Capital Ideas: The Improbable Origins of Modern Wall Street

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein.
Publisher: Wiley, John & Sons, Incorporated
Pub. Date: June 2005
ISBN-13: 9780471731740

Reviewed by: Fahad Almudhaf







Bernstein traces the history of modern finance and provides an interesting summary of the developments in this field. It is common among people to think about academicians as “unrealistic” persons with strange beliefs and ideas which do not work in real life. However, this book shows many examples of applications in finance that are directly related to the great and seminal articles published in “academic” journals. The book gives a clear picture of how academic ideas had influenced the financial industry with the help of information availability and the computer technology.

The author traces the evolution of important concepts such as option pricing, portfolio insurance, efficient markets, diversification and portfolio theory. He shows that the concepts developed by scholars forced the financial industry to rethink its techniques and methods. It took some time but ended up changing the way of practitioners. Developments in academic finance had a great impact on Wall Street. Academics helped investors to be aware of risk and how to deal with it and better control it. The research of academic finance introduced many beneficial financial innovations. For example, Equity mutual funds which are linked to an index are one of the outcomes of academic finance.

The predictability of stock prices:
In 1882, Charles Dow thought that stock prices were predictable. However, in 1900, Louis Bachelier challenged Dow and argued that it is impossible to predict prices in capital markets. The random walk concept was described as “the path a drunk might follow at night in the light of a lamppost”. Eugene Fama is a strong proponent f this concept and argued that security prices follow a random walk movement.

Cowles doubts that stock market forecasters can be accurate in their forecasts. He provides evidence that the average practitioner underperformed the market. However, he states that naive investors would continue to ignore the negative findings of surveys showing that the buy-and-hold strategy beats the average of mutual funds and that analysts have no added value even if they were published every five years. Cowles says “It wouldn’t matter. People are still going to subscribe to these services. They want to believe that somebody really knows”. When will investors change this habit? A stronger effort needs to be done to spread the ideas of random walk and market efficiency. Bloom (1974) casts doubt about the market advice for a fee industry. If they really know, then why would they share their knowledge and not make money themselves!

In 1913, Cowles established an index tracking the performance of the stock market. This was the beginning of what we are all familiar with nowadays as the S&P 500 index.

Paul Samuelson, a Nobel laureate, once said “The non predictability of future prices from past and present prices is the sign, not of failure of economic law, but the triumph of economic law after competition has done its best”

Portfolio Selection:
“Nothing ventured, nothing gained” and “Don’t’ put all your eggs in one basket” are two old rules of investment. However, Harry Markowitz developed a method which helps investors to maximize expected gains while minimizing risk. He shows that we should concentrate on the “covariance” and how the assets in a portfolio perform relative to one another. “The riskiness of a portfolio depends on the covariance of its holdings, not on the average riskiness of the separate investments”. Markowitz includes both risk and return in his “mean variance analysis”

The Separation Theorem:
“Interior decorators” look at investors in a distinct way with unique requirements. However, James Tobin simplified Markowitz’s methodology and came up with the “Separation Theorem” which argues that security selection is separate from the decision of portfolio allocation and rejects the interior decorator approach. According to Tobin’s theory, all investors will choose the super-efficient portfolio which dominates all other portfolios on the efficient frontier regardless of their own styles or preferences.

The single index model:
William Sharpe developed a method to overcome the difficulties in the application of Markowitz’s theories of efficient portfolios and diversification. Sharpe developed the single index model which assumes that the returns of securities are related with a basic single underlying factor which is the market itself. This model helped in saving time by simplifying calculations required especially with the help of computers.

Sharpe was able to combine practical applications with theoretical innovations and showed that academic research can be applied successfully in real life. He discovered the central building blocks of capital market theory by introducing CAPM in 1964. Sharpe’s model concludes that the stock market is Tobin’s super-efficient portfolio. Buying and holding a diversified portfolio of stocks was the optimal investment strategy set forth by Sharpe.

The demon of chance:
Confirming the previous findings of Cowles, Holbrook Working found that price changes are random and unpredictable. Working and the traders themselves couldn’t distinguish between graphs of changes in random numbers and graphs of changes in commodity prices. Maurice Kendall didn’t find any structure in the long history of price patterns. This again confirms the findings of Working. Kendall states that “The best estimate of the change in price between now and next week is that there is no change”.

This was bad news to technicians who follow trends and charts and claim to be able to forecast the future based on such technical analysis. Harry Roberts argues that patterns of technical analysis could be generated by chance. In addition, Osborne argues that the movements of stock prices are not anymore predictable than molecules movements.

On the other hand, Alexander (1961) uses filter strategies and finds that a move in the stock market once initiated tends to persist. Professional investors were happy with such results. However, this good news didn’t last so long when Alexander himself came later with another study to find that such strategies do not work anymore and confirms that forecasters couldn’t predict stock prices.

The search for high Performance Quotient:
Eugene Fama analyzed the random behavior of stock prices. He started by reviewing previous research and said that “The chartist must admit that the evidence in favor of the random walk model is both consistent and voluminous”. He argues that analysts help to narrow discrepancies between intrinsic values and actual prices. However, we have many smart people in the market and it is hard to outguess them. He saw the market as “efficient” where prices reflect all available information. “An efficient market is one in which no single investor has much chance, beyond luck, of consistently outguessing all other participants”. Fama provides empirical evidence in favor of efficient markets hypothesis.

Financial advisors continued to believe that they will do better than the market by spending time on research. However, Peter Bernstein admits that “We fooled ourselves just as much as we fooled our prospective clients” (pg. 140)

Michael Jensen derived a performance measure which adjusts the returns for the level of risk taken. After adjusting for risk, Jensen found that only 26 out of 115 mutual funds outperformed the market! This evidence supports the efficient market.
There are several market anomalies when stock prices might be predictable. Calendar effects are a form of such anomalies. For example, average returns in January were found to be higher than other months especially for small firms. Stock prices tend to go down on Mondays and up on Fridays. Short term momentum is the strongest anomaly where a stock or fund is likely to perform well in the following year if it performs well this year. However, beating the market consistently remains a challenge.

The Best at the Price:
In 1938, John Burr Williams introduced the most influential method for determining intrinsic value which is the Dividend Discount Model. “A stock is worth only what you can get out of it”. The future cash flows (dividends) paid by the company are behind the value of the stock price. William argues that we need to discount future payments to account for uncertainty.

Warren Buffett is a student of Benjamin Graham who believed in fundamentals. Investors ought to base their decisions on intrinsic value which is “the value justified by the facts, e.g. the assets, earnings, dividends, definite prospects”. Graham emphasize on accounting data and not cash flows.

Bernstein argues that “If everyone is a noise trader, the market will be chaotic … the presence of intelligent investors is a necessary condition for a market that lends itself to systematic analysis and understanding … A little inefficiency goes a long way in making the game worth playing” (pg.161)

The Bombshell Assertions:
David Durand rejected the “Entity Theory” which asserts that the value of a firm is independent of its capital structure. However, Franco Modigliani and Merton Miller show that the market value of the firm is independent of its capital structure. Yes, indeed capital structure doesn’t matter.

Modigliani and Miller (MM) significantly contribute to the theory of finance by introducing the concept of “Arbitrage” which exists in imperfect markets where identical assets in two different markets are trading for different prices. In such cases, there is a sure profit opportunities (free lunch) with no risks. Arbitrageurs bring perfection to imperfect markets. MM also came up with their dividend irrelevance proposition which states that dividends will not affect the value of the firm. James Vertin refers to the work of MM as “bombshell assertions”

Risky Business:
Jack Treynor came up with a method for predicting the risk premium and to demonstrate its importance in the behavior of capital markets and portfolio selection. His performance measure relates the returns to the volatility of the portfolio.

William Sharpe divided the total risk into “systematic” (un-diversifiable) and “unsystematic” (diversifiable) components. Investors are just compensated for the taking systematic risk which is the risk of the market. Sharpe’s models helped portfolio managers to predict risk and expected returns. The performance measure helped to evaluate portfolio performance of mutual funds.

In 1976, Stephen Ross developed the Arbitrage Pricing Theory (APT) as an extension of CAPM. It measures how stocks prices will respond to changes in the “multiple” economic factors that influence them. APT avoids the unrealistic assumptions of CAPM and assumes multiple factors instead of a single factor o influence prices.

The Universal Financial Device:
The Greek philosopher Thales is the first one to use the financial instrument known today as an “option”. It gives the owner the right but not the obligation to take an action under specified conditions agreed to in advance. This gives investors an opportunity to hedge their risks. They can control how changes in the market affect their portfolios. Car insurance and prepayment in a mortgage are examples of “options”.

In 1950’s and 1960’s, Paul Samuelson, Cootner, and Kruizenga studied Warrant pricing. Fischer Black and Myron Scholes had great contributions in bringing the theory of option pricing. Black and Scholes came with the option pricing formula that is currently used in investment and corporate finance strategies.

The Constellation:
Wells Fargo Bank is a role model in adopting theoretical concepts into practical applications. Portfolio management revolution started at Wells Fargo. Portfolios in Well Fargo were structured around company size, industry breakdowns, and beta measure. In 1969, William Fouse recommended them to launch the first index fund to replicate the S&P 500. However, they rejected his idea in the beginning. The first index fund was born in 1971 and the indexing business has grown ever since. Wells Fargo switched from active management to passive products by the end of 1970s.

Vertin, McQuown and Fouse helped the academics to participate in Wels Fargo and the financial industry and be respected. Bernstein states that “they who truly brought the gown to town” (pg.252)

The Accountant for Risk:
Barr Rosenberg was successful in educating the practitioners with the ideas of Markowitz, Tobin, and Sharpe. Rosenberg came with the notion of extra-market covariance which added a new dimension to the single-index model of Sharpe. Rosenberg started “BARRA” which is a leading company in portfolio management strategies and measuring investment risks. This company came up with a program to predict a stock’s beta using many characteristics of the company. It also came up with a program called MULMAN (multiple manager risk analysis). Bernstein claims that this program “had changed the world” and described Rosenberg as the “accountant for risk” who advanced the frontiers of portfolio management (pg.264-266)

The Ultimate invention:
Hayne Leland thought of a financial instrument which works like an insurance policy for portfolios in the market and concluded that a put option is what will work as portfolio insurance. Then come Cox, Ross and Rubinstein with their option pricing model that became popular among practitioners.

The market for stock index futures is an active and highly liquid market which helps investors to protect themselves. Some argue that portfolio insurance is a major factor in the October 1974 crash. Therefore, portfolio insurance declined as an accepted investment strategy. However, other possible reasons could be the old infrastructure and trading rules of the financial markets which didn’t match the latest technology of investing. Problems of market liquidity are also a possible cause of the 1974 crash.

The View from the Top of the Tower:
The author ends up his book with a chapter where he shows the significance of stock markets to the economy. He refutes individuals who claim that stock markets are nothing more than regulated casinos or a playground for speculators! Bernstein presented arguments which we as finance academics should be aware about especially nowadays when we start hearing more complaints about the importance of stock markets. We need to have such valid arguments to defend our case that stock markets are vital to the economy. After reading this last chapter, you will be able to support the fact that “Wall Street shapes Main Street”.

My own thoughts and opinion:
I am totally satisfied with this book and have no doubt that this book is a great read. The author conveyed his story in a lively and entertaining way. He did a great job in presenting these theories in simple English. I like the fact that the author is a well respected practitioner in the field of investments. He is also the founder of the Journal of Portfolio Management. This journal seeks to link practitioners with the academic theories of portfolio management. This book fits both industry professionals and academics interested in finance.

Bernstein provided us with an overview of the concepts of thinkers who showed the world how finance ought to be. The author did not forget the pioneers who brought these ideas from academia and implemented them into Wall Street such as Vertin, McQuown and Fouse.
The book has interesting biographical details of the stars of Finance. You will know much more personal stories and interesting facts about the names who are consistently cited in well respected “rigid” academic journals of finance. You will start to put a picture along with the name and think about them as if you met them and did not just read the outcome of their interviews through the author. This helps us to understand the time when they wrote their dissertations and articles and encourages the young researcher to start observing the field and directing research in the areas which can probably have an impact on the real life.

I like the fact that Bernstein interviewed the stars of this story and provided the reader with their research motivation and their backgrounds. However, I did not like the fact that the people whose works are described in this book actually read drafts and contributed to Bernstein’s understating of the subject. This could be a reason behind the fact that the author seems biased in his presentation in favor of the efficient market hypothesis. He presents the failure of portfolio managers and stock analysts to consistently beat the market without taking more risk as if nobody published any studies contradicting the “Efficient Market Hypothesis” coined by Fama. He almost presented the results of one group (the proponents) as if the other group had no valid arguments or even any findings which support them or cast doubt about market efficiency. I wish to read much more than one paragraph talking about market anomalies. I would prefer to rather read more of the results of Behavioral finance academicians and leave the decision to the wise reader to support which group.

It seems obvious that Bernstein throughout the book clearly tries to convert more readers to believe in market efficiency and the fact that they should stop playing the game of beating the market because this mission is impossible! They can continue to do so for fun and as addicts to gambling or daily trading. Noise trading increases the liquidity of the markets. Actually their noise could be an important factor to ensure market efficiency through fundamentalists. Some would like individuals to continue daily trading using technical analysis and following the winners. This would give more and more support to the “truth” which I believe in that the markets are indeed efficient in the long run and not necessarily in all times. No one can neglect and ignore the behavioral and psychological factors.

My final word would be to thank the academics for introducing a number of beneficial innovations to the world of finance. Keep up the great work! The readers are advised to dig through the academic journals because they will better understand the way markets work and find the “best” strategy backed up with empirical findings and not just personal opinions. After reading this book, my answer to the best strategy in stock markets is to buy-and-hold and index which is a replica of the market. Do you accept my challenge to read this book and not end up being convinced with this point? Try it and let me know!