Bernstein has written a fascinating pre-LTCM (pre 8/98) book on the history of econometrics and finance, beginning with the origins of the Cowles foundation as the consequence of Cowles' personal interest in the question: Are stock prices predictable? This book is all about heroes and heroic ideas, and Bernstein's heroes are Adam Smith, Batchelier, Cowles, Markowitz (and Roy), Sharpe, Arrow and Debreu, Samuelson, Fama, Tobin, Samuelson, Markowitz, Miller and Modigliani, Treynor, Samuelson, Osborne, Wells-Fargo Bank (McQuown, Vertin, Fouse and the origin of index funds), Ross, Black, Scholes, and Merton. The final heroes (see ch. 14, The Ultimate Invention) are the inventors of (synthetic) portfolio insurance (replication/synthetic options).
This book consists largely of a pre-LTCM (pre-10/98) cheerleading for option-pricing mathematics based on lognormality, and corresponding synthetic portfolio insurance. Osborne and Mandelbrot are mentioned. The book is not error-free: e.g., Mandelbrot's ideas on stock prices are stated as being the origin of chaos theory (!), and Mandelbrot (of random fractals fame) is misportrayed as an 'articulate proponent' of chaos theory! Another error (page 182): "..persistent forces are constantly driving the market toward (Modigliani-Miller) equilibrium." The evidence for the EMH is supposed to constitute the 'proof' for this nonsense. So much for 'proofs' in economics. So ingrained is the false, misleading and inapplicable notion of "equilibrium" in the minds of economists that it is hopeless to expect to educate them out of their own morass. Even Black, who was educated as a physicist as an undergrad, did no better:
"When people are seeking profits, equilibrium will prevail." (F. Black, quoted by Bernstein)
Among the interesting and entertaining stories that are told are: the displacement of Graham and Dodd's 'value theory' by the EMH, the revolutionary role played by Wells Fargo Bank in using the 'new finance math', and in creating index funds. The importance of the Miller-Modigliani 'theorem, which 'proved' that the (not-uniquely-defined) 'value' of a corporation is independent of it's debt. Then, there is the wild-haired idea of 'portfolio insurance', how to eat your cake and have it too (a free lunch, derived from the assumption that free lunches don't exist). No portfolio can be insured against extreme deviations, especially those that occurred in 10/87 and wiped out confidence in LOR (Leland-O'Brien-Rubinstein Associates). But this failure of finance theory produces no crisis for Bernstein, whose book is the history of heroes, not villains. His last chapter, which can be ignored by the reader without loss, is states his ideology: free market ueber Alles. Or: equilibrium will prevail, even without restoring forces ( I like to put it this way: there are no "springs" in the market). I did get something important from this book: the origin of America's spend-spend-spend ideology in the Modigliani-Miller 'theorem'.
If the optimal portfolio is not risky enough, borrow to finance it's purchase. (Wells Fargo's application of Tobin's idea, quoted by Bernstein)
(This is a shorter version of a longer review that appeared in fall(...).