How academic debate transformed into Wall Street wealth.

This is an exclusive, two-part excerpt from The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street which will be published tomorrow by Harper Business.

In the 1970s, the war between random walkers—theorists who believed that stock prices ultimately fit into the predictable pattern of a bell curve distribution—and professional investors began to settle into an uneasy but profitable truce. Hostilities still flared up from time to time, as on a mid-decade summer morning at Stanford Business School. On the first day of a weeklong seminar for money managers, a young accounting professor just arrived from Chicago kicked things off with a ferocious attack on the idea that anybody could beat the market.

By afternoon the money men were openly grumbling. Some threatened to leave. But they ended up sticking around—they didn't want to be insulted, but they wanted advice. The stock market decline of 1973 and 1974 had been, in inflation-adjusted terms, worse than that of 1929 and 1930. It left Wall Streeters poorer, less confident, and far more willing to listen to new ideas.

At the same time, the investment business was in the midst of a transformation that made it especially receptive to the advice that the professors had to offer. Stock holdings had begun to migrate in the 1950s from individual portfolios to institutionally managed ones.

Early on, mutual funds were the main drivers of this change, but in the 1970s—as stock mutual funds struggled—another group of institutions came to the fore. These were pension funds, first used as a way to circumvent postwar wage and price controls by giving workers benefits that weren't counted as wages, and soon to become part of the social contract between large corporations and their workers. With General Motors leading the way, America's big companies began setting aside money and investing it to pay for future pension benefits. Together with foundations and university endowments, the pension funds had come to constitute a huge new pool of institutional money by the late 1960s.

The people in charge of this money seldom picked the stocks and bonds in their portfolios for themselves. In the early days they left the job to bank trust departments or insurance companies. Then, starting in the 1960s, a new breed of independent money managers began to bid for their business. As middlemen, the pension and endowment chiefs who hired these asset managers tended to focus less on the return end of the operation than on the risk. They followed the 150-year-old "Prudent Man" rule, a legal doctrine that instructed trustees of others' money to "observe how men of prudence, discretion, and intelligence manage their own affairs" and conduct themselves accordingly.