Gallery:Step 2|Step 2: Nobel Laureates

The Early Pioneers of Finance Theory

Gallery:Step 2|Step 2: Nobel Laureates

Leonardo of Pisa (Fibonacci), 1202

Fibonacci

At the heart of modern finance is the ability to calculate the present value of a future cash flow. According to this working paper by William N. Goetzmann, the credit for this discovery belongs to the renowned Medieval Italian mathematician who is most famous for his Fibonacci Sequence that is connected to the golden ratio. This calculation allows us to properly estimate the values of both assets and liabilities that involve future cash flows. The discount rate used to calculate the present value depends on the riskiness of the cash flow. For example, a US Treasury bond payment would be discounted at a lower rate than the anticipated dividend payment of general electric twenty years from now.

Luca Pacioli, 1494

Luca Pacioli

When estimating the value of a company’s shares, it is crucial to have a reliable accounting of assets, liabilities, profits, losses, and cash flows. For this, we credit the Italian Renaissance mathematician, Luca Pacioli, who invented the double-entry accounting system. Also originated by Pacioli is the “rule of 72” which states that the approximate number of years required for a sum that is earning compound interest to double is 72 divided by the interest rate. Below is a portrait of Pacioli of uncertain attribution, possibly painted by da Vinci.

Blaise Pascal, 1654

The Early Attempts to Quantify Risk

Blaise Pascal

Modern finance began with the realization that risk needed to be measured and managed. "The intelligent management of risk" can be traced to 1654 during the Renaissance Period. This was a time of great discovery. Centuries-old beliefs were constantly under question and reevaluation. This time of rebirth challenged wizards, mystics, fortune-tellers, oracles, and soothsayers, who were previously regarded as experts on predicting the future. One day in 1654, a French gambler named Chevalier de Mere and a mathematician named Blaise Pascal tried to predict the future outcome of a game of chance.

They wanted to determine how to divide up the stakes of an unfinished game, when one player was slightly ahead. With input from Pierre de Fermat, they developed the theory of probability. This theory is the basis for the concept of risk management and modern finance. Years later in 1952, Nobel Laureate Harry Markowitz embraced what a French gambler had questioned in 1654 and converted it into the theory of Portfolio Selection. His idea revolutionized the investment process! (Also see How Do We Measure Risk)

Edmund Halley, 1690

Beginning to Understand Risk Management

Edmund Halley

Edmund Halley, the famous English astronomer who discovered Halley's Comet, began work on a series of life tables in early 1690. A probability based life expectancy could be derived from these tables, which later became the blueprint for the life insurance industry. Techniques of risk management were improved over the years, leading to one of the first commercial applications by the English government. Government officials developed life expectancy tables and sold life annuities, soon followed by marine insurance products. Halley’s work ultimately led to the founding of Lloyd's of London, which originated in a tiny English coffee shop that Halley frequented. These same principles of managing risk were later applied to the stock market.

A critical element in the development of risk management was the discovery of standard deviation and the bell shaped curve by Abraham de Moivre in 1730. Francis Galton, cousin to Charles Darwin, proposed the Theory of Regression to the Mean by 1875. This theory predicts that a result will be closer to the "normal" or the expected average over time.