Book Review: Capital Ideas by Peter Bernstein

This is a book nominally for finance aficionados, those interested in the theorists who explained stock and bond markets and laid the basis for index funds, portfolio construction and the explosion in derivatives. Capital Ideas is about the history of the thinkers and some implementers of modern capital markets.

Peter Bernstein, not to be confused with the other popular financial author, William Bernstein (he of Four Pillars fame), writes in a non-technical way about the theories. This is quite an accomplishment, given that modern finance is highly mathematical. In fact, there is only one brief formula in the book, which Bernstein throws in just to show us how complex a formula can be. The Black-Scholes formula for pricing options is the only one in the book (228). There might have been a few more, if only to make a deeper impression on the reader about the difficulty of the intellectual work involved. When doing my MBA in 1982, we went through the mathematical derivation of the Capital Asset Pricing Model, another core financial theory, and I remember feeling quite smart merely at being able to understand and follow the logic. UBC did that because it was a fairly quantitative business school. Most MBA schools at the time did not even go that far, merely presenting the final formula with words to describe its meaning. The Black-Scholes was another order of magnitude more difficult than the CAPM with its reliance on Ito's lemma for the solution and we did not attempt the math. However, to really understand any formula properly in order to apply it intelligently, I maintain that you must be able to do the math, otherwise the intricacies and subtleties are lost. There are likely even today, 30 years later, no more than a few thousand people in the world who truly grasp how options pricing works. Though I consider myself to be of reasonable intelligence, particularly in an academic sense, I feel in awe of the finance theorists that Bernstein pays homage to. It is hard to comprehend the abilities of these individuals. On reading that some of these guys came out of physics, I was reminded of my late wife, who had a doctorate in nuclear physics. She described how she used to pass undergrad physics exams – go to class, listen very carefully to understand what the teacher was saying, remember a few basic principles and formulae, then go to the exam and re-derive whatever additional formula a particular problem might require! It's like any field of endeavour – think what Tiger Woods does with a golf ball - the best are simply amazing to anyone with ordinary abilities. Bernstein might have imparted more of the sense of awe that we should rightly feel.

One of the lasting impressions of the book is amazement at Bernstein himself and his ability to understand and explain the many theories, some of them quite subtle indeed. Not everyone seems to get the message of modern financial theory however, as Bernstein describes in the last chapter. There are many portfolios being managed in the institutional world, which is supposed to be professional, in un-diversified, active trading. Some of the managers probably don't understand the theory properly and so mis-apply it.

There are a number of delightful snippets of information and quotes to give a reflective reader something more to think about:

• The long run returns of the US market of about 8% annually on a real, after-inflation basis, are unique to the United Sates in the 20^th century. No other country has done as consistently well, due to disruptions such as wars, famines, revolutions and the like. (A recent paper by Bernstein suggests that using the number as an assumption about the future rate of return is probably much too high.)

• Or, for us index investors, the S&P 500, is not a very good index. It doesn't represent the market very well, which is what finance theory says a good index should. Bernstein calls the S&P 500 a “a capriciously structured portfolio” (page 248).

• Change in financial markets, and in the practices of those in the business, tend to change after major disruptions like the 1973-74 and the October 1987 severe drops. In the interim, people are smug, fat, happy and resistant to change.

• Financial theorists have been almost exclusively English and American scholars, though that seems to be changing now. And they have been 100% men. Not a woman figures among Bernstein's pantheon. So many theorists were converted engineers, physicists and mathematicians (I think that's where the “improbable origins” subtitle of the book comes from; these guys were just looking for some good problems to work on). It's the ultimate nerd activity.

• The value and significance of research is not immediately apparent, recognized or adopted: Markowitz' paper on portfolio selection languished nearly 10 years after its publication before people took much notice. Or, Black and Scholes submitted their paper on options pricing first to a Chicago University journal and then to one at Harvard, who both promptly rejected it. (220)

• Things can change permanently: in the years after the 1929 crash stocks were considered so risky that the dividend yield on stocks was nearly three times the interest on savings accounts. In the the 1950s stock prices overtook bond prices for the first time in the history of over 100 years of the US market. That relationship has never returned. “Growth had replaced solvency in market valuation.” (160)

There are amusing and useful sayings for the investor:

• “Diversification depends more on the way individual securities perform relative to one another than it does on how many assets the investor owns. In Markowitz's terminology, “It is necessary to avoid investing in securities with high covariances among themselves.”” (50)

• “Diversification takes all the fun out of investing.” (53)

• “The riskiness of a portfolio depends on the covariance of its holdings, not on the average riskiness of the separate investments. A combination of very risky holdings may still comprise a low-risk portfolio so long as they do not move in lockstep with one another – that is so long as they have low covariance. (54)

• The market is so hard to outguess because so many people are out there doing the guessing. (134)

• “The only thing the investor should worry about is how much any asset contributes to the risk of the portfolio as a whole.” (188)

The book has an extensive bibliography with details of all the major papers and books, providing a handy reading list for the essential sources of modern finance up to the date of the book, which was published in 1992.

Buy the book at
chapters.indigo.ca