The world lost one of its foremost financial historians and analysts on Friday, when Peter L. Bernstein died in New York.
As an author, editor and investment strategist, Bernstein forged an analytical template for what is now common in the blogosphere, mainstream media and virtually everywhere else that assigns import to the money game: Reading the academic literature and interpreting it for a wider audience.
Bernstein wasn’t alone in deciphering the hieroglyphics of financial economists for the masses, nor was he the first to make obscure research accessible. But few did it better. And in 1992, few were doing it all, at least not with the skill and depth that are Bernstein’s trademarks.
Surely the history of financial education will record 1992 as a minor milestone: the year when Bernstein’s Capital Ideas: The Improbable Origins of Modern Wall Street was published. As best sellers go, it was an unlikely success. Who would have thought that telling the story of how financial theory evolved could have been such a popular topic?
As a young journalist reading the book for the first time in the summer of 1992, I was stunned and amazed to learn of the efforts that had spilled forth from practitioners and academics over the years in trying to figure out how the market prices securities. I had a vague idea that the intellectual quest to uncover the hidden rules of money management had been unfolding for decades, and that index funds were the chief byproduct of those efforts. But it was Bernstein who brought the ideas to life. His great achievement is explaining the context and application for readers in a way that made the theories accessible to a wider audience.
The ideas of modern portfolio theory (MPT) were, of course, well known in certain money management circles in 1992. Twenty years earlier, institutional investing first became captivated with the concepts of portfolio optimization, the capital asset pricing model and the efficient market hypothesis—ideas that had been fermenting in academia since the 1950s. In the seventies, the concepts attracted real money.
The rest, as they say, is history, but no one will confuse it with the end of history. To say that the capital ideas, as Bernstein called them, remain controversial is an understatement. Although trillions of dollars now reside in index funds the world over, it’s fair to say that the underlying theories that spawned the products remain contentious. Active management, which is to say something other than indexing, still dominates the money game, and probably always will.
That’s partly a reflection of the money game. Investing, unlike the hard sciences, can never be “solved,” forever keeping alive the hope that greener pastures await over the next hill. What appears to work today sometimes looks questionable, if not irrelevant tomorrow, inspiring investors to dig deeper, think differently and otherwise look for superior strategies.
To the extent that there are enduring truths in investing—a debatable idea on its own—some of those truths appear to be captured in the capital ideas, which offer valuable perspective for thinking about the nature of markets and the process of designing and managing portfolios.
No, capital ideas aren’t perfect, but neither are they a static set of ideas resistant to change, as some pundits incorrectly assume. In a book I’m finishing up for Bloomberg Press (tentatively titled Dynamic Asset Allocation), I review some of the critical changes in the academic literature over the last 30 years in an effort to show how modern portfolio theory has evolved. One of the inspirations for undertaking a project which has consumed much of my spare time over the past several years is, of course, Peter Bernstein.
But while capital ideas continue to progress, the core lesson is still unchanged. Risk, in short, is the key to understanding the markets. No surprise, then, that risk is the recurring theme in what I consider the must-read trio from Bernstein: Capital Ideas, along with its sequel: Capital Ideas Evolving and also Against the Gods: The Remarkable Story of Risk.
You may or may not agree with MPT, but reading these three books can only make you a wiser investor. Academics aren’t omniscient, but they have turned up some useful ideas over the past 50 years, and some of those ideas are worthy of deeper study. Peter Bernstein does a masterful job of telling us why.
In essence, the crucial lesson is that we’re all risk managers now. The details remain controversial, but to the extent that investors recognize this basic challenge suggests that finance has enjoyed a bit of progress through time.
On that point, all strategic-minded investors owe a debt of gratitude to Peter Bernstein. He didn’t invent capital ideas, but few have done a better job of explaining the underlying principles.