Fifteen years ago, Peter Bernstein produced Capital Ideas, an invaluable intellectual history of contemporary investment theory.1 At the time, he was unable to provide many examples of practitioners actually applying the ideas introduced by such giants as Harry Markowitz, Franco Modigliani, Merton Miller, and William Sharpe. Bernstein’s sequel reverses the mix: Reflecting the course of financial market developments of the past decade and a half, Capital Ideas Evolving reports little in the way of new theory but many examples of investment professionals achieving extraordinary results by putting academic theory into practice.
At the Yale University endowment funds, investment chief David Swensen has focused on the importance of holding uncorrelated assets and the difficulty of outperforming within traditional, highly efficient asset classes. By relying heavily on private equity, real estate, oil and gas, and timberland, his fund has outperformed traditional benchmarks over a long period. Bill Gross of PIMCO and Marvin Damsma of the BP pension fund have implemented the theoretical concept of separating alpha (excess return on an asset) and beta (systematic risk). They have created immense value by generating alpha within one asset class and “porting” it to another.
Aside from modern portfolio theory’s migration from the classroom to the trading floor, the key development chronicled in this follow-up book is the rise of behavioral finance. Bernstein quotes Paul Samuelson’s jocular definition of the newer field as “the study of people not doing the rational thing as judged by assistant professors of finance,” but he does not view behavioral finance as a threat to established ideas. Rather, he points the way toward a synthesis of theory based on the model of homo economicus and empirical observation of the human brain falling short of that ideal. “Behavioral anomalies,” says Bernstein, “are where alpha is born.”
The longest chapter in Capital Ideas Evolving deals with Robert Shiller of the Cowles Foundation at Yale. Bernstein classifies him, together with Robert Merton and Andrew Lo, as a thinker who emphasizes the role of institutions in the market. At the same time, Shiller is concerned with the difficulties that individuals confront in making proper financial choices, such as a tendency toward excessive concentration in real estate through homeownership. Shiller was instrumental in developing derivatives that enable individuals to insure the value of their homes. Separately, Shiller notes that a 1996 survey found individual investors far more confident in their ability to pick stocks than to time the market, even though his own research indicates that the stock market is much less efficient at the macro than at the micro level.
Imperfections have inevitably crept into the text of Bernstein’s book. Paul Samuelson erroneously states, presumably with Ecclesiastes 3:1–8 in mind, that the Bible speaks of a time to remember and a time to forget. Bernstein states that baseball immortal Yogi Berra “is reported to have said that forecasting is very difficult, especially when it comes to the future.” It would have been more precise to write, “is spuriously reported….” The hoary line has also been put into the mouth of Hollywood mogul Sam Goldwyn.
Such peccadilloes in no way diminish the value of Bernstein’s latest tour de force . Other financial historians can chronicle the evolution of investment thought, but no one can match Bernstein’s entrée with its greatest contributors. Myron Scholes, Martin Leibowitz, and Robert Merton are just a few of the masterminds who were glad to give him firsthand accounts of their intellectual journeys. As a by-product of these descriptions, readers receive unique glimpses into the lives of the field’s greatest innovators (photographs of 17 are included in the volume). In both its sweeping account of investment ideas and the depth of the author’s insights, Capital Ideas Evolving is unmatchable.
—M.S.F.