The Hindu Business Line : Talents that shaped the market

All these are only part of the story, writes Peter L. Bernstein in "Capital Ideas," from Wiley (www.wiley.com), brought out as part of three-in-one `classics' edition.

The book chronicles `the improbable origins of modern Wall Street'. The heroes in the capital of financial markets were "a tiny contingent of scholars, most at the very beginning of their careers, who had no direct interest in the stock market and whose analysis of the economics of finance began at high levels of abstraction," writes Bernstein.

Two basic laws of economics that they taught Wall Street were: "There can be no reward without risk. And gaining an advantage over skilled and knowledgeable competitors in a free market is extraordinarily difficult."

You may wonder if stock prices are not predictable. Doubtful, says the author. "Even smart people have a hard time getting rich by predicting stock prices." In 1900, Louis Bachelier wrote a dissertation titled `The Theory of Speculation', which was "the first effort to employ theory, including mathematical techniques, to explain why the stock market behaves as it does".

Catch up with another seminal work in a chapter titled `Fourteen pages to fame': Harry Markowitz's "Portfolio Selection", published in the March 1952 issue of the Journal of Finance.

"The most famous insight in the history of modern finance and investment," writes Bernstein about the paper.

"Only four of its fourteen pages are straight text without graphs or equations."

The book cites A.D. Roy whose article `Safety first and the holding of assets' appeared `just three months after Markowitz's article'. Roy speaks of `the often close resemblance between economic life and navigation in poorly charted waters or manoeuvres in a hostile jungle'. "Decisions taken in practice are less concerned with whether a little more of this or of that will yield the largest net increase in satisfaction, than with avoiding known rocks of uncertain position or with deploying forces so that, if there is an ambush around the next corner, total disaster is avoided."

Meet William Sharpe in a chapter titled `The most important single influence'. Sharpe's major breakthrough was CAPM (pronounced `cap-em'), short for the Capital Asset Pricing Model.

Bernstein rues how most investors believed they can read the tea leaves that stock prices leave in the cup of fortune.

"They ask one another, over and over, `How's the market?' They call their brokers, sometimes every day, even every hour... They act on the notion that knowing what happened today will somehow tell them what will happen tomorrow."

Then, encounter the `illusions, molecules, and trends' in a part named, `The demon of dance'.

The author narrates how the investment course at Harvard Business School in the 1950s had so few takers that it was taught at noontime so that it would not take up precious classroom space at prime time!

"In a reference to Arthur Koestler's gloomy novel about political prisoners in Stalinist Russia, the course became known as `Darkness at Noon'".

In the following chapter, the author introduces readers to Paul Samuelson and Fischer Black.

Here's a snatch of true value on what is `true value': "The question is not unlike the exchange between three baseball umpires trying to describe how they distinguish between a ball and a strike. `I call them as I see them,' said the first. `I call them as they are,' replied the second. `They ain't nothing till I call them,' declared the third."

Search for `high PQ' in the next chapter. The abbreviation means `performance quotient'. Samuelson's view may be that "the PQs of the men and women who mange other people's money must be lower than the PQs of the people who successfully manage their own". And Bernstein is of the conviction that many have made their fortunes from the fees they earn from their clients rather than from investing their own money.

`What are stocks worth?' To answer this, there are four chapters. "The most rigorous, and also the most influential, method for determining intrinsic value was published in 1938 by John Burr Williams," informs the book.

"It provides the only formal method for determining what a price/earnings ratio or a dividend yield should be."

On Franco Modigliani and Merton Miller and their work, find inputs in a chapter titled `The bombshell assertions'.

Then comes Jack Treynor who believes "that a security analyst can learn more about a company's earning power by looking at what the market thinks the company is worth than by studying the numbers that accountants so meticulously prepare."

Read about options and the Black-Scholes model in `The universal financial device'. And there's more...

Useful read.

BookValue@TheHindu.co.in

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