Pioneers of Finance
Most people don't realize it but finance is actually a very new field as far as being a formal academic field of study. The first landmark study was Louis Bachelier's dissertation in Paris in 1900 and it was largely ignored for half a decade until the discipline was more established.
The first popular finance textbooks in the United States were Security Analysis (Benjamin Graham and David Dodd) in 1934 and Theory of Investment Value (John Burr Williams) in 1938. It is believed that the first Ph.D. in Finance was awarded by the University of Chicago in 1960.
This doesn't mean that financial markets were ignored before the Great Depression in the 1930s, although economics certainly came into its own at that time. Economists have long thought about business problems but the financial side of business wasn't specifically addressed by academicians until shortly before World War II.
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Year |
1900 |
1930s |
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| Name | Louis Bachelier |
Benjamin Graham |
| Contribution | Discovered that stock price changes are random and unpredictable | Popularized the "value" style of investing; published the classic textbook Security Analysis |
| Valuable Links: |
A very brief summary of his life | Biography |
Louis Bachelier, in his landmark dissertation completed in Paris in 1900, studied movements of prices on the Paris stock exchange. Bachelier was discouraged by his professors from studying anything as mundane and low-class as financial markets. (A classical education of math, languages, and literature was strongly encouraged at the time.) He persisted however and uncovered financial truths that would be the foundation of financial principles through the remainder of the century. In particular, he discovered that stock price changes are unpredictable (which was popularized 60 years later as the "random walk" approach). In addition, he discovered an effective method for valuing financial options.
As reward for his efforts, he was blackballed by the academic community for studying the low-class subject of finance and was denied the university professorships that he clearly coveted. His work was largely ignored for sixty years, at which time his genius was belatedly recognized.
In 1934 (as the economic depression raged), Benjamin Graham and David Dodd published the classic Security Analysis, which identified a series of sound investment principles that should lead to building successful portfolios of stocks. Graham and Dodd used the concept of intrinsic value to identify a stock's "fair price". Graham advocated buying stocks that sell at a considerable discount to their intrinsic value.
Today, Graham is often referred to as the "father of security analysis." Many believe that his 1949 book entitled The Intelligent Investor remains the best book ever written on investments.
| 1950s | ||
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| Harry Markowitz |
James Tobin |
Franco Modigliani / Merton Miller |
| Efficient Frontier (1952) | Capital Market Line (1958) | Modigliani-Miller View of Capital Structure (1958) |
| Autobiography | Autobiography | A Discussion of M&M's Contribution |
Harry Markowitz. (1952) often referred to as the "father of portfolio management", conducted the pioneering work into the tradeoff of risk and return that investors are faced with. His "Efficient Frontier" curve identified a series of optimal portfolios, i.e., portfolios that maximize the return for a given level of risk. We had known for centuries that the risk-return tradeoff principle was true: the higher the risk of an investment, the higher the expected return must be. Markowitz however quantified this relationship and showed the true trade-off that was available using various portfolios in the marketplace.
A new term was created to describe Markowitz's approach: Modern Portfolio Theory. Prior to Markowtiz's work, investment management was largely descriptive (non-quantitative): "Diversify across a variety of industries and types of securities and you should be O.K." Markowitz quantified the analysis and optimized the portfolios by maximizing the investors' return per unit of risk. This approach became known as Modern Portfolio Theory, which is a more quantitative approach to analyzing portfolios. Half a decade later, the approach is no longer new but it is still modern since the optimization approach is widely used in practice today.
James Tobin (1958) extended Markowitz's work by pointing out that most investors don't invest in just stocks (as Markowitz's work assumed) but instead invest in a combination of at least two assets - stocks and a liquid savings account (like Treasury bills or a bank savings account). When you consider these two possible investments, you don't have a series of "best portfolios", you have ONE optimal portfolio. This portfolio is often referred to as the "market portfolio" and can be thought of as an index mutual fund or a widely diversified portfolio. You can change your risk and return by splitting your money between the Treasury bills and the market portfolio, e.g., 40% of your money in T-bills and 60% in the market portfolio. If you change this ratio to 50/50, you increase both the risk and return of your investment. By choosing the ratio that is most attractive to you, you can maximize your return relative to the risk incurred.
Modigliani and Miller's 1958 landmark study (and its follow-up study) of capital structure is viewed by many as the most important piece of research ever conducted in finance.
M&M proved that, under certain assumptions (including assumptions of no bankruptcy risk and no taxes), that it doesn't matter how much debt a company uses in financing its operations. A company can borrow no money or a lot of money - it just doesn't matter because the cost of raising these funds (i.e., the cost of capital) is the same. In other words, the value of a company comes from the left-hand side (i.e., the asset side of the balance sheet), not from rearranging the items on the right-hand side (sources of financing).
| 1960s | |
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| William F. Sharpe | Eugene Fama |
| Beta and Capital Asset Pricing Model (1964) | Efficient Market Hypothesis (1965) |
| An Interview with Bill Sharpe | |
William Sharpe (1964) demonstrated that a stock portfolio's risk can be broken down into two parts: a part that can be diversified (called unsystematic risk, measured by alpha) and a part that cannot be diversified (called systematic risk, measured by beta). Markowitz had used the standard deviation of a portfolio's returns as the appropriate measure of risk. Sharpe argued that, while this is true for a portfolio made up of one single stock, it is not true for a portfolio of many stocks. The total risk (standard deviation) can be broken down into two components, alpha and beta, and the alpha can be reduced to almost zero. Therefore, the relevant risk is measured by beta.
He (and two others working simultaneously and independently of one another) derived an equation (called the Capital Asset Pricing Model) that measures quantitatively the amount of return that a portfolio must earn in order to fairly compensate the investor for the risk incurred.
Eugene Fama (1965) eloquently put into words what research studies had been showing for a number of years: investors cannot expect to earn more than the average market return over time. In other words, expensive computer models and professional investors will do no better than a widely diversified portfolio of randomly selected stocks. Under Fama's classification, the Efficient Market Hypothesis has three parts:
a weak form (stock price changes are independent of one another),
| 1970s | |
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No photo available. |
| Myron Scholes and Fischer Black (1973) | Sanjoy Basu (1977) |
| The Black/Scholes Option Pricing Model | His pioneering P/E ratio study focused attention on "anomalies" |
| Some anomalies | |
Fischer Black and Myron Scholes (1973) revolutionized the financial world by introducing the Black/Scholes Option Pricing Model. This model, or equation, allows an investor to determine the fair value of a financial option, such as a call. [A call gives its owner the right to buy 100 shares of stock at a specified price, e.g. $50, within a specified time period, like a few months.] Since virtually all financial securities have some characteristics of financial options, the model was a breakthrough in properly valuing securities.
Sanjoy Basu (1977) is given credit for discovering the first anomaly to Fama's Efficient Market Hypothesis (EMH). Today, over 20 anomalies have been discovered. An anomaly is an "exception to the rule" - and the rule in financial markets is the Efficient Market Hypothesis - so an anomaly in financial markets refers to an exception to the efficient market hypothesis. In other words, the EMH states that an investor cannot expect to outperform the market averages (like the S&P 500); the security's price incorporates all available information. Unless one can predict new information that will become known, one cannot expect to outperform the market averages. An anomaly, however, is a piece of information (a stock's price/earning ratio, in Basu's case) that can be used to an investor's advantage, i.e., can be used to earn above-average returns.
| 1980s and 1990s | ||
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| Amos Tversky |
Daniel Kahneman |
Richard Thaler |
| Pioneering work on investors' irrational behavior | ||
Tversky, Kahneman, and Thaler have all been at the forefront of what has become known as behavioral finance. Behavioral finance is a combination of psychology and finance; it attempts to explain the reasons that investors behave as they do. For example, investors' views toward risk is not symmetrical. The fair price to pay for a game of chance, such as a coin flip game, that pays you $100,000 if you win or requires you to pay $100,000 if you lose is $0. Yet the typical investor would not play this game, even if paid a few hundred dollars to play. The chance of financial ruin outweighs the chance of a large financial gain. Another example is that most investors have too much confidence in their own abilities; they take risks unnecessarily because they believe that their stock-picking ability is above average and that they will win.
Here is a link for my video of the major developments in thought regarding risk and return. It is playable with Windows Media Player and is 28 minutes in length.