Capital Ideas: the Improbable Origins of Modern Wall Street

Topics: Modern portfolio theory, Capital asset pricing model, Myron Scholes Pages: 5 (1851 words) Published: May 5, 2012
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 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...
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