Bernstein's Gale

By David Ott

In 1942, economist Joseph Schumpeter wrote The Process of Creative Destruction that argued that new machines, methods and ideas destroy the existing ones and bring about new and improved systems. In the book Capital Ideas, Peter Bernstein chronicles this process on Wall Street from his perspective as the old guard.

The story begins with a relatively unknown French mathematician named Louis Bachelier in 1900 and ends up covering the titans in modern finance: Markowitz, Sharpe, Fama, Modigliani, Black, and Sholes, among others. Throughout the journey, the prevailing market conditions and technological advances are seamlessly woven into the story, not to mention terrific personal antidotes from Bernstein’s five decade career on Wall Street.

Although the book is divided into six sections, there are really three stories. The first describes the evolution of the theories that revolutionized investment management. Prior to the 1950’s, it appears that there was little attention paid to investment theory beyond fundamental analysis of individual securities. While this is a worthy endeavor, it isn’t enough to appropriately balance the delicate risk and reward equilibrium.

Portfolio investing techniques that are now considered basic like asset allocation were inconceivable to the broker, analyst or portfolio manager in the 1950’s. As a portfolio manager at that time, Bernstein relates this with a funny personal story about how in his view, a portfolio was nothing more than “a fancy leather folder with a sheaf of papers inside.”

The first section takes you from Markowitz’s efficient frontier to Sharpe’s capital asset pricing model (CAPM), and Bernstein slowly but surely builds the case for Modern Portfolio Theory and the Efficient Market Hypothesis. The clarity of his writing, his own personal evolution over the years and his one-on-one conversations with those that originated each theory make you want to accept the totality of all of the arguments presented.

The second part gently guides us through how the academics transformed securities valuation. Bernstein starts with the origins of William’s Dividend Discount Model, then walks through Merton Modigliani’s bombshell assertion that a company’s capital structure is independent of it’s market value, and ends with the creation of the Black-Scholes model for pricing options – one of the fundamental building blocks of modern finance.

The last section is comprised of three case studies where some of the first professionals put the theories into practice, or as Bernstein calls it, taking the ideas “from gown to town.” At first, this seemed to be the least interesting part, but it turns out to be as illuminating as the preceding pure theory.

The 1970’s were the tipping point for putting the ideas into practice for two major reasons. First, the bear market of 1973-74 sent everyone back to the drawing board and opened doors to those with new ideas. Second, there were major advances in computing power that allowed for substantial calculations that the new theories required.

The first case study is Wells Fargo’s creation of the index fund. The second case study is a thorough discussion of a successful pension consultant Barr Rosenberg, founder of BARRA, who took the ideas to Wall Street. Perhaps the most interesting case study, however, is the birth of portfolio insurance.

Theoretically, portfolio insurance is essentially the equivalent of a put option. Because index options didn’t exist yet, two professors from Berkley started a management firm that used computer programming to adjust an allocation between stocks and cash depending on market conditions that acted like a put option. The insured portfolio was designed to be 100 percent cash at a predetermined percentage loss. As conditions changed, the computers were programmed to make additional buys or sells.

Although the strategy was in application for nearly a decade, the day of reckoning came on Black Monday, in October 1987, when the market dropped by 22.6 percent. This was the critical test for portfolio insurance and it failed. In fact, many have argued that portfolio insurance contributed to the losses rather than ameliorated them.

One of the critical assumptions built into portfolio insurance was that there would always be sufficient liquidity to execute any trades that the programming required. Despite all of the modeling and programming that had been done, this was a fatal assumption, because even though the computer may have been ‘right’ to sell, there were no buyers which caused the program to sell more, creating a vicious cycle.

This seems like an interesting choice of topics to end the book since it clearly suggests that while the young turks from the ivory towers had succeeded in breaking down the old system that was firmly entrenched on Wall Street, the new system was far from perfect. The models that had been created were immensely useful, but they tend to create the illusion of precision and somehow urge users to focus more on the output rather than the value and assumptions of the inputs.

In the case of portfolio insurance, the models assumed that there would be sufficient liquidity to execute the waves of orders, but the human element crept in and the system locked up, creating a free fall in prices. Of course, this would seem obvious to an old time floor trader, but to an academic buried in equations and proofs, it was an overlooked factor (one of the inventors went on to argue that the insurance had worked, it was the market that failed).

Bernstein is an incredibly thoughtful writer. The tenor and flow of the book is easy even when the concepts are not. There is plenty of humor and delightful sideshows to keep the reader fully engaged. Most importantly, given Bernstein’s stature in the field, he has the opportunity to interview nearly all of those that he covers in the book and you feel like you know who they are as people, which is fascinating. Bernstein strikes a perfect balance between interesting story and technical description.

Bernstein is still active and recently published Capital Ideas Evolving, the subject of the next review. As the gales of creative destruction continue to reinvent Wall Street, it is easy to appreciate a writer with as much access, curiosity and lucidity as Mr. Bernstein.


June 25, 2008
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Recommendation: Strong Buy

Capital Ideas:
The Improbable Origins of Modern Wall Street
By: Peter Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2005
First Published: 1992

ISBN: 13 978-0-471-73174-0