strategy+business is published by PwC Strategy& Inc.
 
or, sign in with:
strategy and business
Published: February 28, 2006

 
 

Derivative Wisdom

In 1952, Nobel Laureate Harry Markowitz, then a young graduate student studying operations research at the University of Chicago, demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or a business manager can ever come to a free lunch. That revelation touched off the intellectual movement that revolutionized Wall Street, corporate finance, and business decisions around the world; its effects are still being felt today.

Mr. Bernstein is also the author of Capital Ideas: The Improbable Origins of Modern Wall Street (1992), which concentrates on the academic origins of modern finance theory. Both books are enriched by his personal experience as a Wall Street money manager (he has run his own investment consulting firm since 1973, simultaneously becoming a leading financial writer). But Against the Gods is particularly relevant because of its focus on the contemporary concepts of cutting-edge finance against the backdrop of civilization’s progress in mathematics, probability, and statistics.

To his credit, Mr. Bernstein tackles up front the reader’s likely reaction to some insights of finance theory — “Duh!” — and then provides a comprehensive and readable account of its antecedents and development. Against the Gods tells the story of the attempts to understand and measure risk and probability, with brisk histories of mathematics, statistics, probability, insurance, and stock trading from the time of the Pharaohs to the present. The reader meets the Arabian mathematicians, medieval painters, and Renaissance gamblers who, in addition to the usual suspects like Galileo, Newton, and Leibniz, contributed, and learns many interesting facts along the way (for example, that the average life expectancy of a newborn in Ireland in 1674 was 18).

Harry Markowitz’s insight about not putting all your eggs in one basket may seem trivial today, but Mr. Bernstein shows why it was revolutionary in its time and why it’s been so influential since then. Diversification as a risk-mitigation idea and an investment theory was not familiar before the 1960s, and was even scorned by many investment advisors. Dr. Markowitz envisioned an investor’s total capital as a portfolio — a term not in use in 1952 — and he set out to mathematically solve the puzzle of identifying an optimal portfolio in light of the investor’s trade-off between risk and return.

“His analysis,” Mr. Bernstein writes, “shows precisely how investors can combine their hopes of realizing the largest possible gain with exposure to the least possible risk.” Dr. Markowitz’s insights led to the development of the capital asset pricing model in 1964 by his student William Sharpe (with whom he shared the Nobel Prize in economics in 1990). Many other theorists and practitioners also played a role in its development, including Jack Treynor (then at the Boston-based consultancy Arthur D. Little Inc. and later editor of the Financial Analysts Journal); Harvard professor John V. Lintner; Nobel laureates Merton Miller, Franco Modigliani, Paul Samuelson, and James Tobin; and the brilliant and enigmatic mathematician Fischer Black, who was arguably the most original thinker of the group.

The capital asset pricing model is a mathematical formula that determines a theoretically appropriate price for a specific security. Dr. Markowitz’s central insight, which underlies the model, was that investment risk could be boiled down to two elements: the overall risk for the entire market, and the specific risk of a specific security — the degree to which its price movements are uncorrelated with the general market’s fluctuations. This latter risk measure became known as a stock’s beta and has since become a standard tool in the finance kit. (When a stock has moved 1.5 percent for every 1 percent move of the overall market during the past five years, for example, it is said to have a beta of 1.5.) The formula also takes into account the expected return of the market and the expected return of a theoretically risk-free security, such as a Treasury bond.

 
 
 
Follow Us 
Facebook Twitter LinkedIn Google Plus YouTube RSS strategy+business Digital and Mobile products App Store

 

Modern Finance Resources:
Works mentioned in this review.

  1. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, 1996), 400 pages, $19.95
  2. Peter L. Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (Free Press, 1992; John Wiley & Sons, 2005), 352 pages, $16.95
  3. Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance (John Wiley & Sons, 2004), 304 pages, $29.95
  4. Perry Mehrling, Fischer Black and the Revolutionary Idea of Finance (John Wiley & Sons, 2005), 392 pages, $29.95
  5. Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Harvard Business School Press, 2000), 378 pages, $44.50
  6. Lauren Aguirre et al., “Trillion Dollar Bet,” Web site based on the February 8, 2000, WGBH Nova documentary: Click here. 
  7. Wikipedia, the free online encyclopedia edited by its readers: Click here.
 
Close