The Evolution of Finance: A Review of Peter Bernstein's Capital Ideas
The world of finance is ever-changing. Over the last century, the modern form of economic and financial theory as we see today has been developed and shaped by the minds of many. What we have come to know and accept as fact today were seemingly unheard of nearly fifty years ago. It is with the endless efforts of these like-minded scholars that gives us the opportunity to appreciate the tools and fundamentals we used today to capitalize on financial markets.
Peter Bernstein is his book Capital Ideas: The Improbable Origins of Modern Wall Street, provides us with a framework and timeline of how economics and finance interact. He details the ideas and contributions that many men have made in the evolution of financial theory. Finance was neglected by economists for many years, Bernstein argued. Early financial economists struggled to gain the acceptance of their economic colleagues. Yet, throughout his book he explains the process of how many dedicated and improbable individuals, such as engineers, physicists, mathematicians, and eventually economists put their minds into the financial world.
Bernstein begins the financial theory chronology with the question that has stumped stock market analysts for years: How can the movement of stocks be predicted? “This appetite for predicting stock prices is all the more striking, because a huge volume of academic research demonstrates that it is a devilishly difficult job not likely to get any easier” (Pg. 18).
The scholar responsible for first tackling this question was Louis Bachelier, back in 1900. He completed a dissertation titled “The Theory of Speculation”, which attempts to explain why the stock market behaves as is does. He came up with a formula that “anticipated Einstein's research into the behavior of particles subject to random shocks in space” (Pg. 18). And he developed the the concept of stochastic processes, which analyze the random movements of statistical variables. This helped explain to everyone why stock prices are so hard, and most of the time impossible to predict. In the early days, people didn't pay too much attention to what Bachelier had to say because those who controlled the financial world didn't particularly care how the stock market operated. The great success people had in the stock market in the first part of the century was too much of a distraction. However, Bachelier set the stage for the future of finance, and a platform for future scholars to advance from.
One of the biggest contributors that Bernstein gives credit to is Harry Markowitz. Publishing a paper in 1952 titled “ Portfolio Selection”, Markowitz didn't realize that he was setting a landmark in the history of ideas. He stressed that risk is central to the entire process of investing. Bernstein goes on to say, “The perception that human beings are naturally risk-averse seems obvious enough. Nevertheless, the literature on investing up to 1952 had either ignored the interplay between risk and return or had treated it in the most casual manner.” (Pg. 48).
Markowitz was the pioneer for Modern Portfolio Theory. He stressed about efficiency, meaning maximum output for a given input, or vice versa. And with that he developed what is called the Efficient Portfolio, where no added diversification can lower the portfolio's risk for a given return, and also the Efficient Frontier, which is the set of all portfolios that will give the highest expected return for a given level of risk. While new information in the marketplace interacts with prices, expectations and risk, accurate calculations to arrive at Markowitz's theories proved to be a daunting task. However his contributions were a huge step forward that would inspire many more new ideas.
Bernstein attributes the next-in-line contributor as James Tobin. With Markowitz's theories being so complex, and asking investors to perform intimidating approaches to find...
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