Capital Ideas: the Improbable Origins of Modern Wall Street
Capital Ideas: The Improbable Origins of Modern Wall Street
In his book, Capital Ideas: 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.” (2) 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
In his book, Capital Ideas: 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.” (2) 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