Like all innovators who challenge accepted beliefs, the scholars who triggered the revolution in finance and investment were seldom welcomed with open arms. Some critics accused them of being incomprehensible; others complained that they had discovered nothing new. Stephen Jay Gould, the Harvard paleontologist and historian of science, has complained that “we modern scholars often treat our professions as fortresses and our spokes-people as archers on the parapets, searching the landscape for any incursion from an alien field.”11
Like most adventurers, these scholars ended up someplace different from where they had expected to land. They had begun their exploration of the stock market as a way to solve some interesting hypothetical problems. Once having started down this path, they could not stop. In the end they succumbed to the fascination of the stock market and it conquered them. Most of the men in this book, prolific as theoreticians in finance, have at one time or another been associated with a Wall Street firm or a major investment organization.
I will also be telling the stories of six innovators who put the new theories into practice. Here we see the revolution in action. These adventurers, in search of financial reward, shared many of the experiences of the theoreticians. Self-doubt, reluctant colleagues, career risks, and uncertainty accompanied them all the way.
This book reflects my own adventures as an active participant in financial markets for over forty years. At first I found the new theories emerging from the universities during the 1950s and 1960s alien and unappealing, as did most other practitioners. What the scholars were saying seemed abstract and difficult to understand. And beyond that, it seemed both to demean my profession as I was practicing it and to prescribe radical changes in the way I should carry out my responsibilities.
Even if I could have convinced myself to turn my back on the theoretical structure that the academics were erecting, there was too much of it coming from major universities for me to accept the view of my colleagues that it was “a lot of baloney.” Finally the market disaster of 1974 convinced me that there had to be a better way to manage investment portfolios.
It was in that year that I founded The Journal of Portfolio Management to help others to learn what the new theories were all about. My goal was to build a bridge between gown and town: to foster a dialogue between the academics and the practitioners in language they could both understand, and thereby to enrich the contributions of both.
The first issue of the Journal appeared within weeks after the collapse of the great bear market of 1973–74, which probably explains the Journals immediate acceptance. The time was right for opening minds that had been closed to unfamiliar ideas. The lead article alerted the investment management profession to the consequences of the appalling loss of wealth that had just taken place. The author, James Vertin, was chief investment officer for the trust accounts at Wells Fargo Bank in San Francisco and one of the earliest advocates of the use of the new theories. He warned: “Current and prospective customers are increasingly suspicious, hesitant, and downright skeptical that professional investment management can consistently provide benefits that justify its cost… The dissatisfaction is pervasive… [They] are afraid of us, and what our methods might produce in the way of further loss.”12 And yet, he pointed out, “It doesn’t have to be that way.”
This book celebrates the innovators and tinkerers who showed us how it ought to be, as well as the pioneers who brought about the improbable wedding between academia and Wall Street.
PART I
Setting the Scene
Chapter 1
Are Stock Prices Predictable?
Paul Samuelson, economist and Nobel laureate, once remarked that it is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office. All investors, professionals as well as amateurs, acknowledge the truth of this observation. Even smart people have a hard time getting rich by predicting stock prices.
Some people never try to outguess the market: they simply hang on to the stocks they inherited, bought long ago, or acquired in some employer-sponsored savings program. Others buy and hold under the conviction that trading finances yachts only for brokers, not for customers.
Yet, in the face of admittedly high odds, enough people do try to predict stock prices to keep an entire industry humming. The demand for the wisdom produced by armies of security analysts, portfolio managers, television pundits, software peddlers, and newspaper columnists shows no sign of waning. Some of the wealthiest people on Wall Street are professionals whose bank accounts have been inflated by a constant flow of investment advisory fees. I have already pointed out that the number of investment management organizations tripled just during the 1980s. Forbes, Barron’s, and The Wall Street Journal have subscribers that number in the millions. Index funds, which hold a diversified cross-section of the market and never sell one stock in order to buy another, account for less than 15 percent of all equity portfolios.
This appetite for predicting stock prices is all the more striking, because a huge volume of academic research demonstrates that it is a devilishly difficult job not likely to get any easier. While no one goes so far as to say that it is impossible to make good predictions or that all predictions are destined to be wrong, the abundant evidence and the robust character of the theories that explain the evidence confirm that the task of predicting stock prices is formidable by any measure.
The exploration into whether investors can successfully forecast stock prices has roots that reach all the way back to 1900, when Louis Bachelier, a young French mathematician, completed his dissertation for the degree of Doctor of Mathematical Sciences at the Sorbonne. The title of the dissertation was “The Theory of Speculation.” This extraordinary piece of work, some seventy pages long, was the first effort ever to employ theory, including mathematical techniques, to explain why the stock market behaves as it does. Bachelier supported his novel theoretical analysis with a sophisticated study of the French capital markets at the turn of the century.
It is worth noting that Bachelier was an academic all the way. He employed his profound understanding of the markets for his intellectual exercise; we have no evidence that he ever speculated or invested in the markets he was analyzing. He set the style for many later theorists who, like him, refrained from putting their money where their minds were.
Bachelier was far ahead of his time. Paul Cootner, one of the leading finance scholars of the 1960s, once delivered this accolade: “So outstanding is his work that we can say that the study of speculative prices has its moment of glory at its moment of conception.”13
Bachelier laid the groundwork on which later mathematicians constructed a full-fledged theory of probability. He derived a formula that anticipated Einstein’s research into the behavior of particles subject to random shocks in space. And he developed the now universally used concept of stochastic processes, the analysis of random movements among statistical variables. Moreover, he made the first theoretical attempt to value such financial instruments as options and futures, which had active markets even in 1900. And he did all this in an effort to explain why prices in capital markets are impossible to predict!
Bachelier’s opening paragraphs contain observations about “fluctuations on the Exchange” that could have been written today. He recognizes that market movements are difficult to explain, even after the fact, and that they often generate a self-reinforcing momentum:
Past, present, and even discounted future events are reflected in market price, but often show no apparent relation to price changes… [A]rtificial causes also intervene: the Exchange reacts on itself, and the current fluctuation is a function, not only of the previous fluctuations, but also of the current state. The determination of these fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical predictions of it… [T]he dynamics of the Exchange will never be an exact science.14
Despite