Photo: Peter Bernstein
Ø Theories can always resist facts; for facts are hard to establish and are always changing anyway, and ceteris paribus can be made to absorb a good deal of punishment. Inevitably, at the earliest opportunity, the mind slips back into the old grooves of thought since analysis is utterly impossible without a frame of reference, a way of thinking about things, or, in short, a theory (Paul A. Samuelson, Lord Keynes and the General Theory).
Ø We make models to abstract reality. But there is a meta-model beyond the model that assures us that the model will eventually fail. Models fail because they fail to incorporate the inter-relationships that exist in the real world (Myron Scholes).
Ø 1989-1991, beginning with the simple notion that risk is at the center of all investment decisions, that diversification is essential to successful investing, and that markets are hard to beat, the Capital Ideas – the products of the ivory towers (and also known as “neoclassical finance”) – are now the intellectual core of a myriad of powerful innovations in active investing and in risk management.
Ø Today, even some are seeking new methods of active management and searching for alpha while others are applying their theoretical ideas to the problems of financing retirement or enhancing the fairness and efficiency of the market.
Ø The academic creators of these models were not taken by surprise by difficulties with empirical testing. The underlying assumptions are artificial is many instances, which means their straightforward application to the solution of real time investment problems is often impossible.
Ø The academic knew as well as anyone that the real world is different from what they were defining. But they were in search of a deeper and more systematic understanding of how markets work, of how investors interact with one another, and of the dominant role of risk in the whole investing process.
Ø They were well aware that their theories were not a finished work, and that structure is still evolving.
Ø That is just the beginning. It may sound ironic, but as investors increasingly draw Capital Ideas to shape their strategies; to innovate new financial instruments; and to motivate the drive for higher returns in relation to risk, the real world itself is on a path toward an increasing resemblance to the theoretical world described in Capital Ideas.
| Harry Markowitz | Ø Before Markowitz’s 1952 essay on portfolio selection, there was no genuine theory of portfolio construction. Ø It was Markowitz who first made risk the centerpiece of portfolio management which centered on the idea that investing is a bet on an unknown future. Ø Markowitz’s famous comment that “you have to think about risk as well as return” had deeply divides Capital Ideas from the world before 1952. Ø Markowitz’s emphasis on the difference between the portfolio as a whole and its individual holdings has gained rather than lost relevance with the passage of time. |
| Bill Sharpe | Ø Articulation of the CAPM in 1964. Ø Before this, there was no genuine theory of asset pricing in which risk plays a pivotal role. Ø The beta of CAPM is no longer the single parameter of risk, but investors cannot afford to ignore the distinction between the risk of the expected returns of an asset class and the risk in decisions to outperform that asset class. |
| Franco Modigliani and Merton Miller | Ø Before 1958, there was no genuine theory of corporate finance and no understanding of what “equilibrium” means in financial markets. Ø MM’s perception of the stock market as the dominant determinant of whether a corporation earns its cost of capital was in many ways the intellectual driving force of the great bubble of the 1990s and the source of the scandals of corporate accounting that emerged in its wake. |
| Eugene Fama | Ø Before Efficient Market Hypothesis in 1965, there was no theory to explain why the market is so hard to beat (There was not even a recognition that such a possibility might exist). Ø Today, despite its rigid assumptions about investor rationality and the role of information, the Efficient Market Hypothesis remains the standard by which we judge market behavior and manager performance. |
| Fischer Black, Myron Scholes and Robert Merton | Ø Before they confronted both the valuation and the essential nature of derivative securities in the early 1970s, there was no theory of option pricing. Ø BSM insights into the valuation and the virtually unlimited applications of derivatives and into the meaning of volatility have pervaded every market for every asset all around the world. |
| John von Neumann | Ø The most significant insight in Game theory à each individual is not isolated from all others. Ø All economic systems, even the most primitive, depend on production and technology, but capitalism is about combat and competition – about buying and selling even more than it is about production and technology. Capitalism is a giant Von Neumann game. Ø Game Theory teaches us that human beings create a complex jumble of uncertainties for one another. Ø Risk in our world is nothing more than uncertainty about the decisions that other human beings are going to make and how we can best respond to those decisions. |
Note: Capital Ideas refers to Harry Markowitz’s work on portfolio selection, Franco Modigliani’s and Merton Miller’s revolutionary views about corporate finance and the behavior of markets, the Sharpe-Treynor-Mossin-Linther CAPM, Eugene Fama’s explication of the EMH, and the option-pricing model of Fisher Black, Myron Scholes, and Robert C. Merton.
