Improbable Origins of Modern Wall Street

The Improbable Origins of Modern Wall Street, Peter L. Bernstein examines the innovative financial work of various academics that helped shape modern Wall Street. Bernstein sets out to show that Wall Street is in fact a fundamental and useful model to follow, rather than something to be feared. He points out that, “By combining the linkage between risk and reward with the combative nature of the free market, these academics brought new insights into what Wall Street is all about and devised new methods for investors to manage their capital.

These impressive scholars have incorporated scientific measurement to the art of finance, forever changing the world of investment. Prior to 1952, investment theories had ignored this very important relationship between risk and return. Harry Markowitz gave a “formal confirmation of two old rules of investing: Nothing ventured, nothing gained. Don’t put all your eggs in one basket. ” (44) Markowitz recognized that focusing on return, without risk, leads to suboptimal portfolio selection. He concluded that the only way to minimize risk is to select a diversified portfolio of assets with low covariance.

His findings led to the idea of the efficient portfolio, which offers the highest expected return for any given degree of risk. To find this so-called efficient portfolio, one must estimate variance and expected returns of securities, which proved to be a difficult task for investors at a time when computer availability was scarce. Nevertheless, Markowitz put a system in place for assembling portfolios and formed the foundation for all future theories. It was James Tobin who provided a major simplification to Markowitz’s portfolio theory, as well as corrected some weaknesses in the model.

Markowitz assumed that portfolios consisted of only risky assets, while Tobin recognized that it could also consist of risk-free assets. It was here that Tobin developed the Separation Theorem, which argues, “The Markowitzian process of selecting securities for the most efficient risky portfolio is completely separate from the decision of how to divide up the total portfolio between risky and risk-free assets. ” (72) This model allows investors to select the single portfolio on Markowitz’s Efficient Frontier that defeats all the other combinations of portfolios.

Although Tobin’s work helped make the choice of an optimal portfolio, it did not make the task any easier. It was William Sharpe who developed an effective method for surmounting these difficulties. He developed the single-index model, which assumed that “the returns of securities are related only through common relationships with some basic underlying factor. ” (80) In effect, this eliminated the need to calculate the covariance of each pair of securities and made the calculations more feasible.

With diversification, the majority of the portfolio’s variability is explained by the index, which illustrates the important fact that investors cannot avoid accepting the risk of stock ownership in general. Sharpe’s model was a huge advance toward bringing the theory of portfolio selection into real-world applications. However, the real breakthrough came with the development of the Capital Asset Pricing Model. This model concludes that Tobin’s optimal portfolio is the stock market itself, and the optimal strategy is to buy and hold a diversified portfolio.

At a time of ultimate faith in active management strategies, this conclusion was not likely to be received well. Eugene Fama set out to establish a theory explaining the random fluctuation of prices, joining his predecessors in concluding that stock prices are not predictable. He asserts that security analysts, “help narrow discrepancies between actual prices and intrinsic values and cause actual prices, on the average, to adjust ‘instantaneously’ to changes in intrinsic values…

They establish a market in which fundamental analysis is a fairly useless procedure. (134) Fama saw the market as being efficient, in which prices immediately reflect all available information so that the market as a whole knows more than any investor. The important implication of this is that investors cannot consistently outperform the market, and if they do it is purely through luck. With competition for information reaching new heights, professional managers face greater difficulties in attempting to outperform each other. If these professionals are unable to consistently beat the market, there remains little hope for the average investor.

Franco Modigliani and Merton Miller examined how a corporation should select securities to sell in order to attain an optimal mix between debt and equity, the mirror image of what Markowitz and Tobin had studied. Their findings led them to the conclusion that the market value of a firm is independent of its capital structure. In an efficient market, the market will place the same value on firms with equal earnings power and equal risk. Their most innovative contribution to the theory of finance was in elevating arbitrage to the level of a driving force.

This Law of One Price states, “two assets with identical attributes should sell for the same price… a profitable opportunity will arise to sell the asset where it is overpriced and to buy it back when it is underpriced. The arbitrager will then lock in a sure profit, otherwise known as a free lunch. ” (171) In effect, arbitragers actually fix the imperfections in the market by bidding away the discrepancies. In doing so, they make sure that market values of firms with similar earning power and riskiness are equivalent, despite how they are financed.

In the real world firms with similar earning power and risk have very different capital structures, confirming the findings of Modigliani and Miller. Fischer Black, Myron Scholes, and Robert Merton paved the way for the establishment of financial derivatives in controlling risk. Black recognized that the relationship between gain and pain in the Capital Asset Pricing Model drives the market toward the equilibrium that Modigliani and Miller had described, and set out to apply this model to assets other than stocks.

With this model and several assumptions, he derived the differential equation. When Black and Scholes joined forces, they found that neither risk nor return belonged in this new equation because they cancelled each other out. With this new discovery, they concluded that the expected gain on an asset is irrelevant in calculating what the current price of the asset should be. Merton soon joined Black and Scholes in their work, developing the intertemporal capital asset pricing model.

This model used continuous time analysis to “transform CAPM into a description of what happens over a sequence of time periods during which conditions are changing rather than standing still. ” (215) Black and Scholes were experimenting with combining stocks and options in such a way that the value of the option and the value of the stock would move by exactly the same amount in opposite directions. They found this combination to mimic the behavior or a riskless asset and to be independent of what the market was doing.

For investors who want to determine whether an option is inexpensive or not, the Black-Scholes model provides an estimate of the stock’s volatility to help solve this problem. Bernstein pointed out the importance of this new model, stating, “The options traders who ignored the Black-Scholes model and its variants did so at their peril: without it, they were destined to get the short end of the stick. ” (227) With the increasing use of computers and calculators, this model changed the way option traders did business forever.

Options allowed investors to control risk and their outcomes. They were responsible for the growing market for home mortgages, interest rate swaps between financial institutions, escalation in daily foreign trading, and the ability of banks to shield themselves from the unpredictable changes in the market. The advances made by these three men ultimately led to the invention of portfolio insurance, which utilizes the use of put options, and is still widely used today. Bernstein has written a remarkable book that tells the story of this financial revolution and its leaders.

He sums it up nicely, writing: “Markowitzz taught the wisdom of optimizing the trade-off between risk and return. William Sharpe showed how to do it. Black, Scholes, and Merton converted these concepts into the creation of synthetic securities offering many varieties of risk control. Modigliani and Miller emphasized the critical role played by arbitrage in determining the value of securities. And Fama was there to remind investors that, in an unpredictable market, they had better not venture forth unprepared. (294)

One of the most fascinating features of this revolution was the group of individuals leading it. Intuitively, one would think it would have been led by money managers and institutional investors. Yet the leaders were far from the sort, and many of these influential scholars were not even in the financial field! This book gives, a well deserved, recognition to the finance profession. However, this recognition was slow to come among the investment community at large.

Vertin explains, “The guild system… is not an environment in which oat-rocking is encouraged… It pretends that everything worth knowing is already known and in use. ” (243) Many were fixed in their conventional ways and unwilling to disrupt the status quo, knowing that the transformations would alter or eliminate their roles in the business. However, the growing quantity of empirical proof validating these theories made it increasingly difficult to dismiss them. Over time, many of these opponents came to the realization that the investment industry could no longer afford to ignore the theories, and opposition weakened.

Bernstein’s use of summation, as well as reiteration of his main points, throughout the book make it easy to follow along and grasp the concepts. In the process of outlining each scholar’s contribution to the theory of finance, he mixes in personal histories and anecdotes making for a more interesting read and giving the reader an opportunity to connect with each individual. It is very apparent that he conducted lengthy interviews with the scholars written about in this book, lending credibility to the book.

His discussions are linked together in a timeline, allowing the reader to understand the progression of modern finance theory. Furthermore, his writing style does an exceptional job of explaining very complex theories in easily understood language. Although it may be easier to follow with a background in finance, this book is accessible to any reader. One flaw may be his overly optimistic view of these theories, with very little criticism given where it may have been needed. Nevertheless, this book on modern finance theory is a must read for all past, future, and current investors in this rapidly growing, dynamic economy.

These early works will undoubtedly serve as the foundation for further development in the financial field for years to come. Even for those who remain firm believers of the traditional methods, it is crucial to understand these theories that many others will be utilizing. Although opposition to change remains, improvements in technology show that the traditional methods are no longer optimal. All that is needed is a strong ability to communicate these revolutionary ideas to the community of investors, and they too can become believers.