The concept of Risk in Economics
The Concept of Risk In Economics
This report is about various concepts, which have transformed risk management in economics to what we know today. It takes a look at the previous theories used to define risk and how it could be managed and later theories, which revolutionized the economic system. The context of the report is based on economics, more so how decision making within it is influenced by various factors. It is solely based on readings from two chapters of the book “Against the Gods: The Remarkable Story of Risk” and a review of the same. All the findings, conclusions and recommendations made are based on the same reading. The report delves into the works of various economists who have helped revolutionize risk by proposing different theories, which have a link to economics and decision making. It takes a look at the works of Frank Knight, John Keynes, John von Neumann, Oskar Morgenstern and Alan blinder among others. These economists offered insight into the topic of risk associated with decision making through their theories, most of which are being practiced today. The findings reveal the connection between risk, uncertainty, game theory strategies and rational behavior and decision making within an economic system. Prior to these concepts, the economic system was perceived to be risk free, a fact that changed after the emergence of these theories. The purpose of the report therefore is to make readers understand the significance of these theories in the study of decision making in economics. Through this report the question of how uncertainty, game theory strategies and rationality affect decisions made within an economic system including their impact on risk management, is clearly answered.
This report is based on the evolution of risk throughout the centuries to what it is today. This is with regard to economics, more so decision making within the economic framework. The report is founded on an analysis of two chapters of the book “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein. The readings are based on various contributions by scholars and renowned economists on how risk as we know it today came to be in the study of economics. Prior to the chapters being evaluated, economics had been described as a system without risks, one in which stability was always a guarantee. This was especially the case in the period before the First World War where peace contributed to perfect conditions for decision making within the economic system. The laws of probability were distributed symmetrically as proposed in Pascal’s theory. The onset and aftermath of the First World War changed the perception of probability and risk in the economic system and further brought forth new concepts of understanding risk such as uncertainty, game theory and rationality.
The purpose of this report is to distinguish and evaluate how the above concepts changed the study of economics and the decisions made within this context. This is all in an effort to demystify the transition of economics from a risk free system to one clouded with uncertainty which governs the rationale behind decision making. This transition is seen through the works of various economists such as Frank Knight, John Keynes and Oskar Morgenstern among others. Each of these economists put forth different theories, which were then advanced by other scholars in later years. Therefore, this report mainly seeks to understand the question of how a previously risk free economic system changed to one full of risks through observing its relationship with the concepts of uncertainty, game theory strategies and rationality and how they affect decision making.
Frank Knight was among the first economists to counter the assumptions based on classical economic theories. These theories were largely based on mathematical problems to provide economic solutions. In such economic systems, the mathematical laws of probability prevailed, and decision making was based solely on perfect certainty. One needs to take a peek at his family and education background to understand his thoughts on uncertainty. Knight was not born into opulence and was the oldest of eleven children. He attended tiny colleges, one of them known to urge parents to send their hard to handle boys for disciplining as said in its national advertisements (Bernstein, 1998). He was often singled out by his lecturers for his tendencies to talk too much, not to mention the fact that he always flaunted norms was never organized and did not take matters seriously.
Although he shunned moral values, he stuck to capitalism because of the optimum results it yielded. Knight disregarded theories by classical economists citing the element of surprise which brought about uncertainty. According to him, risk and uncertainty should be separated in an emerging system where perfect certainty was no longer the case. He was among the first to propose the aspect of uncertainty and its effects on decision making. He brought attention to the fact that economists should consider the effect of future events and stop relying on past occurrences to determine the future. Probability laws had no accuracy in predicting the future economic conditions especially using events of the past. His proposals were particularly relevant to financial markets, which are uncertain and rely on future trends. These assumptions were echoed by fellow economist John Maynard Keynes.
John Keynes, unlike Knight, was born of a wealthy family and subsequently attended the best schools, at one time being awarded an honorary degree for his works, something with which Knight did not agree. Critics have however dismissed this as mere jealousy because Keynes managed to advance his theories more so by emphasizing on uncertainty. John Keynes disregards the term events instead preferring proposition which places emphasis on future events. He was vehemently against mathematical analysis of past events and using the resultant findings to make economic decisions. His view of economics focuses entirely on uncertainty. His works and thoughts are summarized in his books A “Treatise on Probability” and “The General Theory” which explores the meaning and application of probability. He criticizes analyses based on events but welcomes predictions based on propositions. He argues that probability has no impact on real life events. Simply because similar events have occurred repeatedly in the past, this is no guarantee that they will be observed in the future.
Cumulatively, both Frank Knight and John Keynes managed to distort all previous theories regarding the presence of risk in the economic system. With their new concept of uncertainty, they managed to change the existing perceptions of risk as not being associated with decision making in any economy. They gave rise to the possibility of vulnerability of systems due to the element of surprise. According to Keynes, a system that cannot rely on the frequency distribution of past events is strangely vulnerable to surprise and thus becomes volatile. Decisions once made, create an environment with no chance of replaying the old.
Despite these well though out arguments, the prevailing belief in the power of measurement and rationality in risk management persisted. The game theory emerged after the publication of Keynes book, “The general Theory.” It was invented by John Von Neumann, a physicist and further advances the concept of uncertainty by establishing its source. Neumann proposes that the source of uncertainty lies in knowing the intentions of others. In so doing, strategies can then be implemented to trade off what other people want for that which we want. In the end, there is a game of compromise where alternatives are considered to ensure that everyone gains from any economic transaction.
John von Neumann was from a well to do background and boasted of vast intellectual accomplishments. His interest in probability came when a colleague asked him to define certainty, to which he replied with a mathematical formula. He first presented his theory of games of strategy in a paper delivered to the mathematical society at a university in 1926. The content was highly mathematical and had descriptions of playing a childhood game called match-penny. Through this game, he demonstrated how players are responsible for a 50-50 result in any game. This implies that only players in the game could decide on factors that guarantee them a win or loss, thus discrediting the laws of probability which were previously thought to determine the results of such games.
However it was much later that Neumann realized that there was much more than mathematics in the theory of games. While at the institute of advanced study, he met German- born economist Oskar Morgenstern who requested to write an article on the game theory. Morgenstern linked the theory of games of strategy to the study of economics and decision making. Their joint effort materialized through the book “Theory of Games and economic Behavior.” Morgenstern had for years been troubled by economic assumptions of perfect foresight. According to him no one had the ability of knowing what others were doing at any given moment, implying that unlimited foresight and economic equilibrium were not in any way related. Through collaboration with von Neumann, Morgenstern managed to assert his ideas of uncertainty and advocated for the use of the same mathematical formulae and strategies in economic decision making.
Other contributors to the game theory include Alan Blinder, long-time member of the Princeton economics faculty. He provided an example of game theory, which was published in 1982. The objective of the game was to force individual players to make unpleasant decisions in an aim to establish whether coordination was possible between monetary policies and fiscal policies. The rules made it possible for the players to know one another’s intentions and information was made available to all participants. The outcome of the game came to be known as the Nash Equilibrium, named after John Nash a fellow faculty member at Princeton and a 1994 winner of the Nobel Prize for his significant contributions to the game theory. In the Nash Equilibrium, the outcome is stable but less optimum. Failure to reach a better compromise was due to adversarial positions taken by the players. Coordination was therefore a problem, yet it would have worked well to yield maximum results.
The game theory added further insight to the concept of uncertainty. Through Blinder’s example, we are able to see the issue of uncertainty brought about by not knowing the intentions of other players involved in decision making. However when these intentions were revealed to everyone it was still difficult to arrive at the best decision because of underlying emotions and habits among players. This gives rise to the aspect of rational behavior in decision making, which could be applied practically. Rationality ensures that decisions are made based on the available information and not whim, emotion or habits. It transformed into a widely accepted concept which set the rules for governing risk management and maximizing utility. It affirmed that the individual who wins in economics is the one who makes the best of available tradeoffs within the obstacles set by the game theory. This is in relation to their rational behavior, meaning that those that behave more rationally tend to benefit more than those that do not. All the above contributions helped to revolutionize the economic system as we understand it today. It proposed rationality in the face of uncertainty to manage risks existent in an economic system. These theories were applied in various economic fields henceforth including structure of markets, investment management and instruments used by investors.
Conclusively, the readings in these chapters help to give us a glimpse of economics in previous centuries and outline its remarkable journey to what it is today. From a risk free economic system to the current one of numerous risks, the readers are taken through the journey of transformation. This is done by pointing out the factors that contributed to this change which in this case is the theories and assumptions of countable economic geniuses such as John Keynes. By reviewing these theories, this report has managed to establish the link between decisions made in a risky economic system and theories of uncertainty, game theory strategies and rational behavior. All these theories affect the decisions made in economic systems and disregard previous assumptions that the system was perfect and risk free. The above theories are what assert the presence of risk in the economic system with further emphasis on their consideration before making any decisions.
Bernstein, P. L. (1998). Against the gods: The remarkable story of risk. New York: John Wiley & Sons.
Risk management is an important subject in any economic system. This refers to how economists handle risk to ensure they have maximum results. This report focuses on the rationality behind human behavior when tasked with decision making particularly in the stock market. With numerous decisions being made daily by investors, attention has to be paid on rational human behavior. The following report explores various theories that seek to explain the effect of rationality and lack thereof, when investors are faced with different problems for which decisions have to be made. Readers are given a background of risk and its development in the economic system including how it has continued to transform the decision making process. By reviewing two chapters of the book, “Against the Gods: The Remarkable Story of Risk” this report looks at the contribution to economics by different professionals. Harry Markowitz emphasizes on rationality in making decisions by measuring risk and recommending the efficient portfolio as a solution for minimizing the undesirable element of risk. Through his model, investors are given an opportunity to select what suits them at any given time with regard to returns. Investors are portrayed to be risk aversive. However, the contrasting theory by two psychologists supposes that investors are only averse to losses and not risk as suggested by Markowitz. When presented with the same problem packaged differently, they choose that which is gainful. Their irrationality is witnessed where they have to choose between the same ventures with different risk. This emerges as the perfect solution in an environment that is as competitive as the stock market. These arguments are presented differently but with the same purpose of understanding risk management.
Risk management involves evaluating the risks present in any investment, and dealing with them in a manner best suited to one’s investment objectives. It is the process of identifying uncertainties in decision-making and either accepting or mitigating them. This report analyzes the theories and literature of various economists and psychologists on response to risk where investment is concerned. This literature is derived from two chapters of the book “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein. Through the contributions of the above-mentioned people, economists are able to quantify risk, relate it to returns and decide whether to avert or embrace it. The uncertainty brought about by risk, is the basis of determining the decisions being made in the face of any investment, and returns are affected by rationality or lack thereof, in human behavior when it comes to making decisions. Ultimately, there arises the question of whether decisions made rationally or those made irrationally are the best in capitalizing returns on investment with a focus on risk.
Previous chapters of the book have introduced readers to the concept or uncertainty and risk in the economic system. Decision-making has been significantly affected since then as investors have to consider how to handle risk, in order to get the best returns while at the same time, their rational behavior is put to the test. As earlier mentioned, risk management is done with the best interests of investors at heart. It is therefore clear that investors see risk as a potential for both massive returns and losses, which makes some of them risk averse while the opposite is true for others. The content of this report aims at analyzing how rational and irrational behavior in humans affect decision-making and ultimately have bearing on returns on investment.
Harry Markowitz, a graduate student of the University of Chicago, first brought into light the quantification of risk in investment on securities, in his paper written in 1952. Initially Markowitz had no interest or intimate knowledge of the stock market. His motivation to delve into the topic came by chance when he conversed with a stockbroker, with further encouragement from his lecturer. He set out to read the book “The Theory of Investment Value,” by John Burr Williams. Not long into his reading he was instantly struck by the idea of considering risk when aiming for returns in the stock market. He established theories based on the probability theory as synthesized by the ideas of Pascal, Jevons, Gaul and Galton among others. He placed emphasis on measurement, which he believed could offer solutions to the world’s problems.
The concept of variance is introduced and defined as an undesirable element which investors are keen on minimizing. Variance refers to how widely returns on any asset swing around their average (Bernstein, 1998). In this case, risk is made synonymous to variance, which Markowitz seeks to quantify. By attempting to minimize the undesirable element, in this case variance, investors are portraying an aversion to risk. They are hopeful of returns in the stock market but are not willing to embrace risk, even if it may result in higher returns. This eventually presents a situation of volatility whereby returns are dependent on decisions, which revolve around risk. Many economists argue that the success of these decisions is influenced significantly by human rational behavior. Markowitz was one of the proponents of rationality in decision making more so to reduce the effects of volatility.
Diversification is introduced by Markowitz in an effort to help reduce volatility. This is after observing that most investors are risk aversive in their tendencies to invest in ventures that yield low returns, even when given an opportunity for high returns with riskier ventures. Although he did not mention it in his paper, diversification is similar to the game theory where investors are in full control of the outcomes of their investment decisions. Information about different ventures with varying degrees of risk is made available to investors, and they have to evaluate the ventures and decide which suits them best. Markowitz disagreed with investment as a single-minded affair and made transformations of stock picking by choosing efficient portfolios. These efficient portfolios seek to minimize the undesirable aspect and minimize the desirable one. Investment returns, in this case, are based on the ability to choose efficient portfolios and gives investors the chance to employ rationality in decision making to choose that which best suit them.
Counter theories were made to this theory by Markowitz of portfolio selection. For instance, questions were raised on whether investors are rational enough to come up with the best decisions. Various people doubted the rationality of humans when faced with risk and uncertainty. Others criticized the assumption that the link between risk and returns did not survive empirical tests. In other words, they are skeptical of the fact that risk can be quantified and related with returns. Additionally, the similarity between variance and risk also drew criticism. Furthermore, there were mathematical problems in getting calculations to measure the relationship between stocks or bonds and their variation. Portfolios could only be described with two numbers, that of expected return and variance. The theory of Markowitz thus became problematic in terms of implementation. To counter problems arising from practicing his proposed model, Markowitz teamed up with fellow graduate student William Sharpe. Together, they came up with the solution of estimating how each security varied in relation to the whole market. This led to Sharpe’s development of Capital Asset Pricing Model, which offers analysis of how assets would be valued if investors adhered to the proposals of Markowitz.
Markowitz made a mark in economic history by introducing the above concepts. These concepts of measurement of risk and determination of returns affect the quality of decisions made by investors. The model recommended by Markowitz to minimize volatility through diversification requires that investors exhibit rational behavior when making decisions. This is the only way to ensure that they get maximum returns on their investments. He curves a relationship between risk and returns, leaving readers to assume that high risk ventures yield more than low risk ones. With this in mind, investors through portfolio selection are provided the option of picking the stocks that best suit them at any given time. Rationality comes in where portfolios that best appeal to their interests are concerned, especially in a competitive environment. The recommendations by Markowitz have the assumption that rationality is the best solution for problems that arise in a competitive environment.
Other contributors to risk management are indifferent to the idea that rationality in decision making always results in the best returns. The next chapter gives explanations to this indifference. Those opposed to this notion do so because they are not in agreement with the assumption that only rational behavior can prevail in a competitive environment. Failure of invariance describes the inconsistencies witnesses in the choices of man when the same issue is presented in a different manner. In this case, the same problem is presented in various ways, and individuals are left to decide what to do. The rationality behind human behavior is put to test in the presence of these problems, as they are required to select wisely. In relation to investment, one venture involving both high and low risk is put to the table and investors are tasked with deciding which offer to take. This is unlike the theory of Markowitz, which offers different ventures of varying risk levels. There is therefore no room for inconsistency or difficulty in decision-making. It is crucial to note that these decisions are made with consideration to the expected return.
Two psychologists, Daniel Kahneman and Amos Tversky set out to advance the theory of risk aversion and resultant decision-making. Their assumptions and recommendations were summed up in their work titled the “Prospect Theory.” They challenge the rationality of human behavior in decision making when faced with the same problem presented in different ways. In the event of such as a situation, investors tend to choose ventures, which avert losses rather than risk. This portrays humans as more loss aversive than risk aversive. Through the prospect theory, Kahneman and Tversky propose that there is asymmetry between the way we make decisions to do with gains and losses. This is a useful observation, which is relevant to matters in an economic system as far as decision-making is concerned. Investors are always seeking good returns hence the tendency to make investment decisions that ensure gains. This may be with disregard for the magnitude of risk available in a specific venture.
In advancing this theory, Daniel Ellsberg later in 1961 wrote on ambiguity aversion. This new form of embracing risk focuses on taking risks known instead of unknown probabilities. This means that investors take risks only when they are sure of the returns to be gained from their investment. Revelations from both theories are that there is irrationality and incompetence when faced with uncertainty. It is imperative to note that risks bring forth uncertainty. Therefore, investors would rather place their bet on what they are sure of than what they can only speculate. A competitive environment brings about uncertainty on the gains to be made by any investor. Many investors in such situations will deviate from rational behavior with the aim of making high returns. There will be both high and low risk ventures and whichever has the most gains is chosen over the other. With this regard, individuals are portrayed as not being risk aversive; instead, they select that which ensures they secure the most gains.
The above different theories of managing risk propose two angles, both of which work but vary in terms of ideology. Whereas one supports rationality, the other strongly opposes it. However, one thing is clear from both, that is that decision-making is the key to the determination of gains made in any investment. The competitive environment in the stock market makes it necessary for investors to be cautious in decision making. Whereas rationality is important, the main aim should remain that of attaining maximum gains. Therefore, both rational and irrational human behavior should be taken into consideration for as long as the decisions made ensure profit maximization. The readers of this report hence have a clear understanding of how risk determines the decisions made in investments as it heavily influences rationality.
Bernstein, P. L. (1998). Against the gods: The remarkable story of risk. New York: John Wiley & Sons.
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