When economic historian and consultant Peter L. Bernstein wrote Capital Ideas, published in 1992, he gave us an extraordinarily well-written narrative of how modern portfolio theory has developed. Replete with anecdotes about leading theoreticians, he made the entire subject come alive.
Now, he has advanced our understanding in Capital Ideas Evolving, published by John Wiley & Sons Inc. This new book explains how academicians have shifted into the investment management world. As Mr. Bernstein told the CFA Institutes annual conference April 29-May 2, it is the story of how gown has come to town.
Mr. Bernstein explains the problems with neoclassical finance theory the theory of finance from Harry Markowitz linking risk to return in 1952 through the unveiling of options-pricing theory in 1973. Those towering intellectual developments formed the basis of Mr. Bernsteins earlier book.
As Daniel Kahneman, a psychology professor at Princeton University and 2002 Nobel laureate in economics told Mr. Bernstein, as related in the book: the problem with neoclassical finance is the human brain does not conform to the rational model. Who could design a brain that could perform in the way this model mandates? Every single one of us would have to know and understand everything, completely, and at once, Mr. Kahneman said.
Mr. Bernstein examines the contributions of behavioral finance academics the upstart economists who have thrown repeated darts at the neoclassicists, particularly those who espouse the efficient market hypothesis, which says that all information is immediately reflected in market prices. The behavioral finance types point to numerous anomalies or inconsistencies in the market.
The irony, Mr. Bernstein notes, is active managers employing behavioral finance discoveries have made the market more efficient because they keep unearthing more sources of alpha, which are then exploited until they are exhausted. He wrote: Behavioral finance has also become the driving force toward the Efficient Market Hypothesis that it so vigorously attacks.
But the old school rationalists have changed their tune. William F. Sharpe Jr., who won the Nobel prize in economics for developing the capital asset pricing model, now has become a financial engineer, Mr. Bernstein wrote.
Mr. Sharpe now espouses state-preference theory, which requires a clunky simulation rather than the simple elegance of CAPM. The CAPM model, Mr. Sharpe acknowledges, doesnt work because it makes some extreme assumptions and attempts to measure expectations for asset prices. Its dangerous, at least in general, to think of risk as a number, Mr. Sharpe told Mr. Bernstein in one of the books most electrifying quotes.
Even Harry Markowitz, who shared the 1990 Nobel prize with Mr. Sharpe, has abandoned equilibrium models because of their simplistic assumptions. Instead, Mr. Markowitz, along with Bruce I. Jacobs and Kenneth N. Levy, principals at Jacobs Levy Equity Management Inc., now are developing a simulation that builds in behavioral finance concepts, such as overconfidence and loss aversion.
Whats more, the academicians have shifted their focus from theory to the real world Mr. Sharpe through Financial Engines Inc., which he chairs, and Mr. Markowitz in his recent work with Jacobs Levy.
Capital Ideas Evolving is not as well crafted as its predecessor. Its more inside baseball, and doesnt flow as smoothly as the earlier work. Still, Mr. Bernstein explains modern finance better than any writer in the English language, and when he hits the mark, he is unbeatable. I would have given my eyeteeth to have written that volatility is a fancy word for what happens when we are taken by surprise.