FIFTY years ago, the business of managing other people's money was very much an art not a science, and was largely a matter of finding someone who was privy to inside information. But during the 1950s, 1960s and 1970s, academics changed the study of what became known as portfolio management. They did so in the face of much initial resistance and scepticism from the industry.
In his 1992 book, "Capital Ideas", Peter Bernstein gave a magisterial account of the academics' thinking. The likes of Harry Markowitz, Bill Sharpe and Myron Scholes developed theories to explain the link between risk and reward, the gains to be made through diversification and the framework for valuing financial options.
In recent years, however, some of these concepts have come under attack. Critics have argued that the academics used too many simplifying assumptions, such as ignoring trading costs. A school of thought, known as behavioural finance, has proposed that investors are not as rational as the models assume and are subject to psychological biases, such as a reluctance to cut their losses.
Now Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets. Modern investors are much more sophisticated in the way they think about risk, in particular separating the returns available from market movements (beta in the jargon) and managerial skill (alpha).
The academic concept of efficient market theory—that prices already reflect all available information—has led to the creation of index-tracking funds that allow investors to own a diversified portfolio at very low cost. Although behavioural financiers have spotted market anomalies, they have not shown that these can be systematically exploited: the average fund manager still struggles to produce a return that matches the index.
Indeed, Mr Bernstein seeks to show how financial giants such as Barclays Global Investors and Goldman Sachs Asset Management have built on the insights developed by the academics. If there are ways systematically to beat the markets these days, they probably require men with physics doctorates and massive computer power rather than a smooth manner and the right contact book.
There is the equivalent of a technological arms race as modern fund managers vie to find the best computer models and to trade quickly before their competitors spot the same opportunities. This race is making the markets more efficient, and so making the academics' models look more realistic than before.
As Mr Bernstein recognises, this frantic activity is something of a paradox. The academics have taught us to be suspicious of the claims of the investment industry. But if the fund managers were not beavering away trying to pick stocks, prices would not be set efficiently and the academics would be proved wrong.
Lacking its predecessor's historical sweep, this book is not quite as impressive a feat of scholarship. But Mr Bernstein has yet again produced a book that is insightful and thought-provoking. (The Economist, June 15, 2007)
"…a challenging sequel to (and spirited defense of) his 1992 classic" (Bloomberg, Friday 8th June)
"Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets...a book that is insightful and thought-provoking." (The Economist)
"Mr Bernstein has yet again produced a book that is insightful and thought-provoking." (The Economist, 15th June 2007)
"…an enthusiastic study of the academics whose theories have revolutionised global markets…also a great primer in the ideas that currently govern the way the world’s money is invested." (Financial Times)
"Brilliant...This book should be in your library" (MarketWatch)
"…an enthusiastic study of the academics whose theories have revolutionised global markets…also a great primer in the ideas that currently govern the way the world’s money is invested." (Financial Times, Mon 2nd July)
"satisfying read" (Capital Ideas Evolving, Monday 6th August)
"a clear and elegant introduction to the debate, including vignettes of all the main intellectual figures" (Financial Times, Saturday 15th December 2007)
"… an excellent introduction to…modern portfolio theory and will appeal to academics, practitioners, and to others who study financial markets." (Pension, Economics and Finance Journal (PEF), Vol. 7/2 08)
From the Inside Flap
In all of history and in all fields of intellectual endeavor, a tension has existed between theory and practice. Those of us who earn a living in the real world seldom want to appear as slaves to some set of abstract ideas. It was no surprise, therefore, that the word "baloney" was Wall Street's greeting to the pioneering theories of finance developed by a small group of academics in their ivory towers during the years from 1954 to 1972. Yet those breakthrough theories would in time earn five Nobel Prizes in Economic Science. Baloney they were not.
In Capital Ideas Evolving, today's foremost financial historian expands upon his groundbreaking book of 1992, Capital Ideas: The Improbable Origins of Modern Wall Street, to recount how these financial theories finally migrated from the towers of ivory to the towers of glass on Wall Street and other financial centers around the world. The result has been a global revolution in the nature of financial markets, the menu of investment strategies, the development of exotic financial instruments, and the role of an uncertain future in all investment decisions. Even the academics who originally developed these theories are active today in the markets and in the creation of new financial structures and strategies.
The opening pages of Capital Ideas Evolving confront the attack on these theories from researchers in Behavioral Finance, who argue that the theoretical assumptions of fully rational investors are a far cryfrom reality. Bernstein finds strong positive conse-quences in the daily interaction between these critics and the impact of financial theory. Based on personal interviews with leading practitioners and theoristsincluding five of those who played a prominent role in Capital Ideasthis book also describes how today's key practical applications developed from the core ideas of finance theory into the new and exciting formats of the investment process found in today's environment. This story includes the startling success of a group of leading institutional investors, all of whom developed their strategies from a base composed of the principles once categorized as "baloney."
As Bernstein traverses between financial theory and a history of modern financial innovation, he gives us a vivid and enlightening view of today's investment world. This engaging and insightful book brings to life the individuals, ideas, and issues that are transforming the financial landscape.