Now that I’m in school again at a stage in life where it is not deemed by anyone to be critical to my future or career or any such thing, I get to enjoy school more and ponder over the larger issues of how and why what I’m learning came about.
One such subject where there are fascinating back-stories is finance. If you look at the progress the theory of finance has made in just the past sixty years, it is incredible. So there it was that I decided that as part of general awareness reading for my investment management course this term with Prof. Geczy, I’d spend time understanding the history of modern finance. And there could be no finer source to learn it from than Peter Bernstein’s book Capital Ideas: The Improbable Origins of Modern Wall Street. Written to read like a page-turner thriller (as much as a book on finance can be a page-turner), this book starts in 1900 with the work of a French mathematician, Louis Bachelier, and his doctoral work that showed that under ideal conditions the mathematical expectation of the speculator is zero. This work stayed long forgotten for a long time, until economists in the US discovered it and started buiding upon this foundation. Unfortunately for Bachelier, the financial markets were far from the focus at Sorbonne, and he had a tough time finding a good academic position. Even his teacher Poincaré could not grasp its significance.
Markowitz faced similar trouble 52 years later, with his thesis on portfolio selection that transformed the world of modern finance by relating risk and reward through mean-variance analysis. And even more curiously, his work was almost matched across the big pond by A. D. Roy at Cambridge, without the full insights and depth of analysis. I wouldn’t want to summarize the entire book here, but the anecdotes from the lives of these academics and practitioners is fascinating. The book runs through the familiar cast of characters – names, many of which fill the ranks of Nobel laureates in economics – Tobin, Samuelson, Sharpe, Black, Scholes, Fama, Miller, Merton and Modigliani. It also paints a fascinating picture of characters who were not as well known to an outsider like myself – John McQuown, James Vertin, Barr Rosenberg, and others who were early pioneers in the portfolio management world. It retells the story of Leland, O’Brien and Rubenstein and how portfolio insurance was invented and its role in the stock market crash in 1987.
All in all, it makes for a fascinating read if you are interested in knowing how these methods were invented and how serendipity, perseverance and sheer luck helped make them happen. It shows how computers played such a vital role in accelerating research in returns on financial securities, and measuring and characterizing risk more accurately. Bernstein followed this up with a sequel in mid-2000s, but more about that in another post.