"Capital Ideas Evolving"

Peter L. Bernstein, “Capital Ideas Evolving” , John Wiley & Sons, Inc., 2007, 246 Pages
This book really scares me. I have been reading and studying financial concepts for the past ten years, even completing a Boston University Financial Planning course which covered all the educational requirements for eligibility to take the Certified Financial Planner test, still I only understood about 1/3 of this book. That would not really matter except that this book explains what institutional investors are doing through 2006. Can you imagine how our legislators are going to handle this?? Maybe the new senator from Illinois will get right on this.

Anyway, below are some items I did understand and found worth adding to my notes:
Capital Ideas Evolving describes how the core concepts of modern finance, developed between 1952 and 1973, continue to transform the investment world . People like myself may understand the core concepts, but the way they are being applied since 2002 is becoming more and more mysterious. These concepts are now used in all financial investing institutions world wide.

Part of modern financial theory has a core idea that all investments reflect a trade-off between risk and expected returns and is the starting point of investment decision-making as well as the idea that beating the market is very difficult (hence the growth of index funds, which most of my investments are in). Nevertheless, this book spends most of its time explaining the pursuit of alpha, a return in excess of the market on a risk weighted basis.

Additionally, modern investment theory has spun off new investment and risk management structures: most notably, hedge funds and derivatives, both of which have contributed greatly to the globalization of capital and brought leveraging to new heights.

Modern investment theory’s position that investors behave rationally has proven untenable, given high market volatility, bubbles and crashes, and persistent distortions in asset valuations. Consequently, the theory of behavioral finance has emerged, which attempts to explain the occasional “irrationality” of markets through analysis of investor actions. Nonetheless, Bernstein clearly states that the revolution ignited by the small group of scholars behind modern portfolio theory has forever changed the financial and investment world, and developments of recent years have done nothing to discredit the central tenets of modern financial theory.
This is Bernstein’s follow up to his 1992 book, Capital Ideas: The Improbable Origins of Modern Wall Street which I previously reported on. However this latest book was written in 2007 so has not been impacted by the most recent 2008 debacle.

My Notes from the book (only those items I understand):

Pg. 10: The proponents of Behavioral Finance have drawn heavily on the writings and teachings of Kahneman and Tversky. They have made human quirks like the failure of invariance, framing, and the illusion of validity the core of their confrontation with the assumptions of the rational model that motivates and supports the structure of Capital Ideas. The issue is why does reality differ so much from the idealized world that underlies the efficient market and the Capital Asset Pricing Model (CAPM)? And, can Behavioral Finance enable us to outperform the market?

Pg. 14: Richard Thaler in the early 1970’s began to speculate on how to calculate the value of a human life. It occurred to him that the correct measure would be how much people are willing to pay to save a human life. And so he began asking friends and students what value they would put on their own lives. He sought the answer to these questions. First, what would you pay to eliminate a one-in-a-thousand chance of immediate death. Second, turning the first question around, he asked how much you would have to be paid to accept a one-in-a-thousand chance of immediate death. Not knowing exactly what to expect, he was dumbfounded at the differences in the answers to the two questions. In general, most of the answers were along the lines of: “I wouldn’t pay more than $200 to eliminate a small chance of immediate death, but I wouldn’t accept such an extra risk for $50,000.” Thaler is the author or coauthor of four authoritative books on Behavioral Finance, including The Winner’s Curse: Paradoxes and Anomalies of Economic Life and Quasi-Rational Economics as well as countless articles.

Pg. 65: Robert Shiller considers real estate as much a part of finance as the stock market, the bond market, or the derivatives market.

Pg. 77: LTCM’s primary activity had been bond market arbitrage—selling one security and buying a related or similar security in the expectation that the market would in time narrow any pricing discrepancy between the two assets. After three and a half years, the firms capital had risen from $1.1 billion to $6.7 billion, with returns of over 40% in 1995 and 1996, achieved at volatility below the volatility of the S&P 500. On December 31, 1997, the fund returned $2.7 billion out of a total of $7.5 billion of capital to its partners, declaring that the fund was so successful it had ‘excess capital.’ The $2.7 billion distribution was funded by borrowing against LTCM’s assets, raising the ration of borrowings to equity from 18.3% to 27.7%. By July 1998, however, the capital had shrunk to $4.1 billion from $4.7 billion immediately after the distribution, even though for at least half of July, there was no indication of anything unusual at work in the markets in which LTCM concentrated most of its activity. Trouble was brewing nevertheless. On the single day of August 21, 1998, LTCM lost $550 million, about 15% of its remaining capital. Trading to get out of positions had become virtually impossible. Many other bond houses and funds had begun copying LTCM’s methodology so now everyone was on one side of these kind of trades and trying to trade to the other side. The Russian ruble devaluation was not supposed to happen—but it did.

Pg. 82: Except for the very rich, most people have the largest share of their wealth invested in their homes. In the simplest sense of the word, they are undiversified. Events that would reduce the resale value of their homes—a general decline in home prices, a radical change in the character of their neighborhood, or the loss of a local industry—could suddenly threaten what equity they have left in their homes or affect their ability to keep up their mortgage payments. If they cannot meet the monthly payments on their mortgages, the bank could foreclose and take their homes away from them. Their whole way of life could be damaged.

Pg. 83: This imbalance in their family balance sheet does not concern many home owners, because they simply do not think about such matters as diversification and management of risk, at least where their houses are concerned. They tend to employ what has come to be known as ‘mental accounting,’ which means they maintain a separate basket in their heads for their home and its mortgage, and another basket for their 401(k) accounts, still another for their savings accounts, one for their consumer credit, and another to store their concerns about the cost of their children’s education. No basket has a relation to any of the other baskets. So as a result, they seldom—if ever—take the time to develop an overview of the total amount of the assets and liabilities in all the baskets considered together. And if they did, they would have no idea of what to do about it anyway.

Pg. 92: CAPM predicts the expected return on an asset will be equal to the expected return of the market (in excess of the return on a treasury bond) multiplied by how much the asset in question fluctuates in sympathy with the market. This later measurement, which has come to be known as ‘beta,’ reflects the contribution of the asset to the portfolio’s overall risk, or the riskiness of the asset relative to the overall risk the investor takes from being in the market in the first place. Note: the S&P 500 beta is always assigned the value of 1.0.

Pg. 97: In 1998 Sharpe was cofounder of Financial Engines, a business venture to help individuals make the kinds of choices they confront as potential retirees—especially asset allocation and strategies to manage the risks they face. Financial Engines uses a computerized program based on Sharpe’s contributions to portfolio theory and asset pricing. The output provides individuals with the same kind of sophisticated advice long available to institutional investors, high-ranking corporate officers, and wealthy people. Financial Engines is available, for example, at E*Trade, and for Vanguard investors with Admiral accounts, but many corporations and financial advisers also provide it for the benefit of their employees. This is the most valuable piece of information for me in the entire book. It lends legitimacy to this software which is available to me through Vanguard. When I ran my portfolio through the analysis I found my risk level to be extremely low (beta 0.4) and my diversification very much in line with what the software would choose for me at my desired risk level. For fun, I still pick stocks on my own and am beginning to buy again. I had pretty much liquidated most positions in April of 2007 when I became very nervous (or lucky, I don’t take credit for predicting this fiasco). Anyway this month I have bought: CAT, DE, SMG (three months ago), BUCY, HOG, and BP. I believe the market is ridiculously low at this point but I only use money I will not need. Only young people should jump in with both feet. They will have to as they will have no other pension avenue available to them other than social security.

Pg. 143: Short selling is very effective in fixed-income management. With stocks, the upside may be infinite and the downside may be zero, but as a practical matter the upside and downside are roughly equal. Not so with bonds. The ultimate bond payoff at par is a powerful anchor holding prices close to 100. Unless interest rates take an unusually steep fall, and unless the bonds in question are also non-callable, bonds have a much smaller upside than downside. The result is that short sales in the bond market have less risk and greater potential profitability than buying long. It’s a shame that 401(k) and IRA’s will not let individuals short stocks and bonds. This is the area hedge funds thrive in.

Pg. 152: Long ago John Maynard Keynes stated: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” During the tech bubble many smart financial managers went out of business because they would not participate in the bubble; their customers fled. The same thing has happened in the mortgage business, etc…

Pg. 173: Investors have learned from CAPM that they must recognize the fundamental distinction between investing in an asset class and selecting individual securities on which they hope to earn an extra return. The choice of asset classes—for example, stocks, bonds, emerging market equities, developed country equities, real estate, or subdivisions of those markets—is in essence the choice of beta risks, or the volatility of entire markets rather than their individual components (I have an index fund in each of these classes). The search for alpha, or residual and uncorrelated risks, means taking an extra risk beyond the beta risk in the hope of earning a return over and above the expected returns from the asset classes in the portfolio.

Pg. 219: Stock selection is ‘high-quality risk,’ because adding value from the selection of individual securities—difficult as it may be—is less of a challenge than timing markets or making bets on sectors (for example, capital goods versus consumer staples) or making bets on style (for example, growth versus value). Bets in security selection are easy to diversify because there are thousands of choices available, while the risks of over or underweighting entire asset classes and styles or sectors involve choices among only a few opportunities. This means the consequences of being wrong in any one bet in market timing or style management are more serious than the consequences of being wrong in choosing between Stock A over Stock B in a portfolio composed of a large number of individual positions.

Pg. 224: Nowadays there are electronic networks in which investors transact anonymously with each other across computers, or program trading in which dealers bid on large stock portfolios on the basis of their characteristics rather than knowing the individual names held. In algorithmic trading, a relatively new procedure, positions are either liquidated or accumulated in a series of transactions instead of in just one big transaction. The computer then makes the decision to trade, depending on whether price movements indicate the market will be receptive at any given moment, or to refuse to trade if it appears the transaction would drive the price away from the price at which the investor hopes to settle.