Capital Ideas Evolving

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 academic creators of these models were not taken by surprise by difficulties.

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 was 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.

As with all great revolutions, the passage of time has produced unanticipated variations in the basic themes, both theoretical and practical. Time has also brought periods of disillusion and efforts to mount a counter-revolution. The overarching assumption of investor rationality in every one of these capital ideas was admittedly an unrealistic one, but its fault lines are all too visible in markets given to high volatility, to bubbles and crashes, to concentration on short-term developments, and to shocking inconsistencies in the uses of information.

We cannot examine the role of capital ideas in today's world without giving full consideration to the ideas of what has come to be known as behavioral finance -- especially as here, too, Nobel Prizes have been earned by the leading thinkers.

The conflict has been brutal at some stages, but the impetus provided by behavioral finance to reexamine basic assumptions has also led to fresh perspectives of great value within the framework of the original ideas. Through it all, those capital ideas permeate every investment decision.

Despite its rigid assumptions about investor rationality and the role of information, the efficient market hypothesis remains the standard by which we judge market behavior and manager performance. Today, as in the past, only a precious few investors have found strategies to beat the markets with any acceptable degree of consistency.

Although Harry Markowitz's prescription for constructing portfolios requires assumptions we cannot replicate in the real world, the risk/return tradeoff 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. Franco Modigiliani and Merton 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 insights of Fischer Black, Myron Scholes, and Robert Merton into the valuation and into the virtually unlimited applications of derivatives and the meaning of volatility have pervaded every market for every asset in every capital market all around the world. The Edinburgh professor Donald MacKenzie has described the option pricing theory as "mathematics ... performed in flesh and blood."

Keep in mind that the powerful body of knowledge motivating this whole story was conceived in the space of only 21 years, from 1952 to 1973. The resulting theoretical structure had no prior existence and only a few scattered roots in the past.

Few triumphs in the history of ideas can compare with this achievement. Think of the centuries from Euclid to Isaac Newton to Albert Einstein or the 160 years in the development of modern economic theory from Adam Smith in 1776 to David Ricardo, Alfred Marshall, Karl Marx in the nineteenth century, and finally to John Maynard Keynes in 1936.