Capital Ideas: The Improbable Origins of Modern Wall Street Book

The ideas in Capital Ideas have been covered elsewhere, but probably never as well. Peter Bernstein looked into every old academic journal and interviewed every old economist to help him understand how new ideas about efficient markets and financial engineering penetrated Wall Street and reshaped American finance. It's a great story of abstract economic speculation having a profound effect on real lives and real money. Bernstein himself is in a perfect position to explain these conjoined developments, since he worked as an academic economist and also ran a brokerage shop on Wall Street for decades.

While early Wall Street Journal editors Charles Dow and William Peter Hamilton argued that smart forecasters could predict changing tides in the market (the "Dow Theory"), a tubercular man named Alfred Cowles who invested his family's Chicago Tribune money decided to find out if they were right. After the 1929 Crash proved most of them wrong (Hamilton predicted it, but he had also predicted a crash in 1927, and two in 1928), Cowles founded the Cowles Commission for Research in Economics. With the help of Irving Fisher of Yale, he also founded the Econmetrica journal and discovered that most stock-pickers lost relative to the market. When Henry Markowitz worked with the Cowles Commission as a graduate student (of Jacob Marshak) at the University of Chicago in the 1940s, he used this data and research to formulate his theory of Portfolio Selection, which argued that there was an inevitable, and constant, tradeoff between risk and reward, and that risk was actually just a measure of the variance in one stock portfolio and the rest of the market. When the Cowles Commission moved to Yale in 1956, its new director James Tobin used Markowtiz's insights to show there was in fact one perfect portfolio for all individuals, and that all variations in risk should be managed by the amount held of a "riskless asset," namely cash. Later, William Sharpe, working with Markowitz while the later was at RAND near UCLA, developed the idea of a single "index" by which all stock returns could be measured, which also helped simplify computer calculations about successful stock picks.

Other research influenced the budding new theories. In 1934 Holbrook Working showed that wheat prices followed a "random walk," and couldn't be predicted from former price changes. He showed random number charts to commodities traders and proved they could not differentiate them from actual market price changes. Later, at Carnegie Tech, the old hyperkinetic Keynesian Franco Modigliani and the Boston-born Merton Miller, argued that stock values were entirely independent of the way a company was financed, and that the best way to evaluate a company's investments was to see its effect on stocks.

These ideas all cumulated in the Capital Asset Pricing Model (CAP-M), created independently by William Sharpe, Jack Treynor, and John Lintner around 1963, and the Black-Scholes Options pricing model of 1972. These revolutionized the way stock brokers traded through showing that the overall risk in the stock market was the crucial variable to know and that variance of that risk for stocks and options was the crucial determinant of value.

Bernstein shows how these ideas gradually penetrated markets. They led directly to Wells Fargo's first "index fund," the Stagecoach Fund, and then to portfolio insurance for stocks in the 1980s. Bernstein points out the growth of the computer was essential in this change, since it allowed traders to use the complicated math models of the economists on the trading spot. On the whole, despite wallowing in too many obscure characters, this is another great book showing how great ideas really matter.