The name on my office door tells you who I am: James H. Free Jr. Until today, I thought I had a pretty good life, currently working as the Senior Managing Director of the GM Asset Management Group, the automobile insurance subsidiary of a large corporation. I am entrusted with the task of profitably investing the proceeds of the premiums the company receives, and I am well compensated for my decisions in my salary and bonuses.
But that isn’t how I define myself or what I am known for. I spent my most productive years performing theoretical academic research in the area of Finance. While I was a research fellow at the Federal Reserve Bank of Cleveland, I met and married my wife Cathy We lived in Milwaukee, and we eventually had two children. Later, I moved to Stanford University, where I took a job in the Finance Department as an Assistant Professor. Since I am originally from Texas, I developed an easy-going, down-home teaching style but, cognizant of the relatively short tenure cycle of universities and the relatively lengthy review process at academic journals, I devoted most of my time to my research efforts.
The field of Finance, encapsulating the Corporate Finance decisions of a firm’s capital structure and dividend policy choices and the Capital Markets decisions of investors’ security portfolio choices, has always suffered from an inferiority complex relative to other scholarly disciplines, because financial practitioners tend to use ad hoc, arbitrary rules of thumb to make these decisions. As a result, until relatively recently, academicians in Finance didn’t engage in particularly rigorous research practices and instead chose to view themselves as being more practical than their academic colleagues in other fields.
Four research efforts began the process of changing this unscientific approach and bringing it more in line with rigorous research standards adhered to elsewhere, and these papers formed the basis for the case that the field of Finance was really a branch of Economics, and its research findings should be judged by the same strict standards. Ironically, of course, the most important implication of this adoption of rigorous research methods in Financial Economics was the revelation that most of the common sense, “practical” rules of thumb for making financial decisions turn out to be erroneous.
The first, which concerned Corporate Finance, was the irrelevance theorems of Franco Modigliani of the Massachusetts Institute of Technology (MIT) and Merton Miller of the University of Chicago. Their 1958 paper in The American Economic Review showed that in frictionless capital markets, the firm’s goal of maximizing the market value of its securities was not affected by its capital structure decision (its choice between debt and equity financing), since investors (whose portfolio investment decisions determine the market value of the firm’s securities) can buy or sell the company’s bonds or stock in their own portfolios to adjust the firm’s choice to obtain their desired debt\equity ratio.
And by similar logic they showed in a 1961 Journal of Business paper that the firm’s value was not affected by its choice to pay high dividends at the expense of lower stock price growth or to adopt the opposite dividend policy, since the investors who own their securities can adjust their own portfolios by buying or selling the stock of other firms to get the dividend policy they desire. Of course, the Modigliani-Miller theorems depend on the assumptions that the firm undertakes optimal investment policies, not accepting unprofitable projects or rejecting profitable ones; and that the capital markets are free of transaction costs that can cause investors’ gains or losses from portfolio adjustments to deviate from those of the firm. These costs could be the result of brokerage fees, taxes, or legal expenses incurred in the event of the firm’s bankruptcy.
The other three seminal research breakthroughs more properly belong to the Capital Markets literature. The first concerned the problem of the optimal strategy by which investors evaluate security acquisitions, for which there were two important contributions. One was Harry Markowitz’s 1952 Journal of Finance paper on portfolio selection, in which he stressed the importance of diversification, that securities can be characterized by the expected value and variance of their returns, and that optimal portfolio choices fall along an efficient frontier of risk (measured by variance) and expected returns. William F. Sharpe at Stanford University then extended this idea in his 1964 Journal of Finance paper on the pricing of capital assets, where he showed that the expected rate of return on any individual security or portfolio will be the sum of a risk-free rate of interest and the product of the extra rate of return on a stock market index and its exposure to movements in that market index, as measured by its degree of systematic risk.
The second important research in this area was summarized by the University of Chicago’s Eugene Fama in his 1970 Journal of Finance paper on market efficiency, in which he reported empirical findings demonstrating that stock price movements were unpredictable and followed a random walk, so that traditional efforts to use fundamental or technical analysis to find undervalued securities are doomed to failure.
The final important Capital Market research contribution was the path-breaking paper by MIT’s Fischer Black and the University of Chicago’s Myron Scholes, which appeared in 1973 in the Journal of Political Economy and which utilized the obscure tool of Ito’s Lemma from the arcane mathematical field of Stochastic Calculus to obtain a closed-form solution for the pricing of options (contracts that give the buyer the right, but not the obligation, to buy (in the case of call options) or sell (in the case of put options) an underlying security at a fixed strike price within a fixed time to expiration.
For the record, Modigliani, Miller, Markowitz, Sharpe, Fama, and Scholes all received the Nobel prize for significant contributions in Economic Science. Only Fischer Black, who had died after leaving his university post in the 1990’s to work at an investment bank failed to receive his well-deserved prize.
When I was doing my Ph.D.at Carnegie Mellon University, Merton Miller was my advisor (he was employed there when it was still called the Carnegie Institute of Technology, before he moved to the University of Chicago), and he encouraged me to investigate how the Modigliani- Miller theorem on Capital Structure would be affected by the introduction of bankruptcy costs. He further assured me that he knew an editor at the Bell Journal of Economics who would be quite interested in the results if I could produce them relatively quickly. So, I proceeded to examine the problem for my dissertation, and I could see right away that this market imperfection would invalidate the Irrelevance proposition and produce an optimal capital structure. I formalized this conclusion with some elementary mathematics and presented the results to my dissertation committee, who, with Miller’s urging, approved it and awarded me my doctoral degree.
I had already started working at Stanford, where I set about turning my dissertation result into a publishable journal article. After completing a first draft, I submitted it to the Bell Journal, but the referee wrote that the paper needed major revisions, so I proceeded to get to work on rewriting it. In the meantime, the Dean at the Stanford Business School informed me that after three years, with no publications, I would not be receiving tenure and would need to and look for another job elsewhere. I felt that with Miller’s recommendation, I could get an academic job at another good university, and when I learned at the annual American Finance Association meeting that Columbia was hiring, I applied.
When I was interviewed by the Finance Department’s chairman, an Israeli with several publications in the neglected area of International Finance, he seemed quite interested in my research and told me that if I could get my paper accepted soon Columbia would hire me as a tenured Associate Professor. I accepted Columbia’s offer, and upon learning that Fred Brunswick, one of my Stanford graduate students, had just been denied tenure at MIT, I arranged an Assistant Professor position for him at the same time.
After I began at Columbia in the Fall of 1975, the reason for the chairman’s interest in my work soon became clear to me. It turned out that one of his graduate students, another Israeli, was doing his dissertation on the same topic as my Bell Journal article, which was finally published early the following year. A graduate student named Paul, who had also started at Columbia in 1975, told me that he was taking the advanced level Finance course being taught by this Israeli graduate student, and that he had said some very disparaging things about my article. When I quizzed him about it, Paul told me that this person seemed very insecure and had denied him an “A” in the course despite his excellent performance on the course’s exams and work requirements. And when I finally met this person, he addressed me contemptuously.
In general, though, I found my Finance Department colleagues very stimulating. We held regular seminars open to all professors and graduate students, where someone (often a job candidate) would present a paper and lead a discussion about it. One that particularly impressed me was Larry Golden from the University of Pennsylvania. His professors had published in and served on the editorial boards of prestigious journals like Econometrica; Larry’s work reflected a self-confidence and inventiveness that set him apart from other candidates. When we offered him an Assistant Professor position, I was pleased that he accepted it, and he became a great colleague.
Paul became very successful in the Ph.D. program, getting to the ABD (all but dissertation) stage in record time, so I was pleased to become his dissertation advisor, and I also asked Fred Brunswick to serve on the committee. For some reason, though, Paul took a leave of absence for the summer after passing his Prelim, or major field exam, and when he returned, he explained that he had been working at the library at a university in Washington D.C. to develop a dissertation topic about interest rate futures contracts. In it he envisioned a market whose contracts were modified to permit flexible start dates and end dates. His analysis would then derive the optimal pricing and hedging properties for the new, flexible contracts.
In the meantime, the Israeli graduate student had continued to make wild claims that my Bell Journal article was seriously flawed, that I hadn’t thought through all the complexities of the problem, and that his dissertation provided the correct analysis of the impact of bankruptcy costs on capital structure, even though his dissertation was unpublished and my paper had appeared in a respectable journal. At the same time, in listening to Paul describe his ideas, I realized that they could potentially have a huge impact on the field but they might be controversial, while the Israeli graduate student’s criticism could potentially damage my reputation in the eyes of people like Larry Golden. Accordingly, I told Paul that his research proposal had the potential for a high return but also contained a significant degree of risk, it might be regarded as controversial, and his dissertation defense might not go smoothly. Why not just adopt a safe approach, I suggested, and do a minor extension of my paper? I could tell he was disappointed but, not unaware that he needed the approval of people like me and Fred Brunswick to get his degree, he reluctantly agreed.
Paul met with me regularly while he made trivial adjustments to my paper. Once, I noticed something that I didn’t recognize and when I asked him about it, he told me it was something from the Israeli graduate student’s dissertation that he felt represented improvement on my paper. Later, when we were discussing the matter, he asked my honest opinion about the relative validity of the two models. I maintained that it depended on one’s assumptions, suggesting there were no right or wrong answers. In any event, I told him that citing unpublished work like the Israeli student’s dissertation in his bibliography would weaken his own dissertation’s credibility.
In anticipation of finishing his degree, Paul attended the industry’s annual meeting to interview for academic jobs. He received a positive response from representatives of the University of Michigan, visited the Ann Arbor campus for more interviews, and received the offer of an Assistant Professorship there.
When the day of Paul’s dissertation defense arrived, unbeknownst to me, in addition to the members of his committee, the Israeli graduate student and the Department Chairman showed up to criticize Paul’s work, so what I had expected to be a preemptory meeting did not proceed smoothly at all. In his defense, I argued that Paul was an asset to the Columbia program and already had accepted a job at Michigan, but, nonetheless, the committee voted to require major revisions to his dissertation, consisting mainly of adding relevant references to the Israeli graduate student’s unpublished dissertation, which Paul completed in a couple of days to get his degree.
Paul went on to submit 12 papers to the Journal of Finance which were all rejected. But after being denied tenure at Michigan, he joined the trading division of a commercial bank as the head of its quantitative research group, doing new product development and risk management for interest swap and derivative contracts, which is the realization of the product that he had originally proposed as the subject for his dissertation.
Larry Golden became a Full Professor at Columbia and later founded his own financial consulting company. Fred Brunswick never got a single paper accepted at a journal, but after being denied tenure at Columbia, he joined an investment banking firm and eventually became a billionaire as the developer of the market for index funds, based on the idea that in efficient markets, it is fruitless to try to invest in individual stocks to try to outperform the market.
The Israeli graduate student was denied a tenured position at Columbia and later got a job at someplace called the New York Institute of Technology, which, unlike its Massachusetts namesake, has no accomplished names on its faculty and is not known for being a challenging environment for its students. He never got any papers published from his dissertation, and he never got a real Finance job. The closest he ever got to the financial markets was to teach courses in Finance.
The Bell Journal article proved to be my only publication, so I never advanced beyond the rank of Associate Professor at Columbia. Eventually, I opted to leave the dead-end job. Still, I was regarded as a friendly face and was trusted and well-liked by the faculty and staff. Because of my pleasant style, no one ever suspected me of being defensive about the Israeli graduate student or dishonest and manipulative toward Paul.
But today there has been another development (new information, as we like to say in Finance.) I had been having terrible stomach aches the past few weeks, so I recently consulted a doctor about it to do some diagnostic tests, and I have just learned that I have cancer. I am told that I have no more than two years to live.
On the one hand, I can accept it – as I say, I have had a good life, enjoying the three score and ten years that the Bible promises, but on the other hand, I am having trouble coming to terms with my own mortality, that my being will soon become irrelevant (just like the economic logic of capital structure and dividend policy,) and I will continue to exist only in the memories of the people who knew me: my wife and children, my colleagues and students. I can only hope they will remember me kindly, that despite my advantages, I didn’t attain the successes that others did, and that the image of me that most people have is fundamentally false.
But let me not dwell on the negative. People respect my performance in my current job and the position is very lucrative, so with my accumulated earnings, my wife and children will be well provided for. I still feel a little guilty for my sins, but they are unknown to most people, so, in a relatively short amount of time, it won’t matter anyway.