Capital Ideas. Bernstein Peter L.

last to find buyers when security prices are dropping. Giant financial institutions complain that security prices are dangerously volatile. There is a widely held perception that overpaid MBAs, corporate raiders, and investment managers who talk like astrophysicists are living in a world of their own, detached from the realities of people who really work for a living.

      But that is only part of the story. The untold part, which is what this book is about, reveals that much of this fear and resentment is misplaced. Baffling as it may be to some, Wall Street is vital and productive, a model for the rest of the world, including former socialist countries seeking the path to prosperity and freedom.

      The gap in understanding between insiders and outsiders in Wall Street has developed because today’s financial markets are the result of a recent but obscure revolution that took root in the groves of ivy rather than in the canyons of lower Manhattan. Its heroes were a tiny contingent of scholars, most at the very beginning of their careers, who had no direct interest in the stock market and whose analysis of the economics of finance began at high levels of abstraction.

      Yet the message they brought to Wall Street was simplicity itself, based on two of the most basic laws of economics. There can be no reward without risk. And gaining an advantage over skilled and knowledgeable competitors in a free market is extraordinarily difficult. By combining the linkage between risk and reward with the combative nature of the free market, these academics brought new insights into what Wall Street is all about and devised new methods for investors to manage their capital.

      Much of what these scholars had to say often seemed strange and uninviting to hungry investors and to the aggressive salesmen who inhabit Wall Street. But in their quiet way the academics eventually overcame the old guard and liberated the city of capital. Before they were done, they had transformed today’s wealth of nations and the lives of all of us, as citizens, savers, and breadwinners.

      Today investors are more keenly aware of risk, and better able to deal with it, than at any time in the past. They have a more sophisticated understanding of how financial markets behave and are capable of using to advantage the vast array of new vehicles and new trading strategies specifically tailored to their needs. Innovative techniques of corporate finance have led to more careful evaluation of corporate wealth and more effective allocation of capital. The financial restructuring of the 1980s created novel solutions to the problems arising from the separation of ownership and control and made corporate managers more responsive to the interests of shareholders.

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      The first signs of the revolution in finance and investing appeared in October 1974, with the culmination of the worst bear market in common stocks since the Great Crash of 1929. By the time prices finally touched bottom, market values had fallen more than 40 percent from what they had been two years earlier.

      That was not all. An overheated domestic economy and the rapacity of the OPEC countries had sent inflation soaring. In just a year and a half, the cost of living jumped 20 percent, more than 1 percent a month. After adjustment for inflation, the entire rise in stock prices since 1954 had been erased. At the same time, the bond market, the traditional haven for the risk-averse, suffered a 35 percent loss of purchasing power.

      No one emerged unscathed. Employees found that the decline in the value of their pension funds threatened the security of their retirement. Distress brought pressure for change throughout the world of finance: the way professionals managed their clients’ capital, the structure of the financial system itself, the functioning of the markets, the range of investment choices available to savers, and the role of finance in the profitability and competitiveness of American companies. Many of the star portfolio managers of the go-go years of the 1960s disappeared in the rubble, along with Richard Nixon’s price controls and Gerald Ford’s W.I.N, buttons. Respected banks, major industrial corporations, and even the City of New York stood at the brink of bankruptcy.

      Had it not been for the crisis of 1974, few financial practitioners would have paid attention to the ideas that had been stirring in the ivory towers for some twenty years. But when it turned out that improvised strategies to beat the market served only to jeopardize their clients’ interests, practitioners realized that they had to change their ways. Reluctantly, they began to show interest in converting the abstract ideas of the academics into methods to control risk and to staunch the losses their clients were suffering. This was the motivating force of the revolution that shaped the new Wall Street.

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      Even an incomplete list of the innovations that have emerged since the mid-1970s reminds us of how profoundly the present differs from the past. The unfamiliarity of some of the new terminology suggests the magnitude of that break with tradition.

      Today there are money market funds, bank CDs for small savers, unregulated brokerage commissions, and discount brokers. There are hundreds of mutual funds specializing in big stocks, small stocks, emerging growth stocks, Treasury bonds, junk bonds, index funds, government-guaranteed mortgages, and international stocks and bonds from all around the world. There is ERISA to regulate corporate pension funds, and there are employee savings plans that enable employees to manage their own pension funds. There are markets for options (puts and calls) and markets for futures, and markets for options on futures. There is program trading, index arbitrage, and risk arbitrage. There are managers who provide portfolio insurance and managers who offer something called tactical asset allocation. There are butterfly swaps and synthetic equity. Corporations finance themselves with convertible bonds, zero-coupon bonds, bonds that pay interest by promising to pay more interest later on, and bonds that give their owners the unconditional right to receive their money back before the bonds come due.

      The world’s total capital market of stocks, bonds, and cash had ballooned from only $2 trillion in 1969 to more than $22 trillion by the end of 1990; the market for stocks alone had soared from $300 billion to $55 trillion. Today, more than half of the global market, nearly $12 trillion, trades outside the United States, compared to only one-third of the market in 1969. Hence, the wealth of nations.

      Over $2 trillion, more than 50 percent of the common stock outstanding in the United States, is now owned by pension funds, mutual funds, educational endowments, and charitable foundations, compared with 40 percent in 1980 and less than 15 percent in 1950. These institutions account for 80 percent of all trading activity in the stock market, and none of them pays income taxes or taxes on capital gains. More than 70 percent of all outstanding shares changes hands in the course of a year, up from only 20 percent or so in the 1970s. The average transaction of the New York Stock Exchange now exceeds 2,000 shares, nearly six times what it was in 1974; half of the daily volume of trading takes place in blocks of 10,000 shares or more. Meanwhile, individual investors who buy and sell for their own accounts are a disappearing breed. Their direct holdings of common stocks now represent only 16 percent of their financial assets, down from 44 percent in the late 1960s.1 Odd-lots (transactions of less than 100 shares) have fallen from 5 percent of total volume to less than 2 percent.

      Financial assets now change hands with dizzying speed. Daily trading on the New York Stock Exchange averages over 150 million shares, more than ten times the daily average of 1974, five times the average in the highest year of the 1970s, and 100 times the average in the early 1950s. On Black Monday of October 1987, 604 million shares were traded. Millions of additional shares are traded directly across computers, bypassing the organized exchanges altogether. The volume of shares traded in the markets for futures and options often exceeds the volume traded on the organized exchanges. Trading in Tokyo is ten times what it was in 1982, in Frankfurt twelve times, and in London thirty times.

      The pace is even swifter in the once-sedate bond market. Daily trading in U.S. government bonds runs about $100 billion. That means that the ownership of the entire national debt is turning over ten times a year. Trading is swifter still in the foreign-exchange markets: Transactions in the United States exceed $100 billion a day, while Tokyo does some $30 billion and other world markets do another $100 billion.

      Such volume would be impossible without the computer. Many complex securities could not even be priced without the computer’s speed and mathematical capabilities. So-called DOT transactions automate small trades on the New York Stock Exchange and transmit them instantaneously from the customer’s broker to the post where the order is executed.

1

Some, but by no means all, of this money has come back into the stock market through individual purchases of mutual funds. Distaste for the difficulties individual investors encounter when they try to manage direct holdings of common stocks explains the dramatic growth of the mutual fund business over the past fifteen years.