From Theory to Practice

Best-selling author Peter L. Bernstein explains how heretical, academic research has become investing orthodoxy. And yet, Modern Portfolio Theory is under attack from behavioral finance theorists. Who is right?

Best-selling author Peter L. Bernstein explains how heretical academic research became investing orthodoxy accepted by Wall Street — at first grudgingly and then completely. Yet, Modern Portfolio Theory is under attack by behavioral finance theorists. Who is right?

In 1992, Peter Bernstein published Capital Ideas: The Improbable Origins of Wall Street, a book that describes how academia took over Wall Street — slowly. The investing ideas that are now the bedrock of portfolio construction — that risk should be the centerpiece of investing, that you need a diversified basket of low-correlating assets and — this is the biggie — the market is too efficient to beat consistently, all came out of the ivory tower. Gosh, what radical ideas! (Well, not today anyway.)

Capital Ideas became a bestselling book and is an excellent way to re-learn some of the nuances of Modern Portfolio Theory while following the story of how a bunch of academics — about a dozen people — came upon the ideas that support it between 1952 and 1972. While they were toiling at the books, Wall Street traded with a primitive understanding of risk. (Wall Streeters called the theories “baloney, particularly the finding that the market was very hard to beat if at all,” Bernstein says.) Interestingly, according to Bernstein, some of the academics responsible for the big ideas “never owned a share of stock in their lives.” And yet, their “cascade of theory ended with the [Black-Scholes] options pricing model, which has probably influenced more people than anything else,” he says.

In the 15 years since Capital Ideas came out, implementation of the ideas Bernstein wrote about has taken place rather comprehensively. Capital Ideas Evolving, his new book, released in May, takes on behavioral finance researchers who attack many of the big ideas discussed in his prior book, and addresses the recent evolution of some of these ideas in the market place.

Registered Rep.: In your book Capital Ideas you talk about how painfully slow Wall Street was to accept Modern Portfolio Theory, which was first articulated in 1952. Today, that's hard to imagine, since, obviously, its basic tenants are the prevailing orthodoxy. I mean, what were people actually thinking before MPT?

Peter Bernstein: I don't think they were thinking before that. I ought to know, because I actively managed money for wealthy people from 1951 until 1973, when I thankfully got rid of the responsibility and started writing [financial history] and began a consulting business. [He sold out, by sheer luck, he says, before the full impact of the 1973 - 1974 bear market.] We had no structure to really measure risk. We had rules of thumb that were pretty good. We were very conservative so we did believe in diversification. But we had no systematic way of thinking about valuation, except for a kind of Graham and Dodd [model]. And I think the big difference, the kind of watershed since 1952 [when Harry Markowitz published his Portfolio Selection paper], is that risk is now the centerpiece, at least for institutional and sophisticated investors. Risk is the centerpiece of all strategy. You want high returns, but the outlook before that was, “What was fate going to bring you or not bring you?”

RR.: In your new book, you talk about the behavioral finance movement, which, in some ways, is a reaction against the efficient market thesis. So what's wrong with behavioral finance?

PB: Behavioral finance argues that investors don't make decisions with the cool detachment of a Capital Asset Pricing Model. They have a point. Investors do not share the same information, and, even if they did, they don't arrive at the same conclusions. Although the proponents of behavioral finance insist that investors are not necessarily irrational, the description of the investor in this theoretical apparatus requires a brain that nobody can have. I mean, in reality you just can't deal with all of this information. There's so much of it and you don't know what's important and you don't know how to organize it. We all experience this.

With the passage of time the volume of information has exploded so that's even more difficult. So investors find short cuts to get around this and as a result they don't really behave exactly as the theory described. So behavioral finance is full of examples of how people take short cuts and are more willing to take risks when they have losses than when they have gains, for example. To me behavioral finance performs a very important function because it reveals where mispricings are likely to exist, where assets are not properly priced. So it gives the more sophisticated investor, particularly the institutional investor, who has much greater resources at his disposal than the individual investor, an opportunity to look for an edge for beating the market — the alpha. But the paradox is this: The more urgent the hunt for mispricing by behavioral finance proponents, the more the efficient market hypothesis becomes an undeniable reality.

You see, the more and more behavioral finance research that comes out, the more these people scurry around and try to take advantage of those mispricings, and in the process diminish their importance.

RR.: Well, at what point, by the way, do the capital ideas, as you call these innovations — diversification, quest for risk control — at what point do those truths get exploited out of the market and become useless?

PB: I don't think they can, because the more people try to beat the market the more efficient it gets.

RR.: But if everybody indexed…

PB: Then you could have a ball. It's important to understand why. If everybody indexed, first of all, their portfolios would be static. They would make no changes. Prices wouldn't change, and nobody would be trading. But conditions do change from day to day and surely from month to month and year to year, so the old prices would be no good. Somebody would peel off and say, ‘Oh boy, I see a lot of opportunity here because nobody else is chasing opportunity.’ Then somebody else would peel off. So it's not a stable situation in which everybody indexes.

RR.: What do you think of fundamental indexes, where valuation metrics are added to weighting stocks in a portfolio to limit the “madness of crowds” problem that exists in cap-weighted indexes?

PB: This is a very controversial thing, but it works. The interesting thing so far is Rob Arnott [a pioneer of fundamental indexes at Research Affiliates; see “The Fundamentalist,” Registered Rep., April 2007] has put out indexes all around the world of equities. Now they've begun looking at the bond market, in particular the lower grade bond market, and weighting a bond index on the same basis, mainly according to the size of the companies. And it works there too.

This really impressed me because there are a lot of arguments about why it works in the stock market. But, if it works around the world in the stock market and in the bond market, then this is a very important insight — whether it works because it favors small-company value or not. It's really just biased that way. I don't care; it works.

RR.: What if it gets too popular and everyone does it? After all, when something works, everyone wants a piece, driving out excess return.

PB: It will probably happen, but I think it will take quite a long time.

RR.: So, I guess the lesson for financial advisors is you've got to be on the prowl because I think, as you put it, there's this kind of mauling going on in capital markets, a continuous change. When something works, it will work for a while and then it gets exploited out of the market.

PB: That's right. I mean there's nothing inconsistent between fundamental investing and capital ideas. This is a source of alpha. But Arnott himself admits that if everybody chases after it, the alpha will disappear.

RR.: What do you think has been one of the most important innovations over the past 15 years or so?

PB: One innovation that I think has been explosive and enormous is the whole derivatives business. It's in the hundreds of trillions of dollars of revenues outstanding. And a lot of this is, in one form or another, hedging risk by institutions. So hedging risk has become a market of its own. Think about how things have changed. Banks used to just make commercial loans. Now being a bank is an entirely different kind of business; they can make loans and then they can lay off the risks to thousands, maybe even millions of people. So it's a highly different business than it used to be.

RR.: So does that destabilize or stabilize the market? There is this idea that everyone is connected now, and one bad apple, if it is big enough, can poison thousands and millions of people.

PB: From a theoretical standpoint, you can almost never have enough [hedging of risk], because, the more you can share risk and spread risk, the safer the system is. It's interesting that the crash of 2000 and 2001 was a big shock and an enormous drop in stock prices from 1999. But nothing blew, no institutions failed. Well, Enron went out of business, but they cheated.

But I will say, the scary thing in the derivatives business today is that I think there are people in the market who don't fully understand what they're doing. That can always lead to trouble. The other thing is that the counterparty in a derivatives deal — the other side of the transaction — used to be an investment bank or a commercial bank or some kind of a regulated financial entity. Today it may be just another guy. So when you come to collect on your derivative you may not be able to.

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