phenomenal transformation!

The title of this article was deliberately chosen by me to suggest something more intuitive. When the word ‘odd’ is used in a context, does it imply something more familiar, or logical?

The extraordinary advent of the Theory of Probability!

The concept of modern Risk as we know, and its consequent management, is heavily dependent on the principles and practice of the theory of Probability. This elegant tool of mathematically predicting the occurrence of an event(s) gave extraordinary power to the forecasting techniques, that would be a game changer in modern societies. Probability theory affects outcomes on multiple disciplines we work on. There are hardly a few fields in science and technology that do not utilise the profound impact of this scientific and elegant branch of mathematics.

Let us trace back the origin of Risk, or its scientific study, from the time the Industrial Revolution (a major and significant modern event!) was unfolding. The 17th century saw some spectacular development of societal growth through scientific inventions and innovation, aided by the march of engineering. Great ideas emerged and global exchange of goods and services started in an unprecedented manner. Although trading activities across international borders were always there since the dawn of human civilisation, new frontiers of trade opened up during the great Industrial Revolution especially through maritime activities. Capitalism, nascent though at the time, started its all pervading activities as there were new markets, and investments needed on building technologies that would give one competitive advantage would drive forth steep progression while making lesser technology oriented competition vulnerable and redundant. Stages were set for Risk Management as we know it today!

Please remember that all tools and methodologies we use today for managing risks are but closely interrelated with the analyses of decisions and choice. Such methodologies point to a pioneering concept: the Game Theory. It was indeed a ‘game changer’, along with the theory of Probability. There were something else as well.

In 1875, a mathematician Francis Galton came out with a terrific concept: Regression to the Mean. This simple yet powerful concept explains why prices (not necessarily stocks/bonds) go up before falling down, and that it reverts to the mean. In other words, as we take a decision on anything that has a future implication, we do consider that the matter would return to the ‘normal’. We are simply employing the notion of the Regression to the average or the Mean.

I am sure you, as a student and practitioner of risk, know the technique or universality of Mean Reversion.

To complete this incredible cycle of beginning, stage was set for the entrance of Harry Markowitz and his pioneering portfolio theory, and the elegant Capital Asset Pricing Model!

(Read on in the next instalment. Please comment on this article)