Capital Ideas: The Improbable Origins of Modern Wall Street
by Peter Bernstein,  published 1992

For those that have been looking for a good layman's analysis of Modern Finance Theory, look no further than Peter Bernstein's “Capital Ideas.”  Published in 1992, this book did not have the 20/20 hindsight of practitioners who experienced the 1998 LTCM Crisis – nor other financial theories/events which occurred or were popularized during the late 1990s, such as behavioral finance or the flaws inherent in market cap weighted indexing that were exposed when the bull market of the late 1990s came crashing down in early 2000.

Despite this, however, “Capital Ideas” remains a classic and timeless work – even though many assumptions that had a hand in building the models (such as the CAPM) remain inherently flawed.  The book traces the development of Modern Finance Theory, from the first recorded attempt at developing a mathematical theory to explain stock prices (Louis Bachelier's dissertation entitled “Theory of Speculation” in 1900), to the work of the Cowles Foundation in the 1930s, and, of course, Harry Markowitz's famous 1952 short paper titled “Portfolio Selection” – all the way to more modern theorists and practitioners, such as Paul Samuelson, Bill Sharpe, Fischer Black, Myron Scholes, Robert Merton (Black, Scholes, and Merton could be regarded as the fathers of modern option pricing theory) and Franco Modigliani and Merton Miller.

Mr. Bernstein weaves his discussions together in one, neat timeline, interspersed with many fascinating stories along the way.  For example, on receiving Bill Sharpe's paper on CAPM in 1963, (the paper has been cited more than 2,000 times at the publication of “Capital Ideas in 1992) the editor of the Journal of Finance actually initially rejected the paper.  Quoting Bernstein:

[Dudley] Luckett [the editor of the Journal of Finance at the time] told Sharpe that this assumption that all investors made the same predictions was so “preposterous” as to make his conclusions “uninteresting.”

However, the editorship of the Journal of Finance later changed hands, and Sharpe's paper on the CAPM was finally accepted and published in the Journal of Finance's September 1964 edition.  Meanwhile, if Mr. Luckett had stayed as editor of the Journal of Finance, Bill Sharpe may have had to wait much longer to get the CAPM published.

The only criticism of the book is its own lack of criticism of the many theories that are discussed in the book, such as the “Efficient Market Hypothesis,” CAPM, and the assumption of log-normality in both the financial markets and in option pricing.  It also conveniently brushes off value investing based on the Graham and Dodd method.  Despite these flaws, “Capital Ideas” remains a great piece of work and should be studied by all finance students and investors alike.  In this author's mind, many of the assumptions that go into producing these models are inherently flawed, but the basic ideas remain sound.  If anything, these early works of Markowitz, Samuelson, and Sharpe will only serve as a basis for the further development of Modern Financial Theory, especially since we now possess both the processing power and the data to test theories that are much more complex.  Even for folks that are strict followers of Benjamin Graham and Warren Buffett, it is imperative to at least understand what your competition already knows and may (still) be utilizing on a daily basis.  Ignore this book at your own peril.

Finally, Mr. Bernstein follows “Capital Ideas” with another book that chronicles the latest developments in Modern Finance Theory since the early 1990s.  Entitled “Capital Ideas Evolving,” the book was published in early 2007 and is a great sequel, as well as a great stand-alone work.  Despite everything that has occurred since the early 1990s, however, “Capital Ideas” remains a timeless work – and still serves as a great, basic text for those who are starting to learn about Modern Finance Theory today, as well as most other books or articles that Mr. Bernstein has written over the last 15 years.

Capital Ideas Evolving
by Peter Bernstein,  published 2007

It has been 15 years since the publication of Peter Bernstein's original work on Modern Finance/Portfolio Theory, “Capital Ideas.”  It is no accident that the original environment – cheap computer processing power, floating exchange rates, and bond market volatility – that had allowed these original ideas to flourish had led further to the development of new ideas, theories, and practical applications.  Combined with the widespread adoption of the World Wide Web, cheap bandwidth, and the rapid emergence of the “emerging markets,” it would come as no surprise that there would be a need for a refresh – and Peter Bernstein, once again, is able to deliver the goods.

In the original “Capital Ideas,” Bernstein left us with a world that had the makings of a modern Wall Street – a “post-revolution” world that encompasses index funds, futures and options market, and an institutional market that was only starting to embrace the global diversification of their investments.  Despite the continued evolution of Wall Street since the late 1950s, however, Bernstein and others – from “the top of the Ivory Tower” – still lamented:

Although the revolution inspired by the new theories of finance has been profound, it has been less than total.  Nor has the investment world split into faithful users of the new methodology and inflexible believers in the orthodox approach.  The lines are blurred.

About half of all shares of stock outstanding are still owned by individual investors.  Many of them continue to manage their affairs as they always have – and as their fathers did.  Their portfolios are badly diversified, they seize on the latest market gossip, and they have no idea of how to measure whether they are doing well or poorly at the game; they are the noisiest of the noise traders … Even in the institutional world, old ways die hard.  Two-thirds of institutional money remains outside the index funds and is handled by active managers seeking to outwit the market – or trying to outperform one another.

Despite the subsequent “setbacks” caused by the 1998 LTCM crisis, the exposure of the flaws of market-cap weighted index funds during the late 1990s, and the “war” waged by behavioral finance economists over the last 15 years, the modern finance theories as espoused and practiced by the likes of Paul Samuelson, Robert Merton, Andrew Lo, Bill Sharpe, Harry Markowitz, and Myron Scholes have not only held on, but have actually continued to thrive and evolve.  Unlike his original “Capital Ideas” work (which was effectively an all-encompassing work tracing the development of Modern Finance/Portfolio Theory to the present era), “Capital Ideas Evolving” is designed as a series of interviews of the original practitioners (and others including Robert Shiller and David Swensen, formerly of the Yale Endowment Fund – you won't find George Soros, Warren Buffett, or Jim Rogers in this book) in order to give his readers an update on how modern finance/portfolio theory has evolved over the last 15 years.

Gems in this book includes Robert Merton's views on the how institutional creativity can impact changes and dynamics in the financial markets, Andrew Lo's frustration with behavior finance and the Efficient Market Hypothesis (and his subsequent discussion on his “new theory,” the Adaptive Market Hypothesis), Bill Sharpe's State-Preference Theory (vs. the CAPM), and Myron Scholes latest $2.6 billion hedge fund venture, Platinum Grove Asset Management.  The last few chapters of the book cover the CAPM – and its contributions to absolute and risk-adjusted performance measurement – as well as Wall Street's current fascination of achieving alpha and even making it “portable.”

While “Capital Ideas Evolving” is not a work that is as timeless as the original, keep in mind it is not supposed to be.  Its purpose is to merely serve as an update of Modern Finance/Portfolio Theory, and those of the original pioneers as well as some new faces and institutions (such as Goldman Sachs Asset Management).  For readers who want to read a relatively complete layman's history and update on these theories, I would highly recommend reading both of these two books from Peter Bernstein.