Capital Ideas: The Improbable Origins of Modern Wall Street

"So this is another book that’s written along the lines of A Random Walk Down Wall Street , except that the book isn’t just about great financial ideas, but also about the people who developed them. You read about financial legends like Paul Samuelson, Fischer Black, Myron Scholes and Robert Merton—all the architects of modern finance—and you really feel like you’ve met them after reading Bernstein’s beautiful exposition. He turned what otherwise could have been a rather dry and sterile subject into a living, breathing, all-too-human endeavor. By writing about the subject from the perspective of the individuals who invented these wonderful theories, he turned academic finance into a much more exciting and personal pursuit for me. Exactly. Bernstein describes the beginnings of financial market analysis by asking whether or not stock prices are predictable. He explains the random walk hypothesis and then introduces us to the various academics who attempted to predict the stock market using the fanciest statistical tools of their day and, ultimately, in the hopes of making money. And he also introduces us to those who lost money! Along the way, Bernstein provides a running narrative of the most important academic theories like Harry Markowitz’s portfolio optimization framework, Bill Sharpe’s Capital Asset Pricing Model (CAPM), and then, of course, the Black-Scholes/Merton option pricing model, the crowning achievement of modern finance. Certainly the way that they’re analyzed and priced have come from academic research. The option pricing model of Black, Scholes and Merton is a good example. Financial options had been around for centuries, but it wasn’t until 1973 that a formal exchange for options was established, the Chicago Board Options Exchange. In that same year, Black and Scholes and, separately, Merton published papers describing how to price and hedge these exotic securities. Pretty much overnight, their papers turned these esoteric instruments into well-understood objects that could be managed quantitatively. So 1973 was a pretty key year. Shortly thereafter, Texas Instruments introduced the very first programmable calculator, and one of the first things that these calculators were used for was to price options on the floor of the Chicago Board Options Exchange. So you have the confluence of new financial institutions, new financial theories, and new technology that all came together to get this market off the ground, a remarkable case of serendipity. It’s mushroomed since then, and we now have many trillions of dollars of options and other derivative securities traded each year. These academic ideas played a central role in helping investors to value derivatives and, more importantly, to manage their risks. Yes, it’s rather strange that academics would have played—and continue to play—such an important role in financial markets. You wouldn’t expect that academic finance would have much of an impact on practice, simply because business is business and academia is academia. In many other fields, there’s a pretty clear separation. But, in this instance, you had individuals without a lot of business experience, or interest in business, coming up with ideas that ultimately gave rise to multi-trillion-dollar global industries. In addition to the Black-Scholes/Merton option pricing model, Bernstein introduces readers to an idea that’s become central to how corporations manage their businesses, and that’s Bill Sharpe’s CAPM. This remarkably simple yet powerful model captures the intuition that there should be a trade-off between risk and reward. We all have the sense that when you take on greater risks in the stock market, you need to get rewarded for bearing those risks. So if you put your money into a tech startup, that’s going to be much more risky than if you put it into a company that’s been around for a hundred years, like IBM. And because the risks of smaller startups are much higher, the average rates of return of those companies will have to be higher than those of IBM, otherwise who would want to invest in them? Support Five Books Five Books interviews are expensive to produce. If you're enjoying this interview, please support us by donating a small amount . That’s the basic idea behind the CAPM, except that the model gives us a quantitative relationship between risk and reward—it tells us just how much the reward needs to be for investors to be willing to hold a certain amount of risk. Using Sharpe’s formula, investors can very quickly assess whether an investment is sufficiently attractive given its risk level, and it’s also incredibly useful in helping corporations evaluate new projects and make go/no-go decisions. Once you measure the risk of a project, you can calculate the required rate of return of that risk and then use that cost of capital to determine which project to take and which to avoid, all thanks to Bill Sharpe. There is, but the difference is that Capital Ideas focuses on the academic origins of these ideas, whereas A Random Walk is really just focused on the more practical aspects. Bernstein gives us the backstory of how the most important financial models were first developed by particular academics. Yes, my current research is focused on showing why and how some of these ideas need to be modified to take human behavior into account in a more systematic way. Most of the framework of modern finance presupposes that individuals act rationally, always and everywhere trying to maximize expected utility subject to a budget constraint in markets that are constantly in a state of equilibrium (in other words, where supply equals demand at all times and for all markets). That paradigm works sometimes, and in many cases it works quite well. But, every once in a while, humans end up acting emotionally rather than rationally. So the framework I propose—which I call the Adaptive Markets Hypothesis—offers a way to reconcile human behavior with this rational framework by applying the principles of evolution and ecology to humans engaging in financial decisions. This approach goes a long way towards resolving some of the anomalies that psychologists and behavioral economists have used to criticize financial models like the CAPM."