"Capital Ideas"

I spent most of the day at the beach in my new beach chair, with my new beach umbrella, and this book which I finished. We have to go home this coming Tuesday, weather permitting.

I cannot recommend this book until I read the 2007 update. Until then, the included notes should suffice. For those actually interested in the history of the people behind Modern Portfolio Theory, they should read this book. The concepts of Modern Portfolio Theory are all mentioned but not in any depth.

Peter L. Bernstein, “Capital Ideas” (The Improbable Origins of Modern Wall Street), The Free Press, 1992, 306 Pages
The Improbable Origins of Modern Wall Street is considered a worldwide guide to modern investment theories and practices. Capital Ideas Evolving is a follow-up to this work & was published in May 2007. (I have that book on order).
Peter Bernstein is an economic consultant to institutional investors and was the founder and first editor of The Journal of Portfolio Management. Capital Ideas is a history of modern finance describing how a group of academic scholars showed how risk could be controlled through diversification. Their ideas were dismissed by Wall Street veterans until the shattering bear market of 1974.

Pg. 2: A tiny contingent of scholars who had no direct interest in the stock market and whose analysis of the economics of finance began at high levels of abstraction is the subject of this book. The message they brought is simplicity itself, based on two of the most basic laws of economics. There can be no reward without risk. And gaining an advantage over skilled and knowledgeable competitors in a free market is extraordinarily difficult. By combining the linkage between risk and reward with the combative nature of the free market, these academics brought new insights into what Wall Street is all about and devised new methods for investors to manage their capital.

The first signs of the revolution in finance and investing appeared in October 1974, with the culmination of the worst bear market in common stocks since the Great Crash of 1929. By the time prices finally touched bottom, market values had fallen more than 40% from what they had been two years earlier.
That was not all. An overheated domestic economy and the rapacity of the OPEC countries had sent inflation soaring. In just a year and a half, the cost of living jumped 20%, more than 1% a month. After adjustment for inflation, the entire rise in stock prices since 1954 had been erased. At the same time, the bond market, the traditional haven for the risk-averse, suffered a 35% loss of purchasing power.

Pg. 18: The exploration into whether investors can successfully forecast stock prices has roots that reach all the way back to 1900, when Louis Bachelier, a young French mathematician, completed his dissertation “The Theory of Speculation.” Bachelier laid the ground work on which later mathematicians constructed a full-fledged theory of probability. However, his work lay dormant for 60 years!

Pg. 21: The size of a market fluctuation tends to grow larger as the time horizon stretches out. In the course of a minute, fluctuations will be small—less than a point in most instances. During a full days trading, moves of a full point are not unusual. As the time horizon moves from a day to a week to a month to a year and then to a series of years, the range within which prices swing back and forth will grow ever wider. Bachelier determined that the width interval will be proportional to the square root of time. This prediction as held up with stunning precision. Stock prices in the United States over the past sixty-odd years have behaved almost exactly as Bachelier said they would. Two-thirds of the time, they have moved with a range of 5.9% on either side of their average level in the course of a month. But the range in the course of a year has not been 72%, or twelve times as much; rather, it has averaged around 20%, or about three and a half times the monthly range. The square root of 12 is 3.46!

If stock prices vary according to the square root of time, they bear a remarkable resemblance to molecules randomly colliding with one another as they move in space. Robert Brown discovered this phenomenon early in the nineteenth century, and it is generally known as Brownian motion. Brownian motion was a critical ingredient of Einstein’s theory of the atom. The mathematical formula that describes this phenomenon was one of Bachelier’s crowning achievements.

Pg. 27: The first Dow Jones average appeared in 1884. It consisted of the closing prices of eleven companies: nine railroads and two industrials. Dow’s idea was to provide an overall measure of the performance of active companies, at a time when an average day’s activity on the New York stock Exchange was about 250,000 shares.

Pg. 28: The term “industrial” is really a misnomer, because not all of the companies listed as industrials were industrial companies. They were simply all the companies that were neither railroads nor utilities. Today the industrials include all stocks that are not utilities, railroads, airlines, or truckers.

Pg. 41: The most famous insight in the history of modern finance and investment appeared in a short fourteen page paper titled “Portfolio Selection.” It was published in 1952 in the Journal of Finance by an unknown 25-year-old graduate student from the University of Chicago named Harry Markowitz. Thirty-eight years later this discovery would earn him a Nobel Prize in economic sciences. The ideas in this paper went relatively unnoticed until after 1960; by that time, Markowitz had converted the ideas from the paper into a full-length book.

Pg. 42: Widespread legal restrictions in the early 1950s limited to 50% or less the proportion of personal trusts and estates that could be invested in stocks. Only one in sixteen adults owned any shares, and the number of brokerage offices was still 20% below what it had been in 1929. After twenty-three years, stock prices were still one-third below their 1929 peak. Stock ownership was considered so risky that the stocks of some of the best companies were paying dividends nearly three times the interest being paid on savings accounts.

Pg. 48: The perception that human beings are naturally risk-averse seems obvious enough. Nevertheless, the literature on investing up to 1952 had either ignored the interplay between risk and return or had treated it in the most casual manner. At that time the prevailing sentiment on Wall Street was that diversification was an admission that you apparently did not know what to do so you just tried to strike an average. Markowitz found that a single-minded focus on return, without regard to risk, leads to portfolio selection that is less than optimal.

Pg. 54: Markowitz’s most original contribution was his insistence on distinguishing between the riskiness of an individual stock and the riskiness of an entire portfolio. The riskiness of a portfolio depends on the covariance of its holding, not on the average riskiness of the separate investments. A combination of very risky holdings may still comprise a low-risk portfolio so long as they do not move in lockstep with one another—that is, so long as they have low covariance.
Even a little diversification goes a long way to reduce volatility. A portfolio consisting of just one stock will be twice as variable as the market on the average, but a portfolio consisting of just fifteen stocks selected at random will be only about 5% more variable than a portfolio consisting of a hundred randomly selected stocks.

Pg. 81: About one-third of the variability of the average stock is simply a reflection of moves in the stock market as a whole, which is the most important single influence. The rest of its variability is split about evenly between the influence of other stocks to which it has a family resemblance, such as the auto stock group or the public utility group, and the unique characteristics of the stock itself. Even those influences disappear when as few as a dozen individual stocks are combined into a portfolio. Then the power of diversification obliterates the individual attributes of the stocks, and more than 90% of the portfolio’s variability is explained by the index.

Pg. 86: Sharpe’s major breakthrough came in 1964, with what is known as the Capital Asset Pricing Model. CAPM starts out from the basic idea of the single-index model that returns are related “only through common relationships with some basic underlying factor.” The model concludes with the startling but inescapable conclusion that Tobin’s super-efficient portfolio is the stock market itself. No other portfolio with equal risk can offer a higher expected return; no other portfolio with equal expected return will be less risky. Today this would mean: buy the S&P 500 index with the lowest transaction costs you can find.

Pg. 191: The primary role of the CAPM is to predict expected returns, or to place a valuation on risky assets. The expected returns come in three parts. First, a stock should be expected to earn at least as much as the risk-free rate of interest available on Treasury bills or a government-guaranteed savings account. Second, as stocks are a risky asset, the market as a whole should actually earn a premium over the risk-free rate. Third, an individual stock’s beta—its volatility relative to the portfolio’s volatility—will then determine how much higher or lower the expected returns of that stock will be relative to what investors expect from the market as a whole.

Pg. 131: Mandelbrot’s research implied that stocks are riskier than had been assumed, that diversification might not work as well as Markowitz had indicated, that measures like variance could be highly unstable, and that major price movements would cluster more closely than anticipated. Mandelbrot’s view of the stock market was the genesis of what is known as Chaos Theory. The events of October 1987 lent credence t Mandelbrot’s warnings. However, Mandelbrot remains on the periphery of financial theory, both because of the inconvenience to analysts of accepting his arguments and because of the natural human desire to hope that fluctuations will remain within familiar bounds. (Read my previous notes on “The Black Swan” for a updated perspective of these ideas).

Pg. 137: Fama admits that the statement that in an efficient market prices “fully reflect” available information but that the statement is so general that it cannot be tested empirically. As an alternative, he suggests that an efficient market exists when trading systems based on available information fail to produce profits in excess of the market’s overall rate of return (today at any one time, less than 30% of managed funds after transaction costs out perform the appropriate index fund).

Pg. 171: Arbitrage--or as known by economists: the Law of One Price. Two assets with identical attributes should sell for the same price, and so should an identical asset trading in two different markets. If the prices of such an asset differ, a profitable opportunity will arise to sell the asset where it is overpriced and to buy it back where it is underpriced. The arbitrager will then lock in a sure profit.
Pg. 206: Options. An option that gives the holder the right to acquire an asset is known as a call option. The oldest mentioned option was by Aristotle when he recorded Thales purchase of a call option on olive presses. Homeowners with a prepayment privilege on the family mortgage also have a call option, because the family has the right to repurchase the mortgage from the bank if interest rates decline. An option that gives the holder the right to require another party to buy an asset at the will of its owner is known as a put option. You buy a put option when you insure your car against collision. Put options cover situations in which asset values are likely to fall; call options cover situations in which asset values are likely to appreciate.

Pg. 230: Options were incorporated into the entirely new and complex debt instruments that blossomed during the 1980’s. They are responsible for the mushrooming of the market for government guaranteed home mortgages. Their hedging features made possible the development of the so-called interest rate swaps between major financial institutions, the explosion in daily trading in the foreign exchange markets, the ability of banks to shield themselves from the vagaries of the money markets, and the willingness of major investment banking firms to provide many millions of dollars of instant liquidity to their institutional customers.

Pg. 269: Chapter 14 describes the 1979 development of portfolio insurance and its failure during the October 1987 meltdown. Pg. 282 begins the description of the 1983 futures market development. Now the purveyors of portfolio insurance could change the mix of the overall portfolio without ever disturbing the client’s managers. As the market declined, portfolio insurance called for the investor to sell futures; as the market rose, the investor would repurchase the futures. The system was convenient, inexpensive, and efficient. By 1986, the use of futures on the S&P 500 index had replaced buying and selling individual stocks in nearly all of some major accounts.

October 19, 1987: The Dow Jones Industrial Average was down more than 100 points by noon, but the worst as yet to come. The drop amounted to 190 points between 11:40 and 2:00 alone, and the free-fall came to nearly 300 points during the final hour and a quarter of trading. At the end of the day, the market had plunged 508 points or 23%, a record decline for a single day. At 1749, the Dow Average was almost a thousand points below the zenith it had reached only two months earlier.