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Pioneers of Financial Economics, Volume 2: Twentieth-Century Contributions by GeoffreyPoitras; Franck JovanovicReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 63, No. 6 (Nov. - Dec., 2007), pp. 83-84Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480892 .

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>~\<X\ ~ Martin S. Fridson, CFA Editor For more critiques of books that are relevant to practitioner work, please visit our Book Review service at www.cfapubs.org.

Pioneers of Financial Economics, Volume 2: Twentieth-Century Contributions. 2007. Edited by Geoffrey Poitras and Franck Jovanovic. Edward Elgar Publishing Ltd., +1 (413) 584-5551, www.e-elgar.co.uklcontact.lasso. 244 pages, $130.00.

Reviewed by Martin S. Fridson, CFA.

The history of financial economics belies the myth that science inevitably evolves along a single, true path. Pioneers of Financial Economics, Volume 2: Twentieth- Century Contributions illustrates this point repeatedly.1 For instance, contributor Elton G. McGoun (Bucknell University) demonstrates that today's nearly univer- sal identification of risk with historical probability distributions is the outcome-not the uncontestably correct outcome-of a battle that raged up until the 1940s. Even more startling is the demonstration by Gabriel Hawawini (INSEAD) and Ashok Vora (Zick- lin School of Business, Baruch College) that the stan- dard yield-to-maturity approximation presented in finance textbooks is the least accurate of several for- mulas derived since 1855.

Geoffrey Poitras (Simon Fraser University), assisted by Franck Jovanovic (Universite du Quebec 'a Montreal), has compiled a collection of articles on financial history of far more than historical interest. For example, Bucknell's McGoun points out that the inherent problems of gauging probabilities by historical distributions are as severe as ever, even though mainstream researchers no longer debate the question. In particular, for many types of events to which investors would like to assign probabilities, no "reference class" of previous, relevant observa- tions exists. For practitioners who sense the problem and seek a way out of the intellectual confines of historical probabilities, it is immensely helpful to realize that eminent economists once considered alternative modes of analysis more fruitful than using historical probabilities.

Paul Davidson (University of Tennessee) docu- ments a similar triumph by a single, not necessarily superior, approach to a broad segment of economics. Influenced by a circle of mathematicians who began publishing under the pseudonym "Nicolas Bour- baki" in the 1930s, quantitatively oriented economists came to define "rigor" to mean consistency with a set

Martin S. Fridson, CFA, is CEO of FridsonVision LLC, New York City.

of autonomous, abstract axioms rather than axioms that reflect the physical world. Deliberate rejection of real-world constraints came to dominate mathemati- cal economics largely through the work of Bourbaki disciple Gerard Debreu. Even Debreu's collaborator on foundational work involving equilibrium, Ken- neth Arrow, has acknowledged that forward markets do not exist for most goods in the real world, which renders a general equilibrium system inapplicable to the actual economy.

The second volume of Pioneers of Financial Eco- nomics also includes an excellent history of a doctrine that, to the great benefit of intellectual inquiry, has not been deemed resolved for all time, the efficient market hypothesis. Kian-Guan Lim (School of Business, Sin- gapore Management University) details statistical testing of equity prices in the decade preceding Eugene Fama's 1965 declaration in the Financial Analysts Journal that stocks follow a random walk.2 In a separate article, assistant editor Jovanovic repro- duces the stirring words that Fama wrote in the FAJ:

[T]he only way the chartist can vindicate his position is to show that he can consistently use his techniques to make better than chance pre- dictions of stock prices. It is not enough for him to talk mystically about patterns that he sees in the data. He must show that he can consistently use these patterns to make meaningful predic- tions of future prices. ("Random Walks in Stock Market Prices," p. 59)

Lim continues the story through the 1990s and the establishment of journals devoted to the behavioral finance counterreformation.

Another highlight of the volume is a long- overdue rehabilitation of economist Irving Fisher (1867-1947), now remembered by investors exclu- sively for proclaiming, just prior to the Stock Market Crash of 1929, that stocks appeared to have reached "a permanently high plateau."3 As Robert W. Dimand (Brock University) recounts, the man whom Nobel Laureate Paul Samuelson has called "the great Irving Fisher" * presciently warned that "risk-free" government

bonds were highly vulnerable to inflation, which, in fact, ravaged the debt of several Euro- pean countries after World War I;

* introduced purchasing power-stabilized bonds 60 years before the British government "invented" inflation-indexed obligations;

"Book Reviews" is a regularfeature of the Financial Analysts Journal. The views expressed herein reflect those of the reviewer and do not represent the official views of the FAJ or CFA Institute.

November/December 2007 www.cfapubs.org 83

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Financial Analysts Journal

* developed the expectations theory of the term structure of interest rates; and

* championed prudent portfolio diversifica- tion, in opposition to the leading practitioners of his day.

As for Fisher's supposed forecasting blunder, Dimand cites modern research that found the 1929 crash could not have been predicted even with today's statistical techniques.4

Numerous other delights await readers of Poitras and Jovanovic's fascinating book. They will learn, for example, about mathematician Edward 0. Thorp, a pioneer in the study of both gambling strategies and financial markets. In the cause of science, Thorp unwit- tingly imbibed coffee laced with knock-out drops while playing baccarat at a mob-controlled casino. Hal Varian (University of California, Berkeley) writes:

It has been seriously suggested that there should be a Journal of Negative Results which could contain reports of all those regressions with insignificant regression coefficients and abysmal R-squares.

Additional highlights of Pioneers of Financial Eco- nomics, Volume 2, include profiles of selected Nobel laureates in economics by financial economists prom- inent in their own right-of Merton Miller by Rene

M. Stulz; of Robert C. Merton and Myron S. Scholes by Robert A. Jarrow; and of Fischer Black by Robert C. Merton and Myron S. Scholes.

Not surprisingly for such an ambitious work, minor errors creep into the text. One author implies that American Telephone & Telegraph (AT&T) was a predecessor of ITT, an unrelated company. Another uses the heretofore unknown Latin phrase "sine que non." A discussion of economic first principles alter- nates between "axiomization" and "axiomatization," nowhere indicating that the terms are anything but synonymous. By the same token, editor Poitras cor- rects a longstanding error by noting that fixed- income pioneer Frederick Macaulay was Canadian by birth, not Scottish or British as reported by sources as eminent as the Society of Actuaries.

Taken as a whole, Pioneers of Financial Economics, Volume 2, is an indispensable reference for practitio- ners as well as scholars. It covers 20th century inno- vations thoroughly, and its prose generally meets a high standard of clarity. Above all, the book proves that history written with a point of view can furnish insights of extraordinary practical value. To evaluate where a field of study stands, knowing whence it came is invaluable.

xLI , 'r

Notes 1. Pioneers of Financial Economics, Volume 1: Contributions Prior

to Irving Fisher (Northampton, MA: Elgar, 2006) was edited by Geoffrey Poitras.

2. Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, vol. 21, no. 5 (September/October 1965):55-59.

3. See, for example, Rob Cox, Hugo Dixon, and Nicole Lee, "Optimists: Beware Irving," Wall Street Journal (29 June

2007):C12. The authors mention no contributions to the field by the "Yale economist."

4. Kathryn M. Dominguez, Ray C. Fair, and Matthew Sha- piro, "Forecasting the Depression: Harvard versus Yale," American Economic Review, vol. 78, no. 4 (September 1988):595-612.

Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice. 2006. By William F. Sharpe. Princeton University Press, (800) 777- 4726, orders@cpfsinc.com. 240 pages, $39.95.

Reviewed by Ronald L. Moy, CFA.

Investors, investment professionals, and academics are inundated by books on investing and asset pricing. A search of "investments" on Amazon.com yields a mind-numbing 233,604 matches. Searching "asset pricing" produces a large, although more manageable, 3,344. Which books should be read and whose advice should be followed are million-dollar questions.

Returning to our roots in finance is a good way to find the answers. Like much of the readership of the Financial Analysts Journal, I received my first formal exposure to investments through William F. Sharpe's 1978 classic text Investments (now in its sixth edition). In the ensuing years, Sharpe's writings have continued to shape the thinking of a generation of investment professionals. Sharpe, perhaps more than any other finance academic, has an uncanny ability to commu- nicate important insights so that they are accessible to nearly all professionals and students in the field. From his simplification of Markowitz's portfolio theory, his capital asset pricing model, his widely used measure of portfolio performance, and his early realization that option valuation could be simply explained via a

Ronald L. Moy, CFA, is associate professor of finance at St. John's University, Staten Island, New York.

84 www.cfapubs.org ?2007, CFA Institute

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