bernstein, 2005

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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: http://www.jstor.org/stable/4480714Accessed: 10-09-2015 11:01 UTC

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FIN,&ANCIAL NALYSTS JOURNAL

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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 behavior 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 genuine 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).

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Franco Modigliani, we had no general theory of corporate finance, only rules of thumb and folklore, and no recognition of the overwhelmingly powerful 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 investment 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 understanding of how markets work, how investors inter- act, and how portfolios should be composed. They understood that financial markets are about capitalism, 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 powerful, 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.

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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 flaws that it reveals in modern portfolio theory imply that MPT is irrelevant or whether behavioral finance provides fresh insights. Is behavioral finance the new paradigm? Much of it is not really theory, not a set of generalizations but a collection of anecdotes. Many of the findings are ephemeral and, under no-arbitrage conditions, will be or have been competed away. Other fea- tures in the behavioral literature seem to be more deeply embedded. Robert Shiller pointed out back in the early 1980s that stock prices are too volatile relative to changes in the underlying fundamentals and saw this circumstance as a serious sign of lack of rationality among investors (Shiller 1981).

Others have attacked theories that assume the normal distribution in the market as not being the way the world works-for example, The Misbehav- ior of Markets (Mandelbrot and Hudson 2004). From prospect theory, the centerpiece of Kahneman and Amos Tversky's behavioral work (1974, 1979), we have learned that we are asymmetrical in our views of profits and losses: We are risk takers when we have losses and risk averse when we have profits. In addition, we tend to emphasize recent news rather than long-term trends. We yield to powerful, mysterious phenomena-herding and a taste for momentum.

All of these phenomena add up to insufficient and inadequate processing of information. Inves- tors are not always and everywhere rational. Priors are usually mistaken about the right price. Indeed, even the notion in the efficient market hypothesis that there exists an equilibrium price, a correct price, is false. The world is moving so fast that the equilibrium price today will not be the same equilibrium price tomorrow.

Behavioral finance's impact on the market can be looked at also from other and different perspectives. Merton, in a speech given at the CFA Institute (at the time, AIMR) Annual Meeting of 2004, stated that he believes behavioral finance cannot be

understood without understanding the institutions in which we work and under which we live. He believes that many of the anomalies pointed out in behavioral finance will change, will be altered (and in some cases overcome) by changing institutional arrangements. He may be excessively opti- mistic about some of these things, but it's important to understand what he is talking about. For example, Merton pointed out that more decisions are made by institutions, such as mutual funds, than by individuals for themselves, which changes the patterns in the marketplace. Our institutional framework has been changed by derivatives, by hedge funds, by falling transaction costs, by the end of the Glass-Steagall Act of 1930, by globalization of financial markets, and by the con- tinual drive to a no-arbitrage condition. Merton also thinks investment committees make a differ- ence. Those of us who have been involved with investment committees might wonder about this judgment, but the point is that as the institutional framework changes, the behavioral anomalies change because different forces are affecting them.

A strange two-way feedback process goes on between theory and behavior. Sociologists use a terrible but apt word to describe the relationship of theory to behavior-"performativity." It is akin to "'self-fulfilling prophecy." When people read about a theory and believe in it, they begin to act in conformity to it. So, as we learn MPT ideas-we sit down and read Markowitz and Fama and so on- we begin to act that way. If we say the market is substantially efficient, we then have to rearrange portfolios in a particular way and worry whether we can beat the market. We even index our assets. So, we begin to prove the theory. If we find a new set of models that we believe in, we will begin to make those models work by reflecting them in our decision making.

Andrew Lo has written about the markets being evolutionary, Darwinian. As markets change and evolutionary forces come to play a role, the winners and losers of today are not the same as the winners and losers of yesterday or tomorrow. Having come into this business in 1951, I can attest to that truism. So, although behavioral finance is extremely important in trying to understand what is going on, we have to keep in mind that what look like anomalies today will not necessarily be anomalies tomorrow. Behavioral anomalies are where alphas lurk, but nobody would claim that finding alpha with any degree of consistency and skill is easy.

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Status of Capital Ideas Today With all the anomalies and all the manifestations of a lack of rationality in the markets, and with indi- vidualistic, Darwinian markets, how can anyone assert that capital ideas are alive and well? First, MPT is the root of all risk management theories today. MPT defines risk as volatility. The definition has a lot of problems because volatility is essentially a short-term phenomenon. But it has many advantages. Volatility reflects surprise; what hap- pens is different from what was expected, which reminds us that investing is a risky business. Vola- tility is mathematically malleable, which may be why it has been a focus of theory. But for long-term investors, volatility has a different meaning. It is for them, in many ways, not risk but opportunity. Despite its shortcomings as a measure of risk, volatility is the only measure of risk that runs through all of the MPT body of thought.

I define risk as meaning that more things can happen than will happen. If there were no risk, we would know exactly what was going to happen, and vice versa. All "risk" really means is that the future is uncertain, the future is unknown. So, whether prices are going up or down, volatility is scary. In a period like 2001, you wonder what is going on. Today things look good; tomorrow they look bad. What is going on? If this is going up when I think things are bad, somebody must know more than I do! It's scary. So, although volatility in a strict sense is an incomplete measure of risk, in a psycho- logical (gut) sense, it is a powerful measure of risk. Volatility makes us act differently from the way we would act if the market were calm all the time. Shiller, who is one of the most articulate, interesting, and powerful critics of MPT, nevertheless places overwhelming importance on risk and volatility and asserts that this contribution of portfolio theory towers over the whole field.

Furthermore, we know that capital ideas are alive and well because you cannot improve a theory until you have attacked it, and the attack does not have to be negative. It can be positive. Many applications of the techniques of risk management are as yet unexplored. Shiller and Merton are working in positive ways to develop new forms of risk management that will benefit people as citizens and workers as well as investors.

The efficient market hypothesis may not be an accurate description of reality. The market, in itself, is not truly efficient. Yet, it is the standard by which we judge market behavior and the standard by

which we measure manager performance. No one has found important cases of lagged variables that consistently and forever explain stock price returns. Only a tiny number of investors consistently beat the market year after year on a risk-adjusted basis, even though the market itself is not fully efficient in the classical sense that all information is immedi- ately known, understood, and reflected in asset prices without any lag. Yet, the idea of efficiency is spreading way beyond the United States, and markets abroad that were once considered very ineffi- cient are becoming more efficient all the time. Lo is right: It's Darwinian out there.

Mean-variance efficiency requires assumptions we cannot make, especially relating to the role of time and the normal distribution, but the risk- return trade-off is central to portfolio selection and professional money management. Modern diversi- fication takes many forms-not necessarily Markowitz's paradigm but, philosophically, still the Markowitz idea.

The capital asset pricing model is an empirical failure, and the CAPM beta is certainly no longer the single measure of risk. Yet, the notion of systematic versus specific risk infuses portfolio management. Meanwhile, today's concept of portable alpha as separate from beta is a big idea and a wonderful concept. All of the tools it uses come out of MPT.

Cliff Asness has pointed out that many hedge fund strategies change from alpha to beta as they become accepted and copied through the hedge fund population. Beta means "risk that cannot be diversified away," so as hedge funds begin to do the same things, hedge fund risk becomes beta risk. No alpha remains.

Finally, the ultimate offshoot of the CAPM is indexing. The market portfolio is the only mean- variance portfolio. This huge idea dominates everything that we do. Indexing is alive and well despite the foolishness of the bubble years and variations on the theme.

In addition to the powerful and deeply perva- sive idea that market value is all that matters, M&M taught us something else-something we often forget-namely, the right side of the balance sheet and the left side of the balance sheet add up to the same number on the bottom. They are only opposite sides of the same things, despite all kinds of new ways to dice and splice the liabilities and the risks. We are finally beginning to learn Marty Leibowitz's lesson (1986) that pension funds have liabilities as well as assets and that there is a relationship between the two.

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Re/lec tia ns

Along these lines, Merton has always considered the corporation to be a set of contingent claims in which corporate equity is really a put option that the stockholders have. The stockholders can always put the assets to the creditors-"Here, you take them." The strike price is the debt, the bond yield is the interest rate, and corporate volatility is the implied volatility that prices the equity's worth. To think about a company, the complex system we know as a corporation, in terms of these contingent claims offers important insights.

Finally, derivatives influence almost everything we do. Every aspect of investing, every strat- egy is in one way or another involved in hedging

risks. Exciting work of many different forms is going on in this field.

Conclusion If we say that the theories in Capital Ideas are obsolete, then in the same breath, we must say that Aristotle and Euclid are obsolete. Merton's father, Robert K. Merton, acknowledged, as Newton did, that we stand on the shoulders of giants. We cannot understand the investment process in the present unless we know where it came from, and it came from these ideas, one of the great intellectual leaps in history.

Note 1. Keith Ambachtsheer has important things to say about this

area of theory in his wonderful article in the January/ February 2005 FAJ.

References Ambachtsheer, Keith. 2005. "Beyond Portfolio Theory: The Next Frontier." Financial Analysts Journal, vol. 61, no. 1 (January/ February):29-33.

Bernstein, Peter L. 1992. Capital Ideas: The Improbable Origins of Modern Wall Street. New York: Free Press.

Cornell, Bradford, and Richard Roll. 2005. "A Delegated-Agent Asset-Pricing Model." Financial Analysts Journal, vol. 61, no. 1 (January/February):57-69.

Fama, Eugene, and Kenneth R. French. 2004. "The CAPM: Theory and Evidence." Journal of Economic Perspectives, vol. 18, no. 3 (Summer):25-46.

Kahneman, D., and A. Tversky. 1974. "Judgment under Uncertainty: Heuristics and Biases." Science, vol. 185:1124-31.

.1979. "Prospect Theory: An Analysis of Decisions under Risk." Econometrica, vol. 47, no. 2:313-327.

Leibowitz, Martin L. 1986. "Total Portfolio Duration: A New Perspective on Asset Allocation." Financial Analysts Journal, vol. 42, no. 5 (September/October):18-29, 77; reprinted in Financial Analysts Journal, vol. 51, no. 1 (January/February 1995 50th Anniversary Issue):139-148.

Mandelbrot, Benoit, and Richard L. Hudson. 2004. The Misbehavior of Markets. New York: Basic Books.

Markowitz, Harry M. 1952. "Portfolio Selection." Journal of Finance, vol. 7, no. 1 (March):77-91.

Merton, Robert C. 1987. "On the Current State of the Stock Market Rationality Hypothesis." In Macroeconomics and Finance: Essays in Honor of Franco Modigliani. Edited by Rudiger Dornbusch, Stanley Fischer, and John Bossons. Cambridge, MA: MIT Press.

Modigliani, Franco, and Merton Miller. 1958. "The Cost of Capital, Corporation Finance and the Theory of Investment." American Economic Review, vol. 48 (June):261-297.

. 1963. "Corporate Income Taxes and the Cost of Capital: A Correction." American Economic Review, vol. 53 (June):433-443.

Perold, Andre F. 2004. "The Capital Asset Pricing Model." Journal of Economic Perspectives, vol. 18, no. 3 (Summer):3-24.

Shiller, Robert. 1981. "Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?" American Economic Review, vol. 71, no. 3 (June):421-436. Reprinted in Economic Policy (1996, Edward Elgar Publishing) and in The History of Management Thought (1997, Dartmouth Publishing).

Williams, John Burr. 1938. The Theory of Investment Value. Cambridge, MA: Harvard University Press (1997 edition available from Fraser Publishing, Burlington, VT).

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