# Capital Ideas Evolving  ## Metadata - Author: [[Peter L. Bernstein]] - Full Title: Capital Ideas Evolving - Category: #books ## Highlights - We make models to abstract reality. But there is a meta-model beyond the model that assures us that the model will eventually fail. Models fail because they fail to incorporate the inter-relationships that exist in the real world. Myron Scholes, speech at NYU/IXIS conference on hedge funds, New York, September 2005 ([Location 73](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=73)) - Tags: [[blue]] - What has caused this profound change from a focus on theory to a focus on implementation? Although more subtle forces must also have been at work, the arrival of the desktop computer stands out as the most important contributor, along with the increasingly complex software it can handle. The computer provides opportunities to do handsprings with the data and to test out theories from perspectives never dreamed of in the world of slide rules and electric calculators. On the other hand, the process does not work in reverse. While scholars and practitioners can use the computer to test theories and to find new ways to put theories to use, new theories do not come out of the computer. Theory is a product of the human brain. ([Location 125](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=125)) - Tags: [[blue]] - Before Harry Markowitz’s 1952 essay on portfolio selection, there was no genuine theory of portfolio construction—there were just rules of thumb and folklore. It was Markowitz who first made risk the centerpiece of portfolio management by focusing on what investing is all about: investing is a bet on an unknown future. Before Bill Sharpe’s articulation of the Capital Asset Pricing Model in 1964, there was no genuine theory of asset pricing in which risk plays a pivotal role—there were just rules of thumb and folklore. Before Franco Modigliani and Merton Miller’s work in 1958, there was no genuine theory of corporate finance and no understanding of what “equilibrium” means in financial markets—there were just rules of thumb and folklore.3 Before Eugene Fama set forth the principles of the Efficient Market Hypothesis in 1965, there was no theory to explain why the market is so hard to beat. There was not even a recognition that such a possibility might exist. Before Fischer Black, Myron Scholes, and Robert Merton confronted both the valuation and the essential nature of derivative securities in the early 1970s, there was no theory of option pricing—there were just rules of thumb and folklore. ([Location 137](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=137)) - Tags: [[blue]] - Risk was at the core of all these ideas. Markowitz’s famous comment that “you have to think about risk as well as return” sounds like a homey slogan today. Yet it was a total novelty in 1952 to give risk at least equal weight with the search for reward. Nothing more deeply divides Capital Ideas from the world before 1952. ([Location 153](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=153)) - Tags: [[blue]] - Before von Neumann, decision theory visualized each individual making choices that had no effect on any other individual’s range of choices. They all calculated utilities in the privacy of their own room. That is an artificial concept. No man is an island. As von Neumann and his coauthor Oskar Morgenstern point out, in emphasizing the difference between a real economy and a Robinson Crusoe economy: Crusoe is confronted with a formal problem quite different from the one a participant in a social economy faces.... [Crusoe] controls all the variables exclusively ... to obtain maximum resulting satisfaction.... In order to bring [the rules of the game] into the sphere of combat and competition ... it is necessary to consider n-person games with n ≥ 2 and thereby sacrifice the simple maximum aspect of the problem [emphasis added].5 All economic systems, even the most primitive, depend on production and technology, but capitalism is about combat and competition—about buying and selling even more than it is about production and technology. Capitalism is a giant von Neumann game! ([Location 174](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=174)) - Tags: [[blue]] - as investors increasingly draw on Capital Ideas to shape their strategies, to innovate new financial instruments, and to motivate the drive for higher returns in relation to risk, the real world itself is on a path toward an increasing resemblance to the theoretical world described in Capital Ideas. ([Location 238](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=238)) - Tags: [[blue]] - Perhaps the most remarkable feature of these ideas is the indomitable power of their influence on investment decisions, even though the theories failed to survive a battery of empirical testing. The situation is identical to what Louis Menand, the Pulitzer Prize-winning professor of English and American literature and language, had to say about Freud’s Civilization and Its Discontents: The grounds have entirely eroded for whatever authority it once enjoyed as an ultimate account of the way things are, but we can no longer understand the way things are without taking it into account.7 The academic creators of these models were not taken by surprise by difficulties with empirical testing. The underlying assumptions are artificial in many instances, which means their straightforward application to the solution of real-time investment problems is often impossible. The academics knew as well as anyone that the real world is different from what they were defining. But they were in search of a deeper and more systematic understanding of how markets work, of how investors interact with one another, and of the dominant role of risk in the whole process of investing. They were well aware that their theories were not a finished work. They were building a jumping-off point, a beginning of exploration, and, as each step led to the next, they began the search for an integrated structure to simultaneously explain the performance of markets and to solve the investor’s dilemma in trading off risk against return. That structure is still evolving. ([Location 241](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=241)) - Tags: [[blue]] - Although Markowitz’s prescription for constructing portfolios requires assumptions we cannot replicate in the real world, the risk/return trade-off is central to all investment choices. Just as essential, Markowitz’s emphasis on the difference between the portfolio as a whole and its individual holdings has gained rather than lost relevance with the passage of time. The beta of the Capital Asset Pricing Model is no longer the single parameter of risk, but investors cannot afford to ignore the distinction between the risk of the expected returns of an asset class and the risk in decisions to outperform that asset class. Modigliani-Miller’s perception of the stock market as the dominant determinant of whether a corporation earns its cost of capital was in many ways the intellectual driving force of the great bubble of the 1990s and the source of the scandals of corporate accounting that emerged in its wake. Above all, the Black-Scholes-Merton insights into the valuation and the virtually unlimited applications of derivatives and into the meaning of volatility have pervaded every market for every asset all around the world. In fact, a recent study reports that 92 percent of the world’s top 500 companies are using derivatives.8 The Edinburgh professor Donald MacKenzie has described options pricing theory as “mathematics ... performed in flesh and blood.”9 ([Location 270](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=270)) - Tags: [[blue]] - The bundle of ideas, models, concepts, and systems embodied in the theoretical structure of modern finance—what I describe as Capital Ideas—appeared between 1952 and 1973. They owe little to Keynes and almost everything to Marshall. The entire underlying structure of Capital Ideas rests on one overriding assumption: Investors have no difficulty in making optimal choices in the bewildering jumble of facts, rumors, discontinuities, vagueness, and black uncertainty that make up the real world around us. ([Location 327](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=327)) - Tags: [[blue]] - As Kahneman and Tversky wrote in 1992: “Theories of choice are at best approximate and incomplete.... Choice is a constructive and contingent process. When faced with a complex problem, people . . . use computational shortcuts and editing operations.”1 The result is a decision-making process differing in many aspects from the assumptions of Capital Ideas. ([Location 341](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=341)) - Tags: [[blue]] - It would be a mistake to accuse Kahneman and Tversky of tarring all humanity with the black brush of irrationality. That was never the case, as Kahneman’s autobiography makes clear: “The interpretation of our work as a broad attack on human rationality rather than a critique of the rational-agent model attracted much opposition [to our efforts], some quite harsh and dismissive.”2 As Kahneman put the point to me, “The failure in the rational model is ... in the human brain it requires. Who could design a brain that could perform in the way this model mandates? Every single one of us would have to know and understand everything, completely, and at once.”i He expresses this position even more precisely in writing: I am now quick to reject any description of our work as demonstrating human irrationality. When the occasion arises, I carefully explain that research on heuristics and biases only refutes an unrealistic conception of rationality, which identifies it as comprehensive coherence. . . . In my current view, the study of judgment biases requires attention to the interplay between intuitive and reflective thinking, which sometimes allows biased judgments and sometimes overrides or corrects them.3 ([Location 345](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=345)) - Tags: [[blue]] - Thaler ascribes this inconsistency to what he calls “the house money effect.” If you have money in your pocket, you will choose the gamble. If you have no money in your pocket, you would rather have the $30 for certain than take the risk of ending up with $21.5 In the real world, the house money effect matters. Investors who are already wealthy are willing to take significant risks because they can absorb the losses, while investors with limited means will invest conservatively because of fear they cannot afford to lose the little they have. This is precisely the opposite of how people with different wealth levels should arrive at decisions. The wealthy investor is already wealthy and does not need to take the gamble. If investors with only a small amount of savings lose it all, this would probably make little difference, but a killing on the small accumulation could change their lives. ([Location 414](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=414)) - Tags: [[blue]] - “The central characteristic of agents is not that they reason poorly but that they often act intuitively. And the behavior of these agents is not guided by what they are able to compute, but by what they happen to see at a particular moment.” ([Location 501](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=501)) - Tags: [[blue]] - Black himself, in characteristic style, pointed out in his 1986 paper that “noise creates opportunities to trade profitably, but at the same time makes it more difficult to trade profitably.” ([Location 615](https://readwise.io/to_kindle?action=open&asin=B008NC0VLU&location=615)) - Tags: [[blue]]