Capital Ideas: From the Past to the Future

Modern finance theory, modern portfolio theory, neoclassical economics—the ideas bestowed on us in 1952–1973 by the giants in our field—are alive and well. Challenges to the efficient market theory, the capital asset pricing model, and mean–variance efficiency have been raised, but while recognizing that the assumptions of the theories do not hold up empirically, we still lean on the ideas and develop them in new directions. To say that this body of work is obsolete is to say that Aristotle and Euclid are obsolete. The body of thought that we consider modern finance theory is extraordinarily important. It infuses most of what investment analysts and managers do and influences how we think, whether we think about it positively or negatively.It is a remarkable story: In the space of 21 years, from 1952 to 1973, an entire body of knowledge was created essentially from scratch, with only a few scattered roots in the past. Nothing in the history of ideas can compare with this cascade of ideas in such a short period of time. Before the creators of modern finance theory, we had no genuine theory of portfolio construction, no genuine theory of asset pricing, no general theory of corporate finance, and no recognition of the overwhelmingly powerful concept of arbitrage. We had only rules of thumb and folklore.The academic creators of all these models knew that the real world is different from the models, but they were in search of a process, a systematic understanding of how markets work, how investors interact, and how portfolios should be composed. They understood that financial markets are about capitalism—a dynamic, complex, rough-and-tumble system in which there are always winners and losers.Of course, modern portfolio theory (MPT) has been challenged. Some have attacked the assumption of a normal distribution in the market as not being the way the world works. The major competing doctrine is in the behavioral finance literature. Prospect theory has revealed that we are risk takers when we have losses and risk averse when we have profits. We tend to emphasize recent news rather than long-term trends, and we yield to powerful, mysterious phenomena—herding and a taste for momentum. The key question is whether the flaws that behavioral finance reveals imply that MPT is irrelevant or whether behavioral finance provides fresh insights. Is behavioral finance the new paradigm?Despite all the anomalies and all the manifestations of a lack of rationality in the markets, and with individualistic, Darwinian markets, the ideas bestowed on us in 1952-1973 by the giants in our field—modern finance theory, modern portfolio theory, neoclassical economics—are alive and well. The assumptions of the theories do not hold up empirically, but we still lean on the ideas and develop them in new directions. To say that this body of work is obsolete is to say that Aristotle and Euclid are obsolete.