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    Capital Ideas: From the past to the Future Author(s): Peter L. Bernstein Source: Financial Analysts Journal, Vol. 61, No. 6 (Nov. - Dec., 2005), pp. 55-59Published by: CFA InstituteStable URL: 10-09-2015 11:01 UTC

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  • FIN,&ANCIAL NALYSTS JOURNAL r ~~~~~~A e ....... . . ....

    Capital Ideas: From the Past to the Future Peter L. Bernstein

    The body of thought that we consider modern finance theory is extraordinarily important. It permeates most of what investment analysts and managers do and influences how we think, whether we think about it positively or negatively. I am working on a revision of Capital Ideas (1992), but the basic 11 chapters-from Harry Markowitz to Black-Scholes option pricing-are going to remain exactly as they were in the original edition.

    It is a remarkable story: In the space of 21 years, from 1952 to 1973, an entire body of knowledge was created essentially from scratch, with only a few scattered roots in the past. Nothing in the history of ideas can compare with this cascade of ideas in such a short period of time. Centuries came between Euclid, Newton, and Ein- stein. In economic theory, 160 years came between Adam Smith and John Maynard Keynes. When I started to work on Capital Ideas, one of the inspirations was that all of the heroes were still alive. It was an amazing opportunity.

    Modern Finance Essentially, the assumptions, the simplifications, and the necessary conditions of neoclassical economics do not exist in today's complex world. Eugene Fama recently wrote that the capital asset pricing model (CAPM) is a theoretical triumph and an empirical disaster. In the summer 2004 issue of the Journal of Economic Perspectives, Andre Perold provided a beautiful description of the CAPM that is like reading a brilliant, clear light. And in the same issue, Fama and Kenneth French took up their cudgels against the model.

    Noted innovator of behavioral finance Daniel Kahneman of Prin- ceton University has won a Nobel Prize, which tells you that the exceptions to neoclassical finance theory are very important. We have bubble-and-bust markets, which suggests occasional irrational behavior in the markets in a macro sense. There are also many manifestations of violations of the classical model of investor behav- ior that create "mispricings" in the daily markets. So, what is the theoretical triumph? Why does it matter to us as practitioners to know, to understand, and to appreciate this body of knowledge?

    What I am going to tell you seems amazing now; it is an extraor- dinary leap in human thinking. Before Markowitz, we had no genu- ine theory of portfolio construction, only rules of thumb and folklore. Before Bill Sharpe and Jack Treynor, we had no genuine theory of asset pricing, only rules of thumb and folklore. Before Merton Miller and

    Modern finance theory, modern portfolio theory,

    neoclassical economics the ideas bestowed

    on us in two amazing decades by the giants in our field-are alive and well.

    Peter L. Bernstein is president of Peter L. Bernstein, Inc., New York City. Editor's Note: This article was developed from Mr. Bernstein's presentation to the FAJ 60th Anniversary conference titled Reflections and Insights: Provocative Thinking on Investment Management (February 2005).

    -2005, CFA Institute 55

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    iZeffe (1 ns.. _d 2 Franco Modigliani, we had no general theory of corporate finance, only rules of thumb and folklore, and no recognition of the overwhelmingly power- ful concept of arbitrage.

    M&M (1958, 1963), although not much discussed, may have had the most influence of all- exceeding even the importance of option theory- for it was they who declared that any investment project and its associated financing plan must pass only one test-whether the project as financed will raise the market value of the company's shares. The market knows all. Only when the price of the stock goes up is the company earning its cost of capital. The theory was diverted into all kinds of unfortu- nate directions, but the idea that the stock price is all-the stock price is in our face every day, every minute-has had an enormous influence.

    Before Fama and others, we had no theory to explain why the market was so hard to beat. I tell the story in Capital Ideas of the editor at Random House in the late 1960s, when I was working at Bernstein-Macaulay, who said there was a young fellow in finance, a very, very bright guy, whom she wanted me to meet. It turned out to be Bill Sharpe. When we first sat down to lunch, he turned to me and asked, with his wonderful charm, "Do you beat the market?" I was flabbergasted. How could anybody dare ask me such a question! The notion did not even exist that beating the market was a problem.

    Before Black, Myron Scholes, and Robert Mer- ton, we had no theory of option pricing, only rules of thumb and folklore.1 We did not know what the notion of contingent claims could accomplish for understanding the corporation, in valuation, or hedging risks, or in opening new areas for invest- ment managers to pursue.

    An interesting example of how thinking about option theory can provide a new perspective is the recent NASDAQ "bubble." It was supposedly a bubble, but think about it in terms of options. NAS- DAQ is an index of a bunch of very young compa- nies with more or less unlimited futures. Nobody knows which ones will succeed, but in the 1990s, a great deal of ferment was going on and big possibil- ities existed. If we look at those shares as options, it makes perfectly good sense that the downside was limited, the upside unlimited, and the index con- tained a great deal of uncertainty. As options, those

    shares may have been fairly valued in 1999. Before 1973, nobody would have even raised the question.

    The academic creators of all these models knew that the real world is different from the models, but they were in search of a process, a systematic under- standing of how markets work, how investors inter- act, and how portfolios should be composed. They understood that financial markets are about capital- ism, a word we mention much too infrequently. Capitalism is a dynamic, complex, rough-and- tumble system in which there are always winners and losers, and we do not know in advance who is going to win and who is going to lose.

    Merton said in 1987 that the traditional approach of modern economic theory is to divide the positive theories of how we behave almost com- pletely from the normative theories of how we should behave. Despite all the controversy in the early days about the empirical tests, the design was not a finished work. It was a jumping-off point, a beginning of exploration, an integrative structure from which to make comparisons and to gain insights. And it has been very rich indeed.

    The way people talked about the market before the 1950s was another world. The only people dis- cussing any kind of theory were Benjamin Graham and John Burr Williams. Williams' work (1938) con- tained a kind of theory, but the discount rate was in the eye of the beholder. Graham's work was pow- erful, but it was normative, not positive. It told you what you should do, not how the market works. Both authors proposed theories of asset pricing; they did not develop the larger idea of the portfolio.

    Then came Markowitz (1952). When I inter- viewed him for Capital Ideas, he told me how a chance meeting with a broker one day persuaded him to pursue his interest in operations research by investigating the stock market. Markowitz didn't know anything about the stock market, so he went to his professor. The professor also didn't know anything about the stock market but told Markowitz to read Williams. Now, Williams says you should buy the single stock with the greatest expected return. Markowitz thought, "But, you know, you have to think about risk as well as return."

    By making risk the centerpiece of his ideas, Markowitz directed his attention to the essence of what investing is all about: Investing is a bet on an unknown future.

    56 ?2005, CFA Institute

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    iZeffec (10.ns Challenging the Theory The only competing doctrine to modern finance theory is in the behavioral finance literature. Behav- ioral finance is where alpha flourishes. I sat next to a famous hedge fund manager at dinner the other night, and I said, "How much of modern portfolio theory is involved in what you do?" He said, "It's tremendously important. Those are the guys we pick off every day." So, it is useful even to them.

    The behavioral literature is so enormous and diverse that it is hard to pin down. The key question is whether the