Customer Reviews

Capital Ideas: The Improbable Origins of Modern Wall Street

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"Poets are the unacknowledged legislators of the world....Let those who will, write the nation's laws, if I can write it's textbooks." (P. Samuelson, quoted by Berstein)

Bernstein has written a fascinating pre-LTCM (pre 8/98) book on the history of econometrics and finance, beginning with the origins of the Cowles foundation as the consequence of Cowles' personal interest in the question: Are stock prices predictable? This book is all about heroes and heroic ideas, and Bernstein's heroes are Adam Smith, Batchelier, Cowles, Markowitz (and Roy), Sharpe, Arrow and Debreu, Samuelson, Fama, Tobin, Samuelson, Markowitz, Miller and Modigliani, Treynor, Samuelson, Osborne, Wells-Fargo Bank (McQuown, Vertin, Fouse and the origin of index funds), Ross, Black, Scholes, and Merton. The final heroes (see ch. 14, The Ultimate Invention) are the inventors of (synthetic) portfolio insurance (replication/synthetic options).

This book consists largely of a pre-LTCM (pre-10/98) cheerleading for option-pricing mathematics based on lognormality, and corresponding synthetic portfolio insurance. Osborne and Mandelbrot are mentioned. The book is not error-free: e.g., Mandelbrot's ideas on stock prices are stated as being the origin of chaos theory (!), and Mandelbrot (of random fractals fame) is misportrayed as an `articulate proponent' of chaos theory! Another error (page 182): "..persistent forces are constantly driving the market toward (Modigliani-Miller) equilibrium." The evidence for the EMH is supposed to constitute the `proof' for this nonsense. So much for `proofs' in economics. So ingrained is the false, misleading and inapplicable notion of "equilibrium" in the minds of economists that it is hopeless to expect to educate them out of their own morass. Even Black, who was educated as a physicist as an undergrad, did no better:

"When people are seeking profits, equilibrium will prevail." (F. Black, quoted by Bernstein)

Among the interesting and entertaining stories that are told are: the displacement of Graham and Dodd's `value theory' by the EMH, the revolutionary role played by Wells Fargo Bank in using the `new finance math', and in creating index funds. The importance of the Miller-Modigliani `theorem, which `proved' that the (not-uniquely-defined) `value' of a corporation is independent of it's debt. Then, there is the wild-haired idea of `portfolio insurance', how to eat your cake and have it too (a free lunch, derived from the assumption that free lunches don't exist). No portfolio can be insured against extreme deviations, especially those that occurred in 10/87 and wiped out confidence in LOR (Leland-O'Brien-Rubinstein Associates). But this failure of finance theory produces no crisis for Bernstein, whose book is the history of heroes, not villains. His last chapter, which can be ignored by the reader without loss, is states his ideology: free market ueber Alles. Or: equilibrium will prevail, even without restoring forces ( I like to put it this way: there are no "springs" in the market). I did get something important from this book: the origin of America's spend-spend-spend ideology in the Modigliani-Miller `theorem'.

If the optimal portfolio is not risky enough, borrow to finance it's purchase. (Wells Fargo's application of Tobin's idea, quoted by Bernstein)

(This is a shorter version of a longer review that appeared in fall(...).

This book,published in 1992, is an earlier version of Bernstein's "Against the Gods-The Remarkable Story of Risk",published in 1996.Both books cover much of the same ground.Bernstein traces the origins of the post WW2 portfolio analysis-risk management models ,such as the mean variance(standard deviation)model,CAPM( capital asset pricing model )and the Black Scholes options pricing model ,back to the work done at the turn of the century by the French mathematician Louis Bachelier .Basically,this approach analyzes ALL markets,not just financial markets, on the assumptions that price movements are 1)all independent of each other,2)are all small and homogeneous,so that each price movement or change over time can be viewed as if it were a small gas particle interacting with other billions of identically small gas particles in a series of collisions that all are self cancelling in the long run and 3)the law of large numbers and the central limit theorem holds so that the normal probability distribution can be used .The question that then needs to be asked and answered is "What is the degree of empirical evidence supporting the overwhelming use of the normal probability distribution in financial and economic analysis?"The answer,which can be easily obtained by any reader of this review who picks up a copy of Benoit Mandelbrot's latest book(2004),titled "The (Mis)Behavior of Markets",with Richard Hudson,is that there is little,if any,evidence that supports the use of the Normal probability distribution as a general modeling approach.Mandelbrot's extensive research ,duplicated by a number of other researchers in a number of different countries over the last 25 years,has been available since the mid 1950's.How does Bernstein react to this mass of empirical and scientific evidence?Bernstein reacts in a ,to say the least,nonscientific way:"...Mandelbrot remains on the periphery of financial theory,both because of the inconvenience to analysts of accepting his arguments and because of the natural human desire to hope that fluctuations will remain within familiar bounds"(Bernstein,1992,p.132).It is also strange to find the very favorable,well deserved, comments showered upon John Maynard Keynes throughout the book because Keynes would agree with Mandelbrot,not Bernstein.Keynes made it very clear in chapters 28-30 of his A Treatise on Probability(1921;TP) that the exacting assumptions necessary for the general application of the normal probability distribution,excepting physics and biology,were generally not satisfied unless homogeneity and stability held over time for the material being examined.The objections Keynes made ,in the Keynes-Tinbergen debate in the Economic Journal of 1939-40 over Tinbergen's use of a normal probability distribution ,to the claim that econometricians could test and predict business cycles over time,are clearly in the spirit of Mandelbrot's much,much more empirically supported conclusions.Nonetheless,I would still recommenmd that either this book or the 1996 book be bought,but not both.

Capital Ideas can be a nice introduction to a difficult topic and one should read it before starting to get involved in the more profound literature of financing scholar books.

The only two blames I have to make is 1. that the personal side of the stories is expanded too far - it would be enough to state that some teacher is considered a workaholic, the description of his calling at sunday night gets you out of the more important context of what he rally prooved and claimed for the new theory of fi- nancing. and 2. that the differences in the beta and CAPM theories is not so clearly described - although it is a major topic in the book - that the book alone leaves you with a precise idea of the differences. So this must be left for other books.

The book is nonetheless highly recommendable, since it has the advantage that sine ira et studio all theories find their way into the book, so you will not run into the danger that you loose one financial problem just

because the scholarly author of a financing manual forgets to tellabout it, which is often the case.

So get this book soon, it is easy to read, and a friend of mine - a Dr of Medicine who would for the first time read about this topic - was much impressed by it and liked it immediately; and I can add, he even understood it.

Dr. Rudolf C. King CEO, princeandprince.com

The popular literature about the world of investment in the 1980s carries titles that reflect those events: Bonfire of the Vanities, Barbarians at the Gates, The Predators' Ball, and Liars' Poker. The main characters are arrogant, greedy, cynical, and shady. The movie Wall Street summed it all up: "greed is good", the address by corporate raider Gordon Gekko to a crowd of investors, is the claim that came to epitomize the zeitgeist.

But what if the real heroes of the stock market frenzy were not those pathetic figures that generations of MBA students tried to emulate? What if the unsung heroes of the times were instead the professors and ivory tower academics who wrote those students' textbooks? Finance professors are usually not held in very high esteem: their economics colleagues won't share office space with them, their practically-minded students deride them for not practicing what they are teaching, and the general public considers any accident on the stock market as proof of the flaws in their theories.

Peter Bernstein's book pays due respect to their profession. It focusses on a small group of innovators who created finance as an academic discipline, and transformed Wall Street and the world along the way. Published in 1992, Capital Ideas starts and ends with two turning points in the history of modern finance: the crisis of October 1974, which saw the culmination of the worst bear market in common stocks since the Great Crash of 1929, and the stock market crash of October 1987, in which hundreds of billions of dollars were wiped out in a few hours.

Financial innovation was blamed on those two occasions, and finance specialists were castigated as sorcerer's apprentices. But for Bernstein, finance is more a solution than a problem, and the answer to the risk of innovation getting out of control is still more innovation. Had it not been for the crisis of 1974, few financial practitioners would have paid attention to the ideas on portfolio selection and risk management that had been stirring in the ivory towers for some twenty years. And putting the blame of the 1987 crash on portfolio insurance, as the commission chaired by Nicholas Brady did, is compared by the author to a proposal to slow down the train, when efforts should focus on improving the quality of the roadbed.

Finance had difficulty establishing itself as an academic discipline. It was taught mostly in business administration departments, not in economics faculties. Even in business schools such as Harvard, the investment course in the 1950s attracted so few students that it was taught at noontime so that it would not take up precious classroom space at prime time. Finance attracted marginal individuals, the kind of persons that would be described nowadays as nerds, with a taste for crunching numbers and dabbling with computer mainframes. Only a few of them had formal training in economics. The discipline flourished in only a handful of US universities where the talent of a few individuals made a difference and where business school professors did talk to their colleagues in the economics department: Chicago, MIT, and a few other places.

The body of knowledge that forms the core of the discipline-what Bernstein refers to as Capital Ideas- was conceived in the space of only twenty-one years, from 1952 to 1973. In short, it is contained in Harry Markowitz's work on portfolio selection, Franco Modigliani's and Merton Miller's revolutionary views about corporate finance and the behavior of markets, the Capital Asset Pricing Model developed by Sharpe, Treynor and a few others, Eugene Fama's explication of the Efficient Market Hypothesis, and the option pricing model of Fischer Black, Myron Scholes, and Robert C. Merton.

When the discipline was developed, many economists regarded the stock market as a side-show in the economic system, not worthy of serious attention. Even Milton Friedman, who sat on Markowitz's dissertation committee, reflected the prejudices of the profession when he declared: "Harry, I don't see anything wrong with the math here, but I have a problem. This isn't a dissertation about economics. It's not math, it's not economics, it's not even business administration." And it was something completely new and unrelated to previous work: Markowitz's seminal paper on Portfolio Selection, that brought him fame and a Nobel Prize, lists only three references to other works in its bibliography. One of the most fundamental paper by Jack Treynor, that laid the groundwork for the CAPM, wasn't even published.

There were some exceptions. The most famous was Paul Samuelson, known for his textbook first published in 1948 and who made so many contributions to the economics discipline that the Nobel jury had trouble highlighting only a few when they awarded him the prize in 1970. Although Samuelson was Keynes' most distinguished disciple, he rejected Keynes' own view of the market as little more than a casino, and he saw the stock market as a central institution as well as a source of fascinating intellectual puzzles. Another economist with a keen interest for financial markets was James Tobin, who spent most of his career at Yale except for a brief stint at he Council of Economic Advisers that began with the following dialogue when President Kennedy offered him the job:
- I'm afraid you got the wrong guy, Mr. President. I'm an ivory-tower economist.
- That's the best kind. I'll be an ivory-tower president.
- That's the best kind, Mr. President.

The book is very rich in anecdotes and personal details on the academic founders of modern finance, most of whom were interviewed at length by the author. It requires no prior knowledge of the field, although knowing one's betas from one's alphas will help the reader go through the material. My own exposure to theoretical finance has been very limited, but having done the maths once on the CAPM or the Modigliani-Miller theorem helped me get through the relevant chapters, whereas the last chapters on option pricing theory or continuous time finance are way beyond my grasp and could only be understood metaphorically. But the Capital Ideas and the difference that they made are just too important to be left ignored, and Peter Bernstein has made a great job of explaining them to the general public.

This book is significantly biased towards academic finance and theories. With the sub-title of "the improbable origins of modern wall street" one could expect a greater balance in the active/passive management debate. After all, although passive management and index funds are gaining ground, the active management guys still command a fair share of funds under management. Instead, it seems like the author is dead-set on selling the idea that indexing is the only strategy that works because markets are efficient. Why are markets efficient? Because they are. There is no balance to the debate. In fact, while extolling the theories of Markowitz, Sharpe, Fama etc. the author chooses to skim over important assumptions in all their models, such as no transactions costs, continuous trading etc. This is clearly one-sided. My personal opinion is that the passive/active debate in finance is no different from debating religion. Neither side will ever be proven correct and it is purely a matter of preference; you either believe one side or you don't. Whichever side you choose you will find ample evidence to support your view and plenty of evidence to lead you to doubt! I would have given the book three stars except for the following statement on page 77: "Estimates of such correlations are easy to make. They are also relatively stable, because in many instances past history is a reliable guide." This has been proven to be nonsense time and time again. If this were true, then the black scholes model would not fail; it would always be correct and things like implied volatilities wouldn't exist.

For obvious reasons i.e. "how did we get into this mess", the origins of finance have come under scrutiny. This book provides an excellent historical perspective. It is not a heavy mathematical read, but more of a historic narrative, written from the perspective of an expert market practitioner. It leaves off in the late 1990's and therefore does not include the more recent excesses, but is a very good overview of the key developments that is well worth reading, even if you disagree with the direction finance has taken, it is useful to know how it got there.

I once sat in a meeting with a prospective client who remarked, pointedly, that their business was was in need of someone with an academic orientation to straighten them out. That might seem counter-intuitive to some. But this prospective client was in the investment advisory business. And if you read this book, you'll discover why this comment made sense and who was largely responsible for making it make sense. Peter Bernstein is a classic storyteller. He did omit some significant contributors, but most of the people who made modern Wall Street what it is, their insights, and how they developed them are presented in a heroic light

A very interesting book, if you like books of Richard Dawkins for sure you will love this one.

I read this book some time ago but it still helps me out when I have to do small talk with other finance academics. I enjoyed the gossipy tidbits the most (like Myron Scholes rejecting a pricey offer from University of Texas at Austin in favor of a more presitigious job at MIT). It also helps to know that Fama was quite the athlete in college. There is a bit of too much Paul Samuelson in there for my taste but other than that I would definitely recommend it. Especially if you're bored reading dry academic journals!

A great book to establish an understanding for how the current investment strategies came about. Petere Bernstein did a great job of introducing mathematical masterminds such as Louis Bachelier; the inventor of stochastic analysis concepts, the birth of Dow Jones, the creation of S&P 500 index by Alfred Cowles, Portfolio Selection by Harry Markowitz and many other financial and statistical intellects.