In the early years of the twentieth century, there was little connection between Wall Street and academia. Most of the prominent financiers had not bothered with higher education at all, and those who did—like Pierpont Morgan and Paul Warburg—received a classical education at a university and then followed that up with an apprenticeship at a bank, where they picked up practical knowledge on the job. During the course of that century, however, university-affiliated business schools grew in number and prominence, especially as their focus expanded from vocational undergraduate programs to respectable graduate schools at leading universities.
As the schools gained acceptance in the business world, many of their star professors led dual professional lives, splitting their time between the academy and industry, sometimes with profound effects. In particular, the field of finance has been inalterably shaped by three men whose careers encompassed both the classroom and the real world: Georges Doriot of Harvard, who formed and managed the first venture capital firm; Benjamin Graham of Columbia, who wrote the book on security analysis; and Myron Scholes, who variously taught at the University of Chicago, the Massachusetts Institute of Technology, and Stanford, and laid much of the foundation for the growth of the derivatives markets.
Doriot, Graham, and Scholes made their marks during successive eras and in very different areas of finance, yet they shared common experiences. All three were immigrants to the United States at an early age, and each was a remarkably precocious student and later a success in business. Yet each suffered remarkable setbacks during his professional life.
Doriot’s setback came near the end of his career as a venture capitalist. That career had started in 1946, when a group of Boston businessmen approached him about managing a newly formed “industrial development company”—the term “venture capital” was not yet in use. At that point, he was already a long-tenured professor at the Harvard Business School. He accepted the challenge of running the American Research and Development Corporation and, over a twenty-seven-year stretch, built the company into a highly successful enterprise and, more lastingly, established the pattern for and feasibility of professional venture capital investing. Through highly selective investments in new technologies, coupled with some luck in funding the enormously successful Digital Equipment Company, the mustachioed Frenchman validated the concept of institutionally backed venture capital investing through dedicated pools of capital.
Unfortunately, General Doriot—he rose to brigadier general during World War II and proudly retained the title in civilian life—suffered from an inability to delegate or attract successor talent. And for someone who quickly recognized and acted on technical innovation, he was stubborn in his refusal to adopt the limited partnership format that had become for his competitors the logical and successful form of organization for venture investing. So even though American Research had much to do with establishing Boston as an incubator for new, high-tech enterprises, and everything to do with creating the venture capital industry, the company was ingloriously sold to a conglomerate and soon liquidated.
Where Doriot’s problems came late in his career, Graham’s came early. After his graduation from Columbia as salutatorian, he declined the university’s offer to stay on and teach—he had his choice between mathematics, English, or philosophy—electing instead to travel downtown to make his way in the investment business. He did extraordinarily well on Wall Street and was still in his early thirties in 1926 when he founded Graham-Newman, the money management firm he would run for the next thirty years.
During the waning years of the Roaring Twenties his investment acumen had become widely recognized and, after managing Graham-Newman during business hours, he returned to Columbia in the evenings to deliver a well-attended lecture series on his investing strategies. He was riding high, pleasing the Graham-Newman clients during the day and inspiring his students at night. But the 1929 stock market crash and the long-lasting depression that followed had a disastrous effect on Graham-Newman, with the accounts Graham was managing on his investors’ behalf plummeting in the 1930s to just a fraction of their pre-crash values.
By 1934, however, he had distilled the Columbia lectures and his Wall Street experience, hard knocks and all, into the seven-hundred-page Security Analysis, the first rigorous approach to determining the value of stocks and bonds. The book, cowritten with Columbia University professor David Dodd, transformed stock selection from a hit-or-miss, tip-based activity into a methodical and rational process. The book’s risk-wary, quantitative approach remains in wide use today, and The Intelligent Investor, a more accessible book he wrote in 1949 to encapsulate his ideas for a wider audience, is still in print. His former Columbia student, Warren Buffett, called The Intelligent Investor “by far the best book ever written on investing.”
In Scholes’s case, his most spectacular success and failure occurred simultaneously. He won the Nobel Prize for Economics in 1997, and the next year lost most of his wealth following the collapse of Long-Term Capital Management, the multibillion-dollar hedge fund he had cofounded a few years earlier. Both events were impacted by the development of the derivative securities in which Professor Scholes had played a major role. Professional investors recognize his name from the Black-Scholes option pricing model for which he, along with Robert Merton from MIT, received the Nobel award. He rejected any notion that the informal title “Father of Derivatives” was appropriate for him or his research colleagues, but it was the methodology he developed jointly with Merton and Fischer Black that became key in pricing and understanding derivatives.
Judiciously used, derivatives reduce business and investment risk. But when used for speculation they can also be, as Warren Buffett famously described them, “weapons of mass financial destruction.” It was Scholes’s conceit—if Doriot’s fatal flaw was stubbornness, Scholes’s may have been hubris—to operate as though his models were infallible. But when events in 1997 and 1998, especially in Asia and Russia, caused financial turmoil not anticipated by the models, Long-Term Capital Management lost $4.5 billion, wiping out the investors’ equity and requiring a Federal Reserve–led bailout of its debt holders to forestall a financial panic.
By the twenty-first century the connection between the universities and the real world of finance was well established. In some financial sectors an MBA is considered a license to practice, and the business schools do a commendable job of supplying bright and well-prepared graduates to work on Wall Street. Less well known, perhaps, is the direct role faculty members often play through consulting and sometimes managing financial institutions. The work of the academics profiled in the next three chapters shows how important that role can be.