Neoclassical finance was just beginning to revolutionize markets when Peter L. Bernstein began writing his landmark text on the subject, Capital Ideas.

It was 1989, and academic theories that investors once called “baloney” were percolating from the ivory tower to the trading floor. Soon, billions of dollars would ride on new ideas about risk and investing found in the Efficient Market Hypothesis, the Capital Asset Pricing Model and the Black-Scholes Option Pricing Model. Baloney became orthodoxy.

Were markets really efficient, though? Did the elegant models reflect facts? And, if so, why were they implicated in meltdowns ranging from the stock market’s Black Monday in 1987 to the Long-Term Capital Management debacle in 1998?

Bernstein, a financial consultant whose books include Against the Gods, attempts to answer those questions in Capital Ideas Evolving (Wiley, 288 pages), a challenging sequel to—and spirited defense of—his 1992 classic.

This is no book for impatient neophytes or value investors. Bernstein cites algebraic equations, throws around jargon (alpha, beta and omega, anyone?), and discusses high correlations and low covariances (don’t ask). He gives only passing nods to the likes of Warren Buffett, who beats the “efficient” market by buying good companies at bargain prices.

Yet if you want a primer on what Nobelists such as Harry Markowitz and Myron Scholes have wrought, this is a fine place to begin. Though Bernstein uses Wall Street argot, he puts it into plain English: Volatility, he says, is “a fancy word for what happens when we are taken by surprise.”

Better yet, he shows how powerhouses such as Barclays Global Investors, Goldman Sachs Asset Management and Yale University’s endowment fund translate theory into the business of allocating assets, managing risk and beating market indexes.

Bernstein gamely opens the book by confronting behavioral finance, which pokes holes in the neoclassical assumption that investors are Spock-like automatons trading in markets balanced in perfect equilibrium.

No human, after all, has a brain that can know and comprehend everything instantly, as behavioral proponent Daniel Kahneman observes. Markets bubble, crash and can stay at crazy levels for longer than most people can imagine, as John Maynard Keynes observed. (If you liked the Dow Jones Industrial Average at 13,000, you’ll love it at 14,000.)

“The overarching assumption of investor rationality in every one of these Capital Ideas was admittedly an unrealistic one,” Bernstein writes.

This sets the stage for seven interviews in which Bernstein invites distinguished professors, starting with Nobel laureate Paul Samuelson, to grapple with behavioral finance. Their comments fizz with intellectual honesty.

Markowitz, whose 1952 theory of portfolio selection got the neoclassical steamroller going, now rejects equilibrium models, telling Bernstein that they “make unrealistic—absurd—assumptions about the actors.”

Robert Merton, who won the Nobel Prize along with Scholes for his work on valuing stock options, wants to create an option to counteract a behavioral finding that regret (or fear of it) warps investor decisions.

Leaving “the theoreticians” behind, Bernstein next introduces us to “the practitioners.” Barclays Global Investors, for example, applies index-fund techniques to active money management. Goldman Sachs Asset Management uses strategies so complex that Bob Litterman, head of quantitative resources, demurs when Bernstein asks him to state assets under management.

“I should have a simple answer,” Litterman says, “but the reality is a little more complex.”

One message that emerges from this book is a worrying one for active fund managers: The more investors try to beat the market, the more efficient the market gets. That makes sense, though one can’t help wondering why Bernstein clings so fervently to a hypothetical efficiency that he acknowledges is flawed.

Page after page, the complex strategies described in this book kept driving me back to what Buffett said: “There seems to be some perverse human characteristic that likes to make easy things difficult.” --Bloomberg

Financial sequel

Neoclassical finance was just beginning to revolutionize markets when Peter L. Bernstein began writing his landmark text on the subject, Capital Ideas.

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Pay it forward

The Force of the Weak

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