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Capital Ideas: The Improbable Origins of Modern Wall Street.

Capital Ideas: The Improbable Origins of Modem WaIl Street

By Peter L. Bernstein. New York: The Free Press, 1992, pp. 340,


OVER THE PAST forty years, a revolution has been going on in finance and investment that has significantly changed the way money is managed. The unlikely part of the revolution is that it was not led by money managers but rather by a group of scholars, most of them statisticians and mathematicians and many from fields like engineering and physics. Their published works appear primarily in academic journals and make difficult reading to those with a limited mathematical background. Fortunately, Peter Bernstein, author, former money manager and now consultant to institutidnal investors, has written a book that tells the story of this revolution and its leaders. It explains the concepts in easily understood terms, an important feature. The book is written with a clarity and perception that marks Bernstein's writing, and conrains anecdotes and personal histories that make the book no dry-as-dust theoretical treatise. It will be of interest to business economists who have anything to do with finance and investment or who have any curiosity about new developments in that area.

The basic ideas of this revolution challenge the conventional wisdom of Wall Street and its money managers. Stock prices move at random, and stock markets are efficient. Stock market forecasters cannot forecast. A porffolio of stocks has different characteristics from the stocks in the portfolio because of the way the stocks relate to each other. Diversified portfolios provide reward and also have risk. The market porffolio is the most efficient because no other porffolio with equal risk can offer a higher expected return, and no other portfolio with equal expected return will be less risky. No one can beat the market without taking unwarranted risk. However, in managing portfolios, the use of options and futures can help control risk, and porffolio insurance strategies may provide protection against market declines.

The book includes all of the heroes in the pantheon of modern portfolio theory: Louis Bachelier, who in 1900 offered the first explanation of why stock prices behave the way they do; Alfred Cowles 3rd, who demonstrated that stock market forecasters could not forecast; John Burr Williams, who offered a dividend discount model to value securities; Nobel laureate Harry Markowitz, who introduced the concepts of risk and reward as well as the efficient diversification of portfolios; Nobel laureate James Tobin, whose separation theorem stated that the risky part of a porffolio would be the same for all investors; Nobel laureate William Sharp, who added the capital asset pricing model, systematic and unsystematic risk and stock betas to the financial vocabulary; Nobel laureate Paul Samuelson, who held that market prices are the best measure of intrinsic value; Eugene Fama, who argued that those using either public or nonpublic information could not beat the market; Nobel laureates Franco Modigliani and Merton Miller, who argued that the value of the corporation is independent of its capital structure; Jack Treynor, who developed the concept of risk premium and riskadjusted measures of performance; Fischer Black, Myron Scholes and Robert Merton, who developed option theory; John McQuown, William Fouse and James vertin, who successfully applied these new concepts in managing billions of dollars at Wells Fargo Bank; Barr Rosenberg, who helped managers of large porffolios apply the new concepts; and finally Hayne Leland and Mark Rubenstein, who invented portfolio insurance.

What of the future? The majority of individual investors probably run their portfolios the same way they always did, but this revolution certainly changed the way many large portfolios are managed. Nevertheless, Bernstein reports that twothirds of professional money managers still manage the old-fashioned way. But a broadening understanding of diversification and risk, use of futures and options, growth of a multitude of index-funds, and international diversification all testify to the impact of the revolution. Although not completely converted, financial management will never be quite the same again.

Bernstein has done an outstanding job in making this revolution understandable and interesting. Although the research and techniques are highly mathematical, the book contains only one equation, used to illustrate the complexity of computing an option value without a calculator; the results of the computation would be obsolete by the time the calculation was done by hand. The stories of the individuals, including brief biographical material and their associations with each other, add significantly to the story. And in no other book is modern portfolio theory presented with such remarkable clarity.

The only limitation, and one that Bernstein promises to rectify, is the absence of material on the changes in the way fixed-income portfolios are managed. Bond portfolio management has undergone a revolution comparable to that of stocks, especially in the development of derivative and collateralized securities. When Bernstein gets around to writing that story, it should be equally fascinating reading.

Edmund A. Mennis

Palos Verdes Estates, CA
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Author:Mennis, Edmund A.
Publication:Business Economics
Article Type:Book Review
Date:Apr 1, 1992
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