Capital Ideas Revisited

After 50 years of observing market behavior, Peter

Peter Bernstein has been an eyewitness to an astounding revolution that has created new ways for individuals and institutions to gauge investment risk. As a chronicler of investing and its guiding theories, Bernstein is a one-man Greek chorus for the events, people, and ideas that have shaped finance and investment over the past half-century. After all, it's been half a century since a young graduate student named Harry Markowitz drew a simple relationship between investment risk and reward. But investors today are looking toward a new century. When the future of modern finance is told a generation from now, which ideas and theories will remain crucial to successful portfolio management?

Few observers of market behavior are better qualified to predict what might lie ahead for money management than Bernstein, a gentlemanly financial philosopher and scholar who began his Wall Street career in the 1950s when he took over his father's investment management firm. More recently, he's authored two best-selling books: Against the Gods: The Remarkable Story of Risk, published in 1996, and 1992's Capital Ideas: The Improbable Origins of Modern Wall Street. In his writing, Bernstein reflects on the groundbreaking experiments and experiences of some of the founding fathers of finance - unique personalities like Markowitz, William Sharpe, Eugene Fama, and Paul Samuelson among them. Because of these pioneers and others like them, investors operate on a more solid footing than they might otherwise.

But the foundation of finance never will be completely secure; risk and uncertainty have proved the only sure aspects of investing. Yet trained financial minds and powerful computers are attempting to unearth efficient ways to reduce portfolio risk without trimming expected return. Bernstein understands that risk and reward are symbiotic; one cannot exist without the other. The irony is not lost on him that nowadays many investors are willing to assume greater portfolio risk - just as long as they can tightly control it.

Let's squeeze the history of modern finance down to its essence. What are the most important "capital ideas" that have shaped its evolution and maturation? Markowitz's mean variance and Sharpe's Capital Asset Pricing Model.

That certainly cuts to the core. To be sure, Markowitz was a pioneer. Why did Portfolio Theory become such a driving force? The wonderful thing about Markowitz is that there's nothing fancy or complicated about it. You can make it elaborate, as people have over the past 50 years, but the basic idea - that you don't get a return without taking a risk, and you're crazy to take the risk unless you expect to get rewarded - is pretty powerful.

The risk/reward trade-off is not new to investing, but Markowitz quantified it. Right. Markowitz uses the word "portfolio." Portfolio was not a word used in theoretical finance before Markowitz, it was used in practical finance. I remember my father started an investment counseling firm in 1934, and he used that word. It confused me because I thought when he said they had some nice portfolios in the office, they had nice briefcases. It took me a while to understand that he meant client accounts. The word did exist in practice, but it was absolutely missing in theory until Markowitz came along. Diversification is the answer to his method of managing risk, and portfolio means a collection of different assets - that's why those words appear together. You don't judge a stock in isolation, but in relation to your other assets.

Risk is an unavoidable part of investment life; no potential pain, no realized profit. What were investors missing about risk half a century ago that set the stage for Markowitz? Prior to Markowitz, people were aware of risk, obviously. Widows' and orphans' portfolios were not invested like aggressive businessmen's. There was a sense that different people had different appetites and capacities for risk, and you adjusted a portfolio accordingly. But Markowitz pointed out that there was a systematic relationship between risk and expected return, and that once you thought in those terms it set out a portfolio management paradigm for you. That was his idea and it was not there before.

Sharpe took Markowitz's ideas and put his own stamp on them. In ways, he made portfolio theory more accessible. Sharpe is the Son of Markowitz. The Capital Asset Pricing Model tremendously simplified the working method Markowitz laid out, which was to calculate the covariance in each of your assets with all the others. If you had 100 stocks, you had to do the calculations for each one. CAPM shrinks that down to the covariance between the individual asset and the market.

Yet the CAPM has been attacked for lacking a "real world" view. Is that criticism justified? The model in its full flower says the market is efficient and the optimal portfolio is the market. You can take that or leave that, but it's important because it focuses on diversification and on covariance, which is really the essence of taking risk. Having your eggs in one basket and how many baskets is fundamental to the whole thing, but controlling volatility is fundamental to the process if you're going to be a survivor.

Will the Capital Asset Pricing Model stand the test of time? It's in good health at its core, but very frayed at the edges. We don't know exactly how to measure risk. Is covariance the best measure? And we sure don't know how to measure the market. That problem has become much more complicated. The averages have become less meaningful. It's crazy that a small number of stocks can swing the whole average. It's not representative of most people's portfolios. Also, if this is your bogey, is it really what you want to outperform? The indexes at this point are very risky because they're not diversified. To say that's what I would like my portfolio to track or to be is a very aggressive statement, much more than it ever was in the past.

"Market risk" takes on a completely new meaning when many investors are ignoring traditional yardsticks and believe that this time, it's really different. I don't think this distortion in the averages has ever been this great. It means that when you say "the market," you're not really talking about the market. We're in a no man's land that the people who developed these theories never thought about. I don't know where we come out ultimately, but the world in which were investing is not the world that Sharpe and Markowitz were looking at, or even that people five years ago were looking at. Finding a proper bogey to make a judgment as to how you're doing is very difficult. What you're trying to beat is something that maybe you shouldn't be trying to beat. So much of the theory was built on the idea of the efficient market that you can see and measure as a representative, diversified portfolio. And now the market measures that we conventionally use today are not diversified portfolios. People who are doing spectacularly well don't realize that they're doing it because they are taking very big risks. I've got to believe it will right itself, but maybe it won't.

What a paradox: investors are always looking for market-beating performance with "acceptable" risk, but money managers can't hope to achieve that return without taking above-market risk. This is a question I would love to have somebody answer for me. When I started in the business in the 1950s and we managed almost exclusively individual portfolios, not institutional portfolios, the Dow Jones Industrial Average was a bogey, but the clients didn't care. They just asked, "How are we doing?" If the market went down they wanted to be sure they survived, and when it went up there was a lot of competition at their cocktail parties. They always had friends who had done better, but essentially the question was, "Are we doing all right?" That's probably the right question.

Can you name another basic, yet bold, theory that profoundly influenced modern finance - an addition to Markowitz and Sharpe that would form a kind of Holy Trinity of investing? The efficient market idea has to be thought about explicitly. It's a tough business out there. When the smartest people with the greatest access to information are having a hell of a time, that tells you it can't be easy. Yet the issue as to whether the market is efficient and whether you can beat the market has weakened a lot, and I have very grave doubts about the Fama concept. The Fama concept is that all available information is known and reflected in stock prices. That's why the market is hard to beat, and why past price behavior isn't going to tell you future price behavior. I think that's artificial. First, I don't think all information is immediately available. All information doesn't carry the same meaning to all investors. And more important, underlying this is an implicit notion that there's a right price, an equilibrium price, that if the market deviates from it, it will come back. I don't believe there is an equilibrium price. Equilibrium means stability and standing still. Life in general doesn't stand still.

The case for active management is much stronger than the efficient market people would lead us to believe. Active management is extraordinarily difficult because there are so many knowledgeable investors and information moves so fast. But active management is impossible and not worth doing? That's wrong. The market is hard to beat. There are a lot of smart people trying to do the same thing. Nobody's saying that it's easy. But possible? Yes.

But probable? The fact that the market admittedly is hard to beat would seem to speak well of indexing. My gut sense is that passive investing is the best strategy. But even that is frayed because what am I going to invest passively in? I'm still making a decision. If I said I'm going to own an S&P 500 index fund, which I used to think was the answer to all maiden's prayers, I'm buying a very undiversified portfolio in which the greatest weights are the stocks that have gone up the most. Is that really how I want to invest? The passive choice today is an active one. There isn't any place to hide.

Capital Ideas told the story of the evolution of modern finance. Suppose in the year 2020 someone decides to write their version of Capital Ideas. What would that book likely say about how finance and investment was transformed over this next generation? Who might be the next Markowitz or Sharpe? There are not going to be new core theories on the magnitude of mean variance, CAPM, and the efficient market. The theories are so basic - they're sort of like the law of gravity. Whether there's an Einstein out there to say Newton had it wrong, I don't know. I read The Journal of Portfolio Management, the Financial Analysts Journal, The Journal of Finance. The research is essentially testing ideas and developing strategies and showing whether this theory works or doesn't. But nobody is coming up with something I would write Capital Ideas about. The kinds of things I think we'll be developing, and this is really way off the top of my head, are new ideas of how these relationships work with each other. Markowitz and the CAPM are both linear. There's a systematic relationship between input and output, risk and reward, diversification and risk. And that's probably not the case. The idea that the market is efficient is wrong at its core because it implies an equilibrium price, and the world doesn't stand still long enough to be in equilibrium.

We can expect innovations in finance, though not necessarily new inventions. Everything that comes forward will be variations on those themes or empirical proofs or disproofs of those themes, but they will still be at the center of the investment process because they deal with the basic element: How do you deal with an uncertain future? Investing is really making a bet on an uncertain future; there are only a few basic ideas that come out of that. But there are a million variations on how you apply them, and that measurement is always going to be controversial. What do you mean when you say risk or return, or the long run? Those will continue to be matters of debate. There's also the behavioral argument that core theories don't work because they assume that everybody is rational, and people are not completely rational. Furthermore, people learn. The expected set of reactions today won't be so tomorrow.

Whose academic research in finance impresses you today as the work of someone who thinks outside of the box? Robert Shiller at Yale. I don't know whether this is theory or practice, but at least it's a conscious and bold effort to innovate. Shiller first gained fame because he attempted to show that the market is much more volatile than it would be if people were rational. The fundamentals aren't nearly as volatile as stock prices, and therefore this is a sign that investors are essentially not rational; the efficient market hypothesis can't possibly be valid because people don't think the way the efficient market hypothesis says they think. Shiller's approach has been through a lot of criticism, but this is where people first began to hear about Shiller.

In recent years, he's taken the idea Kenneth Arrow developed many years ago that the trouble with the world is that there aren't enough markets where we can trade off the risk that we have to take. I'm self-employed in a small business, very dependent on my two associates. If something happens to one of them, I can take a life insurance policy out on them, but my business is at risk. How do I hedge that risk? Or I live in a small country like Holland or Belgium where international trade is overwhelmingly important. If the price of my currency changes, my welfare can be seriously damaged. How do I hedge myself against that? How can we construct insurance policies for the kinds of things we've never insured before? It's off the beaten track, but enormously important.

Is there another academic who merits special attention for attempting to break new ground? Robert Merton, the Nobel Prize winner, is also trying to redesign the financial system - independent of the present institutional structure of banks, stock exchanges, and investment bankers. All of this evolved from a history that doesn't exactly describe the world today. We have a financial system that grew like topsy. It evolved from things that began to happen probably 300 years ago. Merton has asked, "If I didn't have any institutions and was trying to set up a financial system that provides services that ours does, how would I design it?" It frees up the system to form new institutional arrangements. We have a financial system that performs certain functions. It trades risk, it finances business, it has a payments system. People who don't need money now can trade it off with people who need money ahead of when they're going to have it. What can we set up that would most efficiently perform those functions?

This sort of thinking, saying "Look at the world around me; what do we not have that we might have?" is where the larger leaps will come. I don't think that Capital Ideas 20 years from now is necessarily going to be about investing, but instead will cover a much wider area of what we call finance in areas that most of us are not even stopping to think about.

You and others have pointed out how difficult it is for money managers to outperform a chosen benchmark. Sophisticated information is available to anyone with a computer and a modem, so knowledge alone doesn't provide the advantage it once did. The question is, as you've wondered in your biweekly newsletter, "Where, oh where, are the .400 hitters of yesteryear?" Competition is too tough for somebody to hit .400. I watch baseball figures like a hawk, and it seems that's how the world has become. The market is full of smart, eager, highly motivated, highly informed people. It's hard to be a winner by enough to matter, or to stay a winner by enough to matter. There's also the whole benchmark problem, namely that there's tremendous pressure on managers to keep their tracking error down. There's no incentive to make the big bets that are necessary to hit .400. You can't beat the market by a lot unless you make big bets.

What could bring back the .400 hitters? Probably investor sentiment and expectations would have to shift tremendously. If we move into a world where the clientele is increasingly what the community refers to as "high net-worth" individual investors, whose own money is on the line when they go to a manager, that may change. But when the client is already an agent - a pension officer or foundation officer - then they can't have managers who will have large tracking error. Until you cut the umbilical cord to the benchmark, then tracking error is the measure of risk, and the manager wants to minimize risk.

If investment managers have trouble outperforming the averages, how then do they add value? Clients believe that managers get paid to perform. In fact, performance is so difficult that they are really being paid for the advice and counsel they provide, and the client doesn't realize that. The value of the management is practically zero, but the value of the other kinds of advice is probably high enough to justify the fee.

That brings up a good point. Who would you say were the two greatest money managers of the 20th century? Peter Lynch, ahead of Warren Buffett. Buffett, to a certain extent, has made his mark by controlling a lot of the companies he bought. He's not an absentee owner in the way that Lynch was. Like Buffett, Lynch had a very simple approach. With both, you say, "Why can't I do that?" But if I told you about Long Term Capital Management, you'd say, "I know why I can't do that."

With all the available information, technology, experience, and learning at our disposal, are we smarter now about finance and investing than we were a generation ago? Four years ago, I would have said, "Absolutely." At this moment, I don't know. The market didn't get so tilted all by itself; somebody put it there. This process of chasing winners, investing in companies you don't know anything about - we don't know yet whether it's a bubble, but there's certainly a case that it is. The economy's been so great - who knows how anybody's going to behave when things change? Everybody thinks the central bankers have their finger on the brakes and the accelerator, and they're going to keep extreme outcomes away. But they haven't really been tested. They look good, but do they look good because they've made the environment good or because it made them look good? Benjamin Disraeli said the glory of the gold standard is not what explained Britain's prosperity, but it was Britain's prosperity that explained the glory of the gold standard. I have the same feeling about central bankers. The glory of the way the system has evolved and the low rate of inflation makes the central bankers look good because they haven't really had the opportunity to make any big mistakes.

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