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'The Black Swan'' and 'Capital Ideas'

Iqbal Latif - 4/3/2008

Two books two different view points. I have highlighted book reviews by great critics, back to back reading of the two books yield two different view points and highlight the two facets of the debate, and I find them very educational, I would like to share the gist of the critics review with the community, for detailed dialogue do go to the links and study the reviews in detail, the links are highlighted below as 1 and 2. The critics have helped understand and appreciate the two positions far much better.

''The Black Swan''-The problem, Nassim explains, is that we place too much weight on the odds that past events will repeat (diligently trying to follow the path of the "millionaire next door," when unrepeatable chance is a better explanation). Instead, the really important events are rare and unpredictable. He calls them Black Swans, which is a reference to a 17th century philosophical thought experiment. In Europe all anyone had ever seen were white swans; indeed, "all swans are white" had long been used as the standard example of a scientific truth. So what was the chance of seeing a black one? Impossible to calculate or at least they were until 1697, when explorers found Cygnus atratus in Australia.1

"Capital Ideas" - In the early 1950s, graduate student Harry Markowitz presented his Ph.D. dissertation to the University of Chicago economics department. The response was less than encouraging. "This isn't a dissertation in economics," Milton Friedman told Markowitz. "It's not math, it's not economics, it's not even business administration." Whatever it was, Markowitz's heterodox theory of portfolio selection changed finance forever and earned a Nobel Prize.In recent years, however, some of these concepts have come under attack. Critics have argued that the academics used too many simplifying assumptions, such as ignoring trading costs. A school of thought, known as behavioural finance, has proposed that investors are not as rational as the models assume and are subject to psychological biases, such as a reluctance to cut their losses.2

''The Black Swan''-Nassim Nicholas Taleb is an essayist principally concerned with the problems of uncertainty and knowledge. Talebs interests lie at the intersection of philosophy,mathematics, finance, literature, and cognitive science but he has stayed extremely close to the ground thanks to an uninterrupted two-decade career as a mathematical trader. Specializing in the risks of unpredicted rare events (black swans), he held senior trading positions in New York and London before founding Empirica LLC, a trading firm and risk research laboratory. Taleb is a fellow at the Courant Institute of Mathematical Sciences of New York University where he has been teaching a class on the failure of models since 1999. His degrees include an MBA from the Wharton School and a Ph.D. from the University of Paris Dauphine. The authors ideas on skeptical empiricism have been covered by hundreds of articles around the world. Since childhood, Taleb has been obsessed with the defects of his own thinking. In addition to his scientific and literary interests, Taleb enjoys cafe lounging and museum hopping.1

"Capital Ideas" - Peter Bernstein "Just as Dante could not have understood or survived the perils of the Inferno without Virgil to guide him, investors today need Peter Bernstein to help find their way across dark and shifting ground. No one alive understands Wall Street's intellectual history better, and that makes Bernstein our best and wisest guide to the future. He is the only person who could have written this book; thank goodness he did."

- Jason Zweig, Investing Columnist, Money magazine

''The Black Swan''-The problem, Nassim explains, is that we place too much weight on the odds that past events will repeat (diligently trying to follow the path of the "millionaire next door," when unrepeatable chance is a better explanation). Instead, the really important events are rare and unpredictable. He calls them Black Swans, which is a reference to a 17th century philosophical thought experiment. In Europe all anyone had ever seen were white swans; indeed, "all swans are white" had long been used as the standard example of a scientific truth. So what was the chance of seeing a black one? Impossible to calculate, or at least they were until 1697, when explorers found Cygnus atratus in Australia.1

"Capital Ideas" - In his 1992 book, "Capital Ideas", Peter Bernstein gave a magisterial account of the academics' thinking. The likes of Harry Markowitz, Bill Sharpe and Myron Scholes developed theories to explain the link between risk and reward, the gains to be made through diversification and the framework for valuing financial options.

Financial historian and investment manager Peter L. Bernstein humanizes his saga of great shifts in financial theory by organizing it around eminent thinkers (Markowitz, Myron Scholes, Franco Modigliani, Robert Merton, Bill Sharpe and others, if you ever want to look up a finance guru). Deepening his analysis with insights from "behavioral finance," Bernstein describes how these innovators generated and extended the now-orthodox "capital ideas" of portfolio selection, capital structure, the Capital Asset Pricing Model, the efficient market hypothesis and the Black-Scholes-Merton theory of option pricing. Bernstein's erudition is dazzling, his explanations pellucid and his narrative filled with scintillating characters.2

Now Mr Bernstein has returned to the fray with a new volume in defence of his academic heroes. Although he accepts some of the theories' limitations, he argues that the professors built the structure for today's capital markets. Modern investors are much more sophisticated in the way they think about risk, in particular separating the returns available from market movements (beta in the jargon) and managerial skill (alpha).

''The Black Swan''-Taleb goes way overboard in attributing everything to luck. He thinks MicroSoft beat out Apple just due to luck. Taleb does not consider that MicroSoft open system allowed it to mushroom while Apple locked itself into a proprietary corner. Also, according to Taleb both the rise and fall of Rome were due entirely to luck. But, Rome was best at developing military strategy and transportation networks. However, it eventually suffered from imperial overstretch.1

"Capital Ideas" - Financial historian and investment manager Peter L. Bernstein humanizes his saga of great shifts in financial theory by organizing it around eminent thinkers (Markowitz, Myron Scholes, Franco Modigliani, Robert Merton, Bill Sharpe and others, if you ever want to look up a finance guru). Deepening his analysis with insights from "behavioral finance," Bernstein describes how these innovators generated and extended the now-orthodox "capital ideas" of portfolio selection, capital structure, the Capital Asset Pricing Model, the efficient market hypothesis and the Black-Scholes-Merton theory of option pricing. Bernstein's erudition is dazzling, his explanations pellucid and his narrative filled with scintillating characters.

FIFTY years ago, the business of managing other people's money was very much an art not a science, and was largely a matter of finding someone who was privy to inside information. But during the 1950s, 1960s and 1970s, academics changed the study of what became known as portfolio management. They did so in the face of much initial resistance and scepticism from the industry.2