From Essays to Equations (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Another financial author known for writing ability, not equations, is Peter L. Bernstein.  He received his degree in economics from Harvard, but is known as a financial historian.  Several of his ten books became best sellers.  In 1992 he wrote Capital Ideas - The Improbable Origins of Modern Wall Street.  In this work, he chronicled the evolution of modern investment theories.  Starting with Louis Bachelier's 1900 Doctoral dissertation, The Theory of Speculation, Bernstein traces the evolution of Bachelier's dissertation with its formulas, which was "discovered" by later economists about sixty years after its publication, into the Modern Portfolio Theory (MPT).  Using MPT and its supporting mathematical equations, investment professionals try to assemble a portfolio of assets to either maximize return at a certain level of risk or minimize risk while achieving a desired rate of return.  It should come as no surprise that the use of equations in financial investing came at the same time as computers capable of executing those complex equations became the financial weapons of choice on Wall Street.

Bernstein summarized investment by equation as follows:

There is Louis Bachelier in 1900, holed up in the Sorbonne scratching out eternal verities about the behavior of speculative markets.....Fischer Black, Myron Scholes, and Robert Merton change the whole world of finance by staring at differential equations.  Through it all, the only sound we hear is the clanking of primitive computers...The clatter of the computer and the roar of the trading floor are the sounds of a great battle in which investors compete with one another to determine who can buy at the lowest and sell at the highest....If the final product of the efforts of the financial theorists was only an assemblage of abstractions, those abstractions are the essential insights into how people do act and how people should act as they engage in the competitive battle.*

One of a growing number of critics of formulaic financial theories is the Wall Street veteran and author, Nassim Nicholas Taleb.  In his 2004 best seller, Fooled By Randomness -- The Hidden Role of Chance in Life and in the Markets, Taleb takes economists to task for their reliance on equations as follows: 

What has gone wrong with the development of economics as a science?  Answer: there was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science.....Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes -- and they refused to accept the fact that no mathematics at all was probably better.**

Criticism of computerized, equation driven investing has grown after several highly publicized investment disasters.  It has spawned a new branch of economic study called Behavioral Finance.

*  Excerpts from Capital Ideas / The Improbable  Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc., page 305.  A new edition of the book was published in 2005 by John Wiley & Sons, Inc.

**  Excerpts from Fooled by Randomness, Nassim Nicholas Taleb, copyright 2004, published by Random House, page 177.

Comments are always welcome.