Capital Ideas Evolving

"A lot has happened in the financial markets since 1992, when Peter Bernstein wrote his seminal Capital Ideas. Happily, Peter has taken up his facile pen again to describe these changes, a virtual revolution in the practice of investing that relies heavily on complex mathematics, derivatives, hedging, and hyperactive trading. This fine and eminently readable book is unlikely to be surpassed as the definitive chronicle of a truly historic era." —John C. Bogle, founder of The Vanguard Group and author, The Little Book of Common Sense Investing "Just as Dante could not have understood or survived the perils of the Inferno without Virgil to guide him, investors today need Peter Bernstein to help find their way across dark and shifting ground. No one alive understands Wall Street's intellectual history better, and that makes Bernstein our best and wisest guide to the future. He is the only person who could have written this book; thank goodness he did." —Jason Zweig, Investing Columnist, Money magazine "Another must-read from Peter Bernstein! This well-written and thought-provoking book provides valuable insights on how key finance theories have evolved from their ivory tower formulation to profitable application by portfolio managers. This book will certainly be read with keen interest by, and undoubtedly influence, a wide range of participants in international finance." —Dr. Mohamed A. El-Erian, President and CEO of Harvard Management Company, Deputy Treasurer of Harvard University, and member of the faculty of the Harvard Business School "Reading Capital Ideas Evolving is an experience not to be missed. Peter Bernstein's knowledge of the principal characters-the giants in the development of investment theory and practice-brings this subject to life." —Linda B. Strumpf, Vice President and Chief Investment Officer, The Ford Foundation "With great clarity, Peter Bernstein introduces us to the insights of investment giants, and explains how they transformed financial theory into portfolio practice. This is not just a tale of money and models; it is a fascinating and contemporary story about people and the power of their ideas." —Elroy Dimson, BGI Professor of Investment Management, London Business School "Capital Ideas Evolving provides us with a unique appreciation for the pervasive impact that the theory of modern finance has had on the development of our capital markets. Peter Bernstein once again has produced a masterpiece that is must reading for practitioners, educators and students of finance." —André F. Perold, Professor of Finance, Harvard Business School

Table of Contents:
Preface ix A Note on Usage xxii PART I: THE BEHAVIORAL ATTACK 1. Who Could Design a Brain . . . 3 2. The Strange Paradox of Behavioral Finance: “Neoclassical Theory Is a Theory of Sharks” 19 PART II: THE THEORETICIANS 3. Paul A. Samuelson: The Worldly Philosopher 37 The Institutionalists 4. Robert C. Merton: “Risk Is Not an Add-On” 47 5. Andrew Lo: “The Only Part of Economics That Really Works” 58 6. Robert Shiller: The People’s Risk Manager 65 The Engineers 7. Bill Sharpe: “It’s Dangerous to Think of Risk as a Number” 91 8. Harry Markowitz: “You Have a Little World” 100 9. Myron Scholes: “Omega Has a Nice Ring to It” 110 PART III: THE PRACTITIONERS 10. Barclays Global Investors: “It Was an Evangelical Undertaking” 127 11. The Yale Endowment Fund: Uninstitutional Behavior 148 12. CAPM II: The Great Alpha Dream Machine: We Don’t See Expected Returns 165 13. Making Alpha Portable: “That’s Become the New Mantra” 179 14. Martin Leibowitz: CAPM in a New Suit of Clothes 196 15. Goldman Sachs Asset Management: “I Know the Invisible Hand Is Still There” 214 PART IV: CAPITAL IDEAS TOMORROW 16. Nothing Stands Still 237 Notes 247 Bibliography 252 Acknowledgments 261 Index 263

About the Author :
Peter L. Bernstein is President of Peter L. Bernstein, Inc., an investment con-sultant firm he founded in 1973, after many years of managing billions of dollars in individual and institutional portfolios. Bernstein is also the author of ten books on economics and finance, including the bestselling Capital Ideas, Against the Gods: The Remarkable Story of Risk, and The Power of Gold: The History of an Obsession. He has lectured widely throughout the United States and abroad, and has received the highest honors from his peers in the investment profession.

Review :
"In both its sweeping account of investment ideas and the depth of the author's insights, "Capital Ideas Evolving" is unmatchable." ("Financial Analysts Journal," July/August 2008) FIFTY years ago, the business of managing other people's money was very much an art not a science, and was largely a matter of finding someone who was privy to inside information. But during the 1950s, 1960s and 1970s, academics changed the study of what became known as portfolio management. They did so in the face of much initial resistance and scepticism from the industry. In his 1992 book, "Capital Ideas," Peter Bernstein gave a magisterial account of the academics' thinking. The likes of Harry Markowitz, Bill Sharpe and Myron Scholes developed theories to explain the link between risk and reward, the gains to be made through diversification and the framework for valuing financial options. In recent years, however, some of these concepts have come under attack. Critics have argued that the academics used too many simplifying assumptions, such as ignoring trading costs. A school of thought, known as behavioural finance, has proposed that investors are not as rational as the models assume and are subject to psychological biases, such as a reluctance to cut their losses. Now Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets. Modern investors are much more sophisticated in the way they think about risk, in particular separating the returns available from market movements (beta in the jargon) and managerial skill(alpha). The academic concept of efficient market theory--that prices already reflect all available information--has led to the creation of index-tracking funds that allow investors to own a diversified portfolio at very low cost. Although behavioural financiers have spotted market anomalies, they have not shown that these can be systematically exploited: the average fund manager still struggles to produce a return that matches the index. Indeed, Mr Bernstein seeks to show how financial giants such as Barclays Global Investors and Goldman Sachs Asset Management have built on the insights developed by the academics. If there are ways systematically to beat the markets these days, they probably require men with physics doctorates and massive computer power rather than a smooth manner and the right contact book. There is the equivalent of a technological arms race as modern fund managers vie to find the best computer models and to trade quickly before their competitors spot the same opportunities. This race is making the markets more efficient, and so making the academics' models look more realistic than before. As Mr Bernstein recognises, this frantic activity is something of a paradox. The academics have taught us to be suspicious of the claims of the investment industry. But if the fund managers were not beavering away trying to pick stocks, prices would not be set efficiently and the academics would be proved wrong. Lacking its predecessor's historical sweep, this book is not quite as impressive a feat of scholarship. But Mr Bernstein has yet again produced a book that is insightful and thought-provoking. ("The Economist," June 15, 2007) .,."a challenging sequelto (and spirited defense of) his 1992 classic" ("Bloomberg," Friday 8th June) "Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets...a book that is insightful and thought-provoking." ("The Economist") "Mr Bernstein has yet again produced a book that is insightful and thought-provoking." ("The Economist," 15th June 2007) .,."an enthusiastic study of the academics whose theories have revolutionised global markets...also a great primer in the ideas that currently govern the way the world's money is invested." ("Financial Times") "Brilliant...This book should be in your library" ("MarketWatch") .,."an enthusiastic study of the academics whose theories have revolutionised global markets...also a great primer in the ideas that currently govern the way the world's money is invested." ("Financial Times," Mon 2nd July) "satisfying read" (Capital Ideas Evolving, Monday 6th August) "a clear and elegant introduction to the debate, including vignettes of all the main intellectual figures" ("Financial Times," Saturday 15th December 2007) .,." an excellent introduction to...modern portfolio theory and will appeal to academics, practitioners, and to others who study financial markets." ("Pension, Economics and Finance Journal" (PEF), Vol. 7/2 08) FIFTY years ago, the business of managing other people's money was very much an art not a science, and was largely a matter of finding someone who was privy to inside information. But during the 1950s, 1960s and 1970s, academics changed the study of what became known as portfolio management. They did so in the face of much initial resistance and scepticism from the industry. In his 1992 book, "Capital Ideas," Peter Bernstein gave a magisterial account of the academics' thinking. The likes of Harry Markowitz, Bill Sharpe and Myron Scholes developed theories to explain the link between risk and reward, the gains to be made through diversification and the framework for valuing financial options. In recent years, however, some of these concepts have come under attack. Critics have argued that the academics used too many simplifying assumptions, such as ignoring trading costs. A school of thought, known as behavioural finance, has proposed that investors are not as rational as the models assume and are subject to psychological biases, such as a reluctance to cut their losses. Now Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets. Modern investors are much more sophisticated in the way they think about risk, in particular separating the returns available from market movements (beta in the jargon) and managerial skill (alpha). The academic concept of efficient market theory--that prices already reflect all available information--has led to the creation of index-tracking funds that allow investors to own adiversified portfolio at very low cost. Although behavioural financiers have spotted market anomalies, they have not shown that these can be systematically exploited: the average fund manager still struggles to produce a return that matches the index. Indeed, Mr Bernstein seeks to show how financial giants such as Barclays Global Investors and Goldman Sachs Asset Management have built on the insights developed by the academics. If there are ways systematically to beat the markets these days, they probably require men with physics doctorates and massive computer power rather than a smooth manner and the right contact book. There is the equivalent of a technological arms race as modern fund managers vie to find the best computer models and to trade quickly before their competitors spot the same opportunities. This race is making the markets more efficient, and so making the academics' models look more realistic than before. As Mr Bernstein recognises, this frantic activity is something of a paradox. The academics have taught us to be suspicious of the claims of the investment industry. But if the fund managers were not beavering away trying to pick stocks, prices would not be set efficiently and the academics would be proved wrong. Lacking its predecessor's historical sweep, this book is not quite as impressive a feat of scholarship. But Mr Bernstein has yet again produced a book that is insightful and thought-provoking. ("The Economist," June 15, 2007) .,."a challenging sequel to (and spirited defense of) his 1992 classic" ("Bloomberg," Friday 8th June) "Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he acceptssome of the theories' limitations, he argues that the professors built the structure for today's capital markets...a book that is insightful and thought-provoking."--"The Economist" "Mr Bernstein has yet again produced a book that is insightful and thought-provoking." ("The Economist," 15th June 2007) .,."an enthusiastic study of the academics whose theories have revolutionised global markets...also a great primer in the ideas that currently govern the way the world's money is invested."--"Financial Times" "Brilliant...This book should be in your library"--"MarketWatch" .,."an enthusiastic study of the academics whose theories have revolutionised global markets...also a great primer in the ideas that currently govern the way the world's money is invested." ("Financial Times," Mon 2nd July) "satisfying read" (Capital Ideas Evolving, Monday 6th August) "a clear and elegant introduction to the debate, including vignettes of all the main intellectual figures" ("Financial Times," Saturday 15th December 2007) .,." an excellent introduction to...modern portfolio theory and will appeal to academics, practitioners, and to others who study financial markets." ("Pension, Economics and Finance Journal" (PEF), Vol. 7/2 08)