Abstract
Paul Samuelson regarded finance as the “Mount Everest” of economic pursuits. He proved that informationally efficient markets implied random price behavior and believed that very few investors could “beat the market.” Motivated by his study of the dismal performance of “managed money,” Samuelson was the first to advocate the creation of a low-cost stock index fund and his writings spurred Jack Bogle to create the S&P 500 Index Trust. His work on option theory brought him to the verge of the Black–Scholes formula, but the final equation eluded him. Samuelson warned investors that the Law of Large Numbers did not imply that investors with longer horizons should put a greater proportion of their portfolio in stocks but demonstrated that mean reversion of equity prices coupled with sufficient risk aversion would imply that strategy.
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Notes
- 1.
Although Samuelson was not the economist with the greatest political impact, in my opinion, that honor goes for John Maynard Keynes in the first two-thirds of the twentieth century, and Milton Friedman in the last third.
- 2.
See also an earlier review by Merton (1983).
- 3.
This was evident by Merton’s 1969 class paper, “An Empirical Investigation of the Samuelson Rational Warrant Pricing Theory,” which became part of his MIT Ph.D. dissertation in 1970.
- 4.
This article, published while a student at Harvard, was the second of nearly 1000 scholarly pieces that Samuelson published in his lifetime. The David M. Rubenstein Rare Book & Manuscript Library at Duke University contains almost 89,000 items (printed and teaching materials, correspondence, speeches and interviews, and other audiovisual materials) related to the work of Paul Samuelson, which they claim occupy 119 linear feet of shelf space!
- 5.
It is well known that Friedman opposed approving Harry Markowitz’s Ph.D. dissertation, which was the foundation of modern portfolio theory and later worthy of a Nobel Prize in economics. Friedman regarded it as a statistical exercise, not an economic contribution. In contrast, Samuelson praised Markowitz in a 2010 article entitled, “On the Himalayan Shoulders of Harry Markowitz.” Friedman’s resistance to analyzing stock prices possibly arose from his work on the monetary history of the United States , which debunked the popular explanation that the stock market crash of 1929, not the collapse of the banking system, caused the Great Depression.
- 6.
He understates his disappointment in his personal reminisces on modern finance theory (Samuelson 2009: 19) where he contends that his attempts to establish pricing theory for options fell “a bit short of the Black-Scholes-Merton Holy Grail.”
- 7.
Vanguard’s index funds had an enormous impact on college pension practices as faculty agitated for inclusion of these funds to supplement TIAA-CREF, which had held a virtual monopoly.
- 8.
See S&P Dow Jones Indices (2016). According to Thomson Reuters, ICI (topdowncharts.com), since the 2009 financial crisis about $750 billion of funds have moved out of actively managed accounts and over $1 trillion have moved into passive (indexed) accounts.
- 9.
Milton Friedman also railed against those ceilings in a Newsweek article entitled “The Bank Depositor,” 7 November 1966.
- 10.
Samuelson’s stake is worth about $750,000 in 2018 dollars. He was very comfortable financially, having earned millions from his bestselling textbook, Economics (Samuelson 1948). This text, through its 19 editions, has sold nearly 4 million copies and has been translated into 40 languages.
- 11.
Weymar told Mallaby (2010: 64), “I thought random walk was bullshit. The whole idea that an individual can’t make serious money with a competitive edge over the rest of the market is wacko.”
- 12.
In other words, Samuelson considered his “comparative advantage” was tackling tough economic problems, not trading strategies.
- 13.
He also claimed that commodity trader Amos Hostetter Sr. (whose picture was on the wall of the Commodities Corporation) garnered positive returns over virtually every year in the half century before his death, a performance which would have virtually zero chance of being the result of random outcomes. See Samuelson (1989a: 7).
- 14.
Samuelson cites Buffett’s: “Aw shucks, just buy a good business franchise at a favorable price!” See Samuelson (1993: 3).
- 15.
Indeed, over the past 10 years, Berkshire Hathaway has underperformed the S&P 500.
- 16.
The real return on short-term fixed income assets has fallen dramatically in recent years and has been less than zero over the past decade.
- 17.
Today a large part of earnings is deployed for stock buybacks , also generating “systematic capital gains.”
- 18.
The “Fed Model” received its name from a graph in the 22 July 1997 Fed Monetary Policy (“Humphrey-Hawkins”) Report to Congress. It was popularized by Edward Yardeni, then at Deutsche Morgan Grenfell.
- 19.
He finally identified his colleague 28 years later in Samuelson (1989b: 292) as E. Cary Brown (one of my professors at MIT), referring to him as his “long-time boss.” Brown was chairman of the Economics Department for 18 years.
- 20.
Zvi Bodie, who crusaded with Samuelson against the belief that in the long run stocks would always beat bonds, often mentioned my book, Stocks for the Long Run, as providing the basis for this incorrect belief (Bodie 1995). When I confronted Zvi and said that I never claimed that in my book, he agreed and replied, “I know you don’t, Jeremy, but everyone thinks you do!”
- 21.
- 22.
I retold this story at Samuelson’s 90th birthday celebration. It received loud chuckles from the audience and even Samuelson smiled.
- 23.
For example, if we assume a long-run real rate on bonds of 2%, and an equity premium of 2% (which is still much larger than Mehra and Prescott propose), we get a real return on stocks of 4%, which corresponds to a 25 price-to-earnings ratio. These are all geometric returns.
- 24.
Fortunately, a quarter of a century after receiving this letter I am basking in the “blessed territory.” From the date of this exchange through 31 July 2018, the US stock market has returned over 9.4% per year (about 7.1% after inflation is taken into account), more than its historical average. In contrast, a 25-year US government bond would have returned about 6%, and rolling over in bills, less than 2.5%. However, the ride to these great stock returns was rocky. I clearly would have been in the “cursed territory” at the bottom of the bear market in March 2009.
- 25.
In January 1997, one month after Alan Greenspan, Chairman of the Federal Reserve, made his famous “Irrational Exuberance” speech, Samuelson wrote a short piece, “Dogma of the Decade: Sure-Thing Risk Erosion for Long-Horizon Investors” (Samuelson 1997) claiming that the “can’t-lose-in-equity” philosophy was flawed.
- 26.
These returns can be simulated by a “bootstrapping” technique.
- 27.
I was not the first to suggest that stock returns followed a mean-reverting process. Poterba and Summers (1988) and Fama and French (1988) showed that long-term stock returns did not conform to the random walk hypothesis. Mean reversion became even more apparent when I extended the stock return series back to 1802.
- 28.
Analytically, if U(c) = c1−γ/(1 − γ), the class of investors who would hold more stocks are those with a risk coefficient γ > 1, i.e., those more risk averse than U(c) = log(c).
- 29.
In Samuelson (1989a: 10; italics in original), he states that “the bulk of the empirical evidence, cross-sectional and from time series, is that real life investors are more risk-averse than Bernoulli utility function log(c).”
- 30.
In their 2018 yearbook, Dimson et al.’s sixteen country sample was expanded to 21, and stock returns still dominated in all countries. Equities outperformed bonds by 4.3 percentage points per year and bonds by 3.2 percentage points. They state that “this provides a reassuring reminder that, over the long run, there has been a reward for the higher short-term risk from stocks” (Dimson et al. 2018: 24).
- 31.
The importance of labor supply flexibility is found in Bodie et al. (1992).
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Acknowledgements
The author is the Russell Palmer Professor of Finance at the Wharton School of the University of Pennsylvania and a student of Paul Samuelson from 1967 through 1971. I would like to thank Robert Cord for offering me the opportunity to write about this iconic economist and Michal Kolakowski for valuable research support.
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Siegel, J.J. (2019). Climbing Mount Everest: Paul Samuelson on Financial Theory and Practice. In: Cord, R., Anderson, R., Barnett, W. (eds) Paul Samuelson. Remaking Economics: Eminent Post-War Economists. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-56812-0_13
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