Capital Ideas Evolving
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Capital Ideas Evolving

Peter L. Bernstein
Wiley, 2007

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9

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In the early 1950s, graduate student Harry Markowitz presented his Ph.D. dissertation to the University of Chicago economics department. The response was less than encouraging. "This isn't a dissertation in economics," Milton Friedman told Markowitz. "It's not math, it's not economics, it's not even business administration." Whatever it was, Markowitz's heterodox theory of portfolio selection changed finance forever and earned a Nobel Prize. Financial historian and investment manager Peter L. Bernstein humanizes his saga of great shifts in financial theory by organizing it around eminent thinkers (Markowitz, Myron Scholes, Franco Modigliani, Robert Merton, Bill Sharpe and others, if you ever want to look up a finance guru). Deepening his analysis with insights from "behavioral finance," Bernstein describes how these innovators generated and extended the now-orthodox "capital ideas" of portfolio selection, capital structure, the Capital Asset Pricing Model, the efficient market hypothesis and the Black-Scholes-Merton theory of option pricing. Bernstein's erudition is dazzling, his explanations pellucid and his narrative filled with scintillating characters. getAbstract doesn't need to hedge: you'll find this overview of current finance theory and practice brilliant, even if you don't know your alpha from alfalfa.

Summary

You Say You Want a Revolution?

Before the 1950s, investors had little rational guidance on getting the most return from their money. Finance theory was a grab bag of folk wisdom, bromides and home-brewed nostrums that hadn't changed much in a century. Then came the revolution. Armed with highly mathematical, computation-intensive theories, a small band of economists took aim at contemporary investment wisdom and didn't let up. Finance theory – and practice – has never been the same.

Harry Markowitz fired the first shot in 1952. In a 14-page paper, Markowitz proposed a simple but powerful idea: Investors should assemble investment portfolios that yield maximum return for a given level of risk. Markowitz treated risk as an input and admonished investors to squeeze as much output (return) from it as possible, a groundbreaking insight at the time. Then, Markowitz added another notion: investors can manage risk by diversifying. The riskiness of a portfolio of stocks can diverge from the riskiness of its individual stocks. The trick is ensuring that these stocks don't move up and down together (in other words, that they don't have a high covariance).

Six years later...

About the Author

Peter L. Bernstein is president of a major investment firm he founded in 1973.

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