Understanding risk and utility concept
“Remember this, young man, you don’t have to make me rich. I am rich already” That’s the words an investor told Bernoulli, the famous Swiss mathematician, when he ventured into portfolio management. Let me explain the meaning of these words.
Risk understanding is relatively recent, it has few hundred years, previously people believed in fate and God's will only. The understanding could be formulated after the wide introduction in Europe of the Arabic numbers, which enabled complex calculations and after much mathematical development came the statistics.
Augmenting our personal wealth does not mean the same for all of us. Those who have, get less value out of increasing a certain amount, while for those who don't have, this same certain amount has a strong meaning and much worth. This brings us to the utility concept developed by Bernoulli.
The satisfaction derived from each successive increase in wealth is smaller than the satisfaction derived from the previous increase in wealth, then the disutility caused by a loss will always exceed the positive utility provided by a gain of equal size.
The rich man from the beginning of the text was telling Bernoulli that he is not interested in risky activities that might generate huge income, he is worried about any loss and preferred low risk in exchange for lower returns. This is a problem for the European continent where most wealth originates from inheritance and not from business creation, people are pathologically risk averse and fearing of losing their status. And this is the advantage of places starting from a lower stand point as of today, with a vibrant atmosphere and full of people willing to risk to win, to have what others have had for centuries. While some try to make it, others try to stay where they were. Look at the enormous advance of Asian countries in recent decades.
No risk, no economy. Risk takers generate an active economy and the result is the increase in wealth for the nation.
Post based on the book Against the Gods of Peter L. Bernstein© Art3Labs.