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.
This book tells the story of a group of thinkers whose remarkable vision revealed how to put the future at the service of the present. By showing the world how to understand risk, measure it, and weigh its consequences, they converted risk-taking into one of the prime catalysts that drives modern Western society. Like Prometheus, they defied the gods and probed the darkness in search of the light that converted the future from an enemy into an opportunity. The transformation in attitudes toward risk management unleashed by their achievements has channeled the human passion for games and wagering into economic growth, improved quality of life, and technological progress.
By defining a rational process of risk-taking, these innovators provided the missing ingredient that has propelled science and enterprise into the world of speed, power, instant communication, and sophisticated finance that marks our own age. Their discoveries about the nature of risk, and the art and science of choice, lie at the core of our modern market economy that nations around the world are hastening to join. Given all its problems and pitfalls, the free economy, with choice at its center, has brought humanity unparalleled access to the good things of life.
The ability to define what may happen in the future and to choose among alternatives lies at the heart 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 would 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.2 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 liquid 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 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.
The modern conception of risk is rooted in the Hindu-Arabic numbering system that reached the West seven to eight hundred years ago. But the serious study of risk began during the Renaissance, when people broke loose from the constraints of the past and subjected long-held beliefs to open challenge. This was a time when much of the world was to be discovered and its resources exploited. It was a time of religious turmoil, nascent capitalism, and a vigorous approach to science and the future.
In 1654, a time when the Renaissance was in full flower, the Chevalier de Méré, a French nobleman with a taste for both gambling and mathematics, challenged the famed French mathematician Blaise Pascal to solve a puzzle. The question was how to divide the stakes of an unfinished game of chance between two players when one of them is ahead. The puzzle had confounded mathematicians since it was posed some two hundred years earlier by the monk Luca Paccioli. This was the man who brought double-entry bookkeeping to the attention of the business managers of his day – and tutored Leonardo da Vinci in the multiplication tables. Pascal turned for help to Pierre de Fermat, a lawyer who was also a brilliant mathematician. The outcome of their collaboration was intellectual dynamite. What might appear to have been a seventeenth-century version of the game of Trivial Pursuit led to the discovery of the theory of probability, the mathematical heart of the concept of risk.
Their solution to Paccioli’s puzzle meant that people could for the first time make decisions and forecast the future with the help of numbers. In the medieval and ancient worlds, even in preliterate and peasant societies, people managed to make decisions, advance their interests, and carry on trade, but with no real understanding of risk or the nature of decision-making. Today, we rely less on superstition and tradition than people did in the past, not because we are more rational, but because our understanding of risk enables us to make decisions in a rational mode.
At the time Pascal and Fermat made their breakthrough into the fascinating world of probability, society was experiencing an extraordinary wave of innovation and exploration. By 1654, the roundness of the earth was an established fact, vast new lands had been discovered, gunpowder was reducing medieval castles to dust, printing with movable type had ceased to be a novelty, artists were skilled in the use of perspective, wealth was pouring into Europe, and the Amsterdam stock exchange was flourishing. Some years earlier, in the 1630s, the famed Dutch tulip bubble had burst as a result of the issuing of options whose essential features were identical to the sophisticated financial instruments in use today.
These developments had profound consequences that put mysticism on the run. By this time Martin Luther had had his say and halos had disappeared from most paintings of the Holy Trinity and the saints. William Harvey had overthrown the medical teachings of the ancients with his discovery of the circulation of blood – and Rembrandt had painted “The Anatomy Lesson,” with its cold, white, naked human body. In such an environment, someone would soon have worked out the theory of probability, even if the Chevalier de Méré had never confronted Pascal with his brainteaser.
As the years passed, mathematicians transformed probability theory from a gamblers’ toy into a powerful instrument for organizing, interpreting, and applying information. As one ingenious idea was piled on top of another, quantitative techniques of risk management emerged that have helped trigger the tempo of modern times.
By 1725, mathematicians were competing with one another in devising tables of life expectancies, and the English government was financing itself through the sale of life annuities. By the middle of the century, marine insurance had emerged as a flourishing, sophisticated business in London.
In 1703, Gottfried von Leibniz commented to the Swiss scientist and mathematician Jacob Bernoulli that “[N]ature has established patterns originating in the return of events, but only for the most part,”3 thereby prompting Bernoulli to invent the Law of Large Numbers and methods of statistical sampling that drive modern activities as varied as opinion polling, wine tasting, stock picking, and the testing of new drugs.4 Leibniz’s admonition – ”but only for the most part” – was more profound than he may have realized, for he provided the key to why there is such a thing as risk in the first place: without that qualification, everything would be predictable, and in a world where every event is identical to a previous event no change would ever occur.
In 1730, Abraham de Moivre suggested the structure of the normal distribution – also known as the bell curve – and discovered the concept of standard deviation. Together, these two concepts make up what is popularly known as the